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DYADIC INTERNATIONAL INC
2019-03-27
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 financial statements and the notes to those statements appearing in this Annual Report. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks, assumptions and uncertainties. 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 include, but not limited to those set forth in “Item 1A. Risk Factors” in this Annual Report. All forward-looking statements included in this Annual Report are based on information available to us as of the time we file this Annual Report and, except as required by law, we undertake no obligation to update publicly or revise any forward-looking statements. Overview Description of Business Dyadic International, Inc. (“Dyadic”, “we”, or the “Company”) is a global biotechnology platform company based in Jupiter, Florida with operations in the United States, a satellite office in the Netherlands and research organizations performing services under contract to Dyadic in Finland and Spain. Over the past two decades, the Company has developed a gene expression platform for producing commercial quantities of industrial enzymes and other proteins, and has previously licensed this technology to third parties, such as Abengoa Bioenergy, BASF, Codexis and others, for use in industrial (non-pharmaceutical) applications. This technology is based on the Myceliophthora thermophila fungus, which the Company named C1. The C1 technology is a robust and versatile fungal expression system for the development and production of enzymes and other proteins. On December 31, 2015, the Company sold its industrial technology business to DuPont Danisco (“DuPont”), the industrial biosciences business of DuPont (NYSE: DD) for $75.0 million (the “DuPont Transaction”). As part of the DuPont Transaction, Dyadic retained co-exclusive rights to the C1 technology for use in all human and animal pharmaceutical applications, and currently has the exclusive ability to enter into sub-license agreements (subject to the terms of the license and certain exceptions). DuPont retained certain rights to utilize the C1 technology in pharmaceutical applications, including the development and production of pharmaceutical products, for which it will be required to make royalty payments to Dyadic upon commercialization. In certain circumstances, Dyadic may owe a royalty to either DuPont or certain licensors of DuPont, depending upon whether Dyadic elects to utilize certain patents either owned by DuPont or licensed in by DuPont. After the DuPont Transaction, the Company has been focused on the biopharmaceutical industry, specifically in further improving and applying the proprietary C1 technology into a safe and efficient gene expression platform to help speed up the development, lower production costs and improve the performance of biologic vaccines and drugs at flexible commercial scales. We believe that the C1 technology could be beneficial in the development and manufacturing of human and animal vaccines (such as virus-like particles (VLPs) and antigens), monoclonal antibodies (mAbs), Bi-Specific antibodies, Fab antibody fragments, Fc-Fusion proteins, and other therapeutic enzymes and proteins. The Company is aiming to develop such products as innovative vaccines and drugs, biosimilars and/or biobetters. Additionally, in early 2018, we began to conduct certain funded research activities to further understand if, or how the C1 technology may be applied for use in developing and manufacturing certain metabolites. The initial data from this metabolite project, where the Phase I data milestone was achieved, demonstrated that C1 has the potential to be engineered to produce certain metabolites. In the first quarter of 2019, the Company initiated two new internal research projects, including engineering C1 to express adeno-associated viral vectors (AAV) which has been reported as expensive and in short supply. Critical Accounting Policies, Estimates, and Judgments The preparation of these consolidated financial statements in accordance with U.S. generally accepted accounting principles (“GAAP”) requires management to make estimates and judgments that affect the reported amount of assets and liabilities and related disclosure of contingent assets and liabilities at the date of our consolidated financial statements and the reported amounts of revenues and expenses during the applicable period. Actual results may differ from these estimates under different assumptions or conditions. Such differences could be material to the consolidated financial statements. We define critical accounting policies as those that are reflective of significant judgments and uncertainties and which may potentially result in materially different results under different assumptions and conditions. In applying these critical accounting policies, our management uses its judgment to determine the appropriate assumptions to be used in making certain estimates. These estimates are subject to an inherent degree of uncertainty. Our critical accounting policies include the following: Revenue Recognition The Company has no pharmaceutical products approved for sale at this point, and all of our revenue to date has been research revenue from third party collaborations and government grants. The Company may generate future revenue from license agreements and collaborative arrangements, which may include upfront payments for licenses or options to obtain a license, payment for research and development services, milestone payments, and royalties. The Company typically performs research and development services as specified in each respective agreement on a best efforts basis, and recognizes revenue from research funding under collaboration agreements in accordance with the 5-step process outlined in Topic 606: (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. We recognize revenue when we satisfy a performance obligation by transferring control of the service to a customer in an amount that reflects the consideration that we expect to receive. Since the performance obligation under our collaboration agreements is generally satisfied over time, we elected to use the input method under Topic 606 to measure the progress toward complete satisfaction of a performance obligation. Under the input methods, revenue will be recognized on the basis of the entity’s efforts or inputs to the satisfaction of a performance obligation (e.g., resources consumed, labor hours expended, costs incurred, or time elapsed) relative to the total expected inputs to the satisfaction of that performance obligation. The Company believes that the cost-based input method is the best measure of progress to reflect how the Company transfers its performance obligation to a customer. In applying the cost-based input method of revenue recognition, the Company uses actual costs incurred relative to budgeted costs to fulfill the performance obligation. These costs consist primarily of full-time equivalent effort and third-party contract costs. Revenue will be recognized based on actual costs incurred as a percentage of total budgeted costs as the Company completes its performance obligations. A cost-based input method of revenue recognition requires management to make estimates of costs to complete the Company’s performance obligations. In making such estimates, significant judgment is required to evaluate assumptions related to cost estimates. The cumulative effect of revisions to estimated costs to complete the Company’s performance obligations will be recorded in the period in which changes are identified and amounts can be reasonably estimated. A significant change in these assumptions and estimates could have a material impact on the timing and amount of revenue recognized in future periods. We invoice customers based on our contractual arrangements with each customer, which may not be consistent with the period that revenues are recognized. When there is a timing difference between when we invoice customers and when revenues are recognized, we record either a contract asset (unbilled accounts receivable) or a contract liability (deferred research and development obligations), as appropriate. The Company adopted the following practical expedients and exemptions: We generally expense sales commissions when incurred because the amortization period would be one year or less. We do not disclose the value of unsatisfied performance obligations for (i) contracts with an original expected length of one year or less and (ii) contracts for which we recognize revenue at the amount to which we have the right to invoice for services performed. Provision for Contract Losses The Company assesses the profitability of our collaboration agreements to provide research services to our contracted business partners and identifies those contracts where current operating results or forecasts indicate probable future losses. If the anticipated contract cost exceeds the anticipated contract revenue, a provision for the entire estimated loss on the contract is recorded and then accreted into the statement of operations over the remaining term of the contract. The provision for contract losses is based on judgment and estimates, including revenues and costs, where applicable, the consideration of our business partners’ reimbursement, and when such loss is deemed probable to occur and is reasonable to estimate. Accrued Research and Development Expenses In order to properly record services that have been rendered but not yet billed to the Company, we review open contracts and purchase orders, communicate with our personnel and we estimate 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 or quarterly 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 consolidated 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. Examples of accrued research and development expenses include amounts owed to contract research organizations, to service providers in connection with commercialization and development activities. Stock-Based Compensation We have granted stock options and restricted stock to employees, directors and consultants. The fair value of each option award is estimated on the date of grant using the Black-Scholes option-pricing model. The Black-Scholes model considers volatility in the price of our stock, the risk-free interest rate, the estimated life of the option, the closing market price of our stock and the exercise price. For purposes of the calculation, we assumed that no dividends would be paid during the life of the options and restricted stock and applied a discount to reflect the lack of marketability due to the holding period restriction of its shares under Rule 144. We also used the weighted-average vesting period and contractual term of the option as the best estimate of the expected life of a new option (except for our CEO which is 5 years). The Company performs a review of assumptions used in the Black-Scholes option-pricing model on an annual basis. During the Company’s annual review of its volatility assumption in 2018, the Company determined that it would be appropriate to use the Company’s historical volatilities since 2016, as the DuPont Transaction resulted in significant changes in the Company’s business and capital structure. The change in assumption is effective January 1, 2018 and only impacts new options granted in 2018. The estimates utilized in the Black-Scholes calculation involve inherent uncertainties and the application of management judgment. These estimates are neither predictive nor indicative of the future performance of our stock. As a result, if other assumptions had been used, our recorded share-based compensation expense could have been materially different from that reported. In addition, because some of the options and restricted stock issued to employees, consultants and other third-parties vest upon the achievement of certain milestones, the total ultimate expense of share-based compensation is uncertain. In connection with board member and employee terminations, the Company may modify certain terms to outstanding share-based awards. We have recorded charges related to these modifications based on the estimated fair value of the share-based options immediately prior to and immediately after the modification occurs, with any incremental value being charged to expense. We have used the Black-Scholes pricing model in this valuation process, and this requires management to use various assumptions and estimates. Future modifications to share-based compensation transactions may result in significant expenses being recorded in our consolidated financial statements. Accounting for Income Taxes The Company accounts for income taxes under the asset and liability method in accordance with ASC Topic 740, “Income Taxes”. Under this method, income tax expense /(benefit) is recognized for: (i) taxes payable or refundable for the current year and (ii) deferred tax consequences of temporary differences resulting from matters that have been recognized in an entity’s financial statements or tax returns. 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. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the results of operations in the period that includes the enactment date. A valuation allowance is provided to reduce the deferred tax assets reported if based on the weight of the available positive and negative evidence, it is more likely than not some portion or all the deferred tax assets will not be realized. In determining taxable income for the Company’s consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process requires the Company to make certain estimates of our actual current tax exposure and assessment of temporary differences between the tax and financial statement recognition of revenue and expense. In evaluating the Company’s ability to recover its deferred tax assets, the Company must consider all available positive and negative evidence including its past operating results, the existence of cumulative losses in the most recent years and its forecast of future taxable income. Significant management judgment is required in determining our provision for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. The Company is required to evaluate the provisions of ASC 740 related to the accounting for uncertainty in income taxes recognized in a company’s financial statements. ASC 740 prescribes a comprehensive model for how a company should recognize, present, and disclose uncertain positions that the company has taken or expects to take in its tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. Differences between tax positions taken or expected to be taken in a tax return and the net benefit recognized and measured pursuant to the interpretation are referred to as “unrecognized benefits.” A liability should be recognized (or amount of net operating loss carry forward or amount of tax refundable is reduced) for unrecognized tax benefit because it represents a company’s potential future obligation to the taxing authority for a tax position that was not recognized because of applying the provision of ASC 740. The Tax Cuts and Jobs Act (the “TCJA”) was enacted on December 22, 2017 and is effective January 1, 2018. The new legislation includes, among other things a reduction of the U.S. Federal corporate income tax rate from 35% to 21%, and a change to alternative minimum taxes. The TCJA eliminated the corporate Alternative Minimum Tax (AMT) and permits existing AMT credit carryforwards to be used to reduce the regular tax obligation in 2018, 2019, and 2020. Any AMT credit carryforwards that do not reduce regular taxes are eligible for a 50% refund in 2018 through 2020, and a 100% refund in 2021. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements. Recent Accounting Pronouncements See Note 1 to the Consolidated Financial Statements for information about recent accounting pronouncements. Results of Operations Year Ended December 31, 2018 Compared to the Year End December 31, 2017 Revenue, Cost of Revenue, and Provision for Contract Losses The following table summarizes the Company’s revenue, cost of research and development revenue and provision for contract losses for the years ended December 31, 2018 and 2017: The changes in revenue and cost of research and development revenue reflect two research collaborations completed in 2017 and five new research collaborations started in 2018. The provision for contract losses recorded in 2017 was associated with the Company's extended involvement in the ZAPI program. Research and Development Expenses Research and development costs are expensed as incurred and primarily include salary and benefits of research personnel, third-party contract research organization services and supply costs. Research and development expenses for the year ended December 31, 2018 increased to approximately $2,102,000 compared to $1,765,000 for the year ended December 31, 2017. The increase primarily reflects the costs of additional internal research activities with third-party contract research organizations. Research and development expenses - related party, for the year ended December 31, 2018, increased to approximately $1,216,000 compared to $438,000 for the year ended December 31, 2017. The increase reflects the research and development costs related to the Company’s R&D Agreements with BDI, which started in July 2017. General and Administrative Expenses General and administrative expenses for the year ended December 31, 2018, decreased 10.1% to approximately $4,523,000 compared to $5,030,000 for the year ended December 31, 2017. The decrease primarily reflects reductions in litigation costs of $541,000, legal costs of $236,000 and share-based compensation expenses of $158,000, partially offset by increases in business development and investor relationship costs of $217,000, and SEC registration related costs of $215,000. Foreign Currency Exchange Loss (Gain) Foreign currency exchange loss for the year ended December 31, 2018, was approximately $21,000 compared to a gain of $249,000 for the year ended December 31, 2017. The change reflects the reduction in cash balance carried in Euro and the currency fluctuation of the Euro in comparison to the U.S. dollar. Interest Income Interest income for the year ended December 31, 2018, increased 58.1% to approximately $895,000 compared to $566,000 for the year ended December 31, 2017. The increase in interest income reflects higher yield on the Company’s investment grade securities, which are classified as held-to-maturity. Income Taxes The Company had net operating loss (“NOL”) carryforwards available in 2018 that will begin to expire in 2036. As of December 31, 2018, and 2017, the Company had NOLs in the amount of approximately $9.1 million and $2.9 million, respectively. For the year ended December 31, 2018, the Company’s current income tax benefit of $1.0 million was generated from the corporate alternative minimum tax credit refund under the Tax Cuts and Jobs Act. The Company expects to receive a 50% refund in 2018 through 2020, and a 100% refund in 2021. Net Loss Net loss for the year ended December 31, 2018 was approximately $5.7 million compared to a net loss of $2.1 million for the year ended December 31, 2017. The change was primarily due to the receipt of a litigation settlement of $4.4 million in 2017. Liquidity and Capital Resources Our primary source of cash has been the cash received from the DuPont Transaction in December 2015, interest income received from investment grade securities, and funding from our research collaboration agreements. In 2017, the Company’s liquidity was further improved with the receipt of a litigation settlement of approximately $4.4 million, net of legal fees and other payments, and the release of escrowed funds from the DuPont Transaction of approximately $7.4 million. The Company completed its 2016 Stock Repurchase Program in February 2017. On August 16, 2017, the Board of Directors authorized the 2017 Stock Repurchase Program, under which the Company may repurchase up to $5 million of its outstanding common stock. On August 6, 2018, the Board of Directors authorized an extension of the 2017 Stock Repurchase Program through August 15, 2019. The Company financed the 2017 Stock Repurchase Program from its existing cash on hand. As of December 31, 2018, the Company has repurchased a total of 14,390,254 shares of its common stock at a weighted average price of $1.52 for an aggregate purchase price of $21,814,530. Our ability to achieve profitability depends on a number of factors, including our scientific results and our ability to continue to obtain funded research and development collaborations from industry and government programs, as well as sublicense agreements. We may continue to incur substantial operating losses even if we begin to generate revenues from research and development and licensing. Our primary future cash needs are expected to be for general operating activities including additional costs and expenses as an SEC reporting company and a potential uplisting to a national exchange, and our business development and research and development expenses. We believe that our existing cash position and investments in investment grade securities will be adequate to meet our operational, business, and other liquidity requirements for the next twelve months. At December 31, 2018, cash and cash equivalents were approximately $2.4 million compared to $5.8 million at December 31, 2017. The carrying value of investment grade securities, including accrued interest at December 31, 2018 was $39.1 million compared to $43.3 million at December 31, 2017. Net cash used in operating activities for the year ended December 31, 2018 of approximately $4.4 million resulted from a net loss of $5.7 million, offset by share-based compensation expense of $0.5 million, amortization of premium and discount on held-to-maturity securities of $0.7 million, BDI research and development activities of approximately $0.9 million and changes in other operating assets and liabilities of $0.8 million. Net cash used in operating activities for the year ended December 31, 2017 of approximately $1.7 million was principally attributable to a net loss of approximately $2.1 million, BDI research and development activities of approximately $1.2 million, foreign currency exchange gain of approximately $0.2 million, amortization of contract losses of approximately $0.2 million, partially offset by stock based compensation expense of approximately $0.6 million, changes in other operating assets and liabilities of approximately $0.3 million, and net amortization of premium on held-to-maturity securities of approximately $1.1 million. Net cash provided by investing activities for the year ended December 31, 2018 was approximately $3.3 million compared to net cash used in investing activities of $0.1 million for the year ended December 31, 2017. Cash flows from investing activities in 2018 and 2017 was primarily related to proceeds from maturities, net of purchases of investment grade debt securities. Net cash used in financing activities for the year ended December 31, 2018 was approximately $2.3million compared to $6.2 million for the year ended December 31, 2017. Cash flows used in financing activities in 2018 and 2017 were primarily related to repurchases of common stock.
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<s>[INST] The following discussion and analysis of financial condition and results of operations should be read in conjunction with the financial statements and the notes to those statements appearing in this Annual Report. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report, including information with respect to our plans and strategy for our business, includes forwardlooking statements that involve risks, assumptions and uncertainties. Important factors that could cause actual results to differ materially from the results described in or implied by the forwardlooking statements contained in the following discussion and analysis include, but not limited to those set forth in “Item 1A. Risk Factors” in this Annual Report. All forwardlooking statements included in this Annual Report are based on information available to us as of the time we file this Annual Report and, except as required by law, we undertake no obligation to update publicly or revise any forwardlooking statements. Overview Description of Business Dyadic International, Inc. (“Dyadic”, “we”, or the “Company”) is a global biotechnology platform company based in Jupiter, Florida with operations in the United States, a satellite office in the Netherlands and research organizations performing services under contract to Dyadic in Finland and Spain. Over the past two decades, the Company has developed a gene expression platform for producing commercial quantities of industrial enzymes and other proteins, and has previously licensed this technology to third parties, such as Abengoa Bioenergy, BASF, Codexis and others, for use in industrial (nonpharmaceutical) applications. This technology is based on the Myceliophthora thermophila fungus, which the Company named C1. The C1 technology is a robust and versatile fungal expression system for the development and production of enzymes and other proteins. On December 31, 2015, the Company sold its industrial technology business to DuPont Danisco (“DuPont”), the industrial biosciences business of DuPont (NYSE: DD) for $75.0 million (the “DuPont Transaction”). As part of the DuPont Transaction, Dyadic retained coexclusive rights to the C1 technology for use in all human and animal pharmaceutical applications, and currently has the exclusive ability to enter into sublicense agreements (subject to the terms of the license and certain exceptions). DuPont retained certain rights to utilize the C1 technology in pharmaceutical applications, including the development and production of pharmaceutical products, for which it will be required to make royalty payments to Dyadic upon commercialization. In certain circumstances, Dyadic may owe a royalty to either DuPont or certain licensors of DuPont, depending upon whether Dyadic elects to utilize certain patents either owned by DuPont or licensed in by DuPont. After the DuPont Transaction, the Company has been focused on the biopharmaceutical industry, specifically in further improving and applying the proprietary C1 technology into a safe and efficient gene expression platform to help speed up the development, lower production costs and improve the performance of biologic vaccines and drugs at flexible commercial scales. We believe that the C1 technology could be beneficial in the development and manufacturing of human and animal vaccines (such as viruslike particles (VLPs) and antigens), monoclonal antibodies (mAbs), BiSpecific antibodies, Fab antibody fragments, FcFusion proteins, and other therapeutic enzymes and proteins. The Company is aiming to develop such products as innovative vaccines and drugs, biosimilars and/or biobetters. Additionally, in early 2018, we began to conduct certain funded research activities to further understand if, or how the C1 technology may be applied for use in developing and manufacturing certain metabolites. The initial data from this metabolite project, where the Phase I data milestone was achieved, demonstrated that C1 has the potential to be engineered to produce certain metabolites. In the first quarter of 2019, the Company initiated two new internal research projects, including engineering C1 to express adenoassociated viral vectors (AAV) which has been reported as expensive and in short supply. Critical Accounting Policies, Estimates, and Judgments The preparation of these consolidated financial statements in accordance with U.S. generally accepted accounting principles (“GAAP” [/INST] Positive. </s>
2,019
3,755
1,213,809
DYADIC INTERNATIONAL INC
2020-03-30
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 financial statements and the notes to those statements appearing in this Annual Report. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks, assumptions and uncertainties. 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 include, but not limited to those set forth in “Item 1A. Risk Factors” in this Annual Report. All forward-looking statements included in this Annual Report are based on information available to us as of the time we file this Annual Report and, except as required by law, we undertake no obligation to update publicly or revise any forward-looking statements. Overview Description of Business Dyadic International, Inc. (“Dyadic”, “we”, “us”, “our” or the “Company”) is a global biotechnology platform company based in Jupiter, Florida with operations in the United States, a satellite office in the Netherlands and currently two research organizations performing services under contract to Dyadic in Finland and Spain. Over the past two decades, the Company has developed a gene expression platform for producing commercial quantities of industrial enzymes and other proteins, and has previously licensed this technology to third parties, such as Abengoa Bioenergy, BASF, Codexis and others, for use in industrial (non-pharmaceutical) applications. This technology is based on the Thermothelomyces heterothallica (formerly Myceliophthora thermophila) fungus, which the Company named C1. The C1 technology is a robust and versatile fungal expression system for the development and production of enzymes and other proteins. On December 31, 2015, the Company sold its industrial technology business to DuPont Danisco (“DuPont”), the industrial biosciences business of DuPont (NYSE: DD) for $75.0 million (the “DuPont Transaction”). As part of the DuPont Transaction, Dyadic retained co-exclusive rights to the C1 technology for use in all human and animal pharmaceutical applications, and currently has the exclusive ability to enter into sub-license agreements (subject to the terms of the license and certain exceptions). DuPont retained certain rights to utilize the C1 technology in pharmaceutical applications, including the development and production of pharmaceutical products, for which it will be required to make royalty payments to Dyadic upon commercialization. In certain circumstances, Dyadic may owe a royalty to either DuPont or certain licensors of DuPont, depending upon whether Dyadic elects to utilize certain patents either owned by DuPont or licensed in by DuPont. After the DuPont Transaction, the Company has been focused on the biopharmaceutical industry, specifically in further improving and applying the proprietary C1 technology into a safe and efficient gene expression platform to help speed up the development, lower production costs and improve the performance of biologic vaccines and drugs at flexible commercial scales. We believe that the C1 technology could be beneficial in the development and manufacturing of human and animal vaccines and drugs, such as virus-like particles (VLPs), protein antigens, monoclonal antibodies (mAbs), Bi-Specific antibodies, Fab antibody fragments, Fc-Fusion proteins, as well as other therapeutic enzymes and proteins. The Company is aiming to develop products such as innovative vaccines and drugs, biosimilars and/or biobetters. Critical Accounting Policies, Estimates, and Judgments The preparation of these consolidated financial statements in accordance with U.S. generally accepted accounting principles (“GAAP”) requires management to make estimates and judgments that affect the reported amount of assets and liabilities and related disclosure of contingent assets and liabilities at the date of our consolidated financial statements and the reported amounts of revenues and expenses during the applicable period. Actual results may differ from these estimates under different assumptions or conditions. Such differences could be material to the consolidated financial statements. We define critical accounting policies as those that are reflective of significant judgments and uncertainties and which may potentially result in materially different results under different assumptions and conditions. In applying these critical accounting policies, our management uses its judgment to determine the appropriate assumptions to be used in making certain estimates. These estimates are subject to an inherent degree of uncertainty. Our critical accounting policies include the following: Revenue Recognition The Company has no pharmaceutical products approved for sale at this point, and all of our revenue to date has been research revenue from third-party collaborations and government grants. The Company is expected to generate future revenue from license agreements and collaborative arrangements, which may include upfront payments for licenses or options to obtain a license, payment for research and development services and milestone payments, in the form of cash or non-cash consideration. Revenue related to research collaborations and agreements: The Company typically performs research and development services as specified in each respective agreement on a best efforts basis, and recognizes revenue from research funding under collaboration agreements in accordance with the 5-step process outlined in ASC Topic 606 (“Topic 606”): (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. We recognize revenue when we satisfy a performance obligation by transferring control of the service to a customer in an amount that reflects the consideration that we expect to receive. Since the performance obligation under our collaboration agreements is generally satisfied over time, we elected to use the input method under Topic 606 to measure the progress toward complete satisfaction of a performance obligation. Under the input method, revenue will be recognized on the basis of the entity’s efforts or inputs to the satisfaction of a performance obligation (e.g., resources consumed, labor hours expended, costs incurred, or time elapsed) relative to the total expected inputs to the satisfaction of that performance obligation. The Company believes that the cost-based input method is the best measure of progress to reflect how the Company transfers its performance obligation to a customer. In applying the cost-based input method of revenue recognition, the Company uses actual costs incurred relative to budgeted costs to fulfill the performance obligation. These costs consist primarily of full-time equivalent effort and third-party contract costs. Revenue will be recognized based on actual costs incurred as a percentage of total budgeted costs as the Company completes its performance obligations. A cost-based input method of revenue recognition requires management to make estimates of costs to complete the Company’s performance obligations. In making such estimates, significant judgment is required to evaluate assumptions related to cost estimates. The cumulative effect of revisions to estimated costs to complete the Company’s performance obligations will be recorded in the period in which changes are identified and amounts can be reasonably estimated. A significant change in these assumptions and estimates could have a material impact on the timing and amount of revenue recognized in future periods. Revenue related to sublicensing agreements: If the sublicense to the Company’s intellectual property is determined to be distinct from the other performance obligations identified in the arrangement, the Company recognizes revenue allocated to the license when technology is transferred to the customer and the customer is able to use and benefit from the license. Milestone payments: At the inception of each arrangement that includes development, commercialization, and regulatory milestone payments, the Company evaluates whether the achievement of the milestones is considered probable and estimates the amount to be included in the transaction price. If the milestone payment is in exchange for a sublicense and is based on the sublicensee’s subsequent sale of product, the Company recognizes milestone payment by applying the accounting guidance for royalties. To date, the Company has not recognized any milestone payment revenue resulting from any of its sublicensing arrangements. Royalties: With respect to licenses deemed to be the predominant item to which the sales-based royalties relate, including milestone payments based on the level of sales, the Company recognizes revenue at the later of (i) when the related sales occur or (ii) when the performance obligation to which some or all of the royalty has been allocated has been satisfied (or partially satisfied). To date, the Company has not recognized any royalty revenue resulting from any of its sublicensing arrangements. We invoice customers based on our contractual arrangements with each customer, which may not be consistent with the period that revenues are recognized. When there is a timing difference between when we invoice customers and when revenues are recognized, we record either a contract asset (unbilled accounts receivable) or a contract liability (deferred research and development obligations), as appropriate. If upfront fees or considerations related to sublicensing agreement are received prior to the technology transfer, the Company will record the amount received as deferred revenue from licensing agreement. We are not required to disclose the value of unsatisfied performance obligations for (i) contracts with an original expected length of one year or less and (ii) contracts for which we recognize revenue at the amount to which we have the right to invoice for services performed. The Company adopted a practical expedient to expense sales commissions when incurred because the amortization period would be one year or less. Accrued Research and Development Expenses In order to properly record services that have been rendered but not yet billed to the Company, we review open contracts and purchase orders, communicate with our personnel and we estimate 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 or quarterly 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 consolidated 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. Examples of accrued research and development expenses include amounts owed to contract research organizations, to service providers in connection with commercialization and development activities. Stock-Based Compensation We have granted stock options and restricted stock to employees, directors and consultants. The fair value of each option award is estimated on the date of grant using the Black-Scholes option-pricing model. The Black-Scholes model considers volatility in the price of our stock, the risk-free interest rate, the estimated life of the option, the closing market price of our stock and the exercise price. For purposes of the calculation, we assumed that no dividends would be paid during the life of the options and restricted stock and applied a discount to reflect the lack of marketability due to the holding period restriction of its shares under Rule 144 prior to the Company’s April 2019 uplisting to NASDAQ. We also used the weighted-average vesting period and contractual term of the option as the best estimate of the expected life of a new option (except for our CEO which is 5 years). The Company performs a review of assumptions used in the Black-Scholes option-pricing model on an annual basis. During the Company’s annual review of its volatility assumption in 2018 and 2019, the Company determined that it would be appropriate to use the Company’s historical volatility since 2016, as the DuPont Transaction resulted in significant changes in the Company’s business and capital structure. The change in assumption was effective January 1, 2018 and only impacts new options granted in 2018 and thereafter. The estimates utilized in the Black-Scholes calculation involve inherent uncertainties and the application of management judgment. These estimates are neither predictive nor indicative of the future performance of our stock. As a result, if other assumptions had been used, our recorded share-based compensation expense could have been materially different from that reported. In addition, because some of the options and restricted stock issued to employees, consultants and other third-parties vest upon the achievement of certain milestones, the total ultimate expense of share-based compensation is uncertain. In connection with board member and employee terminations, the Company may modify certain terms to outstanding share-based awards. We have recorded charges related to these modifications based on the estimated fair value of the share-based options immediately prior to and immediately after the modification occurs, with any incremental value being charged to expense. We have used the Black-Scholes pricing model in this valuation process, and this requires management to use various assumptions and estimates. Future modifications to share-based compensation transactions may result in significant expenses being recorded in our consolidated financial statements. Accounting for Income Taxes The Company accounts for income taxes under the asset and liability method in accordance with ASC Topic 740, “Income Taxes”. Under this method, income tax expense /(benefit) is recognized for: (i) taxes payable or refundable for the current year and (ii) deferred tax consequences of temporary differences resulting from matters that have been recognized in an entity’s financial statements or tax returns. 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. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the results of operations in the period that includes the enactment date. A valuation allowance is provided to reduce the deferred tax assets reported if based on the weight of the available positive and negative evidence, it is more likely than not some portion or all the deferred tax assets will not be realized. In determining taxable income for the Company’s consolidated financial statements, we are required to estimate income taxes in each of the jurisdictions in which we operate. This process requires the Company to make certain estimates of our actual current tax exposure and assessment of temporary differences between the tax and financial statement recognition of revenue and expense. In evaluating the Company’s ability to recover its deferred tax assets, the Company must consider all available positive and negative evidence including its past operating results, the existence of cumulative losses in the most recent years and its forecast of future taxable income. Significant management judgment is required in determining our provision for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. The Company is required to evaluate the provisions of ASC 740 related to the accounting for uncertainty in income taxes recognized in a company’s financial statements. ASC 740 prescribes a comprehensive model for how a company should recognize, present, and disclose uncertain positions that the company has taken or expects to take in its tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. Differences between tax positions taken or expected to be taken in a tax return and the net benefit recognized and measured pursuant to the interpretation are referred to as “unrecognized benefits.” A liability should be recognized (or amount of net operating loss carry forward or amount of tax refundable is reduced) for unrecognized tax benefits, because it represents a company’s potential future obligation to the taxing authority for a tax position that was not recognized as a result of applying the provision of ASC 740. The Company classifies accrued interest and penalties related to its tax positions as a component of income tax expense. The Company currently is not subject to U.S. federal, state and local tax examinations by tax authorities for the years before 2014.The United States Internal Revenue Service (the “IRS”) completed its review of the Company’s 2015 tax filing on October 17, 2017, and no changes were required. See Note 4 to the Consolidated Financial Statements in Section for further information on the examination of the Company’s 2016 tax return. 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 market participants at the measurement date. The Company utilized various methods, including income, cost and market approaches to determine the fair value of its investments in equity interest, which may fall into Level 3 of the fair value hierarchy because of the significant unobservable inputs utilized in these valuation approaches. These inputs can be readily observable, market corroborated, or generally unobservable inputs. The Company utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. Our key inputs included, but were not limited to, significant management judgments and estimates, including projections of the timing and amount of the project’s cash flows, determination of a discount rate for the income approach, market multipliers, probability weighting of potential outcomes of legal and regulatory proceedings, and weighting of the valuations produced by the income, cost and market approaches. The Company bases its fair value estimates on assumptions it believes to be reasonable, but which are unpredictable and inherently uncertain. Actual future results may differ from those estimates. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements. Recent Accounting Pronouncements See Note 1 to the Consolidated Financial Statements for information about recent accounting pronouncements. Results of Operations Year Ended December 31, 2019 Compared to the Year End December 31, 2018 Revenue and Cost of Revenue The following table summarizes the Company’s revenue and cost of research and development revenue for the years ended December 31, 2019 and 2018: The increases in revenue and cost of research and development revenue for the year ended December 31, 2019 reflect ten research collaborations compared to six research collaborations for the year ended December 31, 2018. Research and Development Expenses Research and development costs are expensed as incurred and primarily include salary and benefits of research personnel, third-party contract research organization services and supply costs. Research and development expenses for the year ended December 31, 2019 increased to approximately $3,088,000 compared to $2,102,000 for the year ended December 31, 2018. The increase primarily reflects the costs of additional internal research projects. Research and development expenses - related party, for the year ended December 31, 2019, decreased to approximately $869,000 compared to $1,216,000 for the year ended December 31, 2018. The decrease is primarily due to completion of a research service agreement with BDI in June 2019. General and Administrative Expenses General and administrative expenses for the year ended December 31, 2019, increased 22.0% to approximately $5,520,000 compared to $4,523,000 for the year ended December 31, 2018. The increase principally reflects increases in noncash share-based compensation expenses of $717,000 related to 2019 stock options awards and options vested upon the April 2019 uplisting to NASDAQ, business development and investor relations costs of $186,000, insurance costs of $138,000, and legal costs and NASDAQ uplisting expenses of $125,000, offset by reductions in executive compensation costs, including the separation of the Company’s former CFO, of $168,000, which was a one-time expense in 2018. Foreign Currency Exchange Foreign currency exchange loss for the year ended December 31, 2019, was approximately $28,000 compared to $21,000 for the year ended December 31, 2018. The increase reflects the currency fluctuation of the Euro in comparison to the U.S. dollar. Interest Income Interest income for the year ended December 31, 2019, increased 10.1% to approximately $985,000 compared to $895,000 for the year ended December 31, 2018. The increase reflects the higher yield on the Company’s investment grade securities, which are classified as held-to-maturity. Income Taxes The Company had net operating loss (“NOL”) carryforwards available in 2019 that will begin to expire in 2037. As of December 31, 2019, and 2018, the Company had NOLs in the amount of approximately $19.7 million and $9.1 million, respectively. For the year ended December 31, 2018, the Company’s current income tax benefit of $1.0 million was generated from the corporate Alternative Minimum Tax credit refund resulting from the Tax Cuts and Jobs Act (“TCJA”). Net Loss Net loss for the year ended December 31, 2019 was approximately $8.3 million compared to a net loss of $5.7 million for the year ended December 31, 2018. The change was primarily due to increases in general and administrative expenses of approximately $1.0 million, research and development expenses of approximately $0.6 million, and the prior year income tax benefit from the corporate Alternative Minimum Tax credit refund of approximately $1.0 million. Liquidity and Capital Resources Our primary source of cash has been the cash received from the DuPont Transaction in December 2015, interest income received from investment grade securities, and funding from our research collaboration agreements. Between January 2016 and August 2018, the Company repurchased a total of 14,390,254 shares of its common stock from its existing cash on hand, for an aggregate purchase price of $21,814,530 at a weighted average price of $1.52 per share. As of December 31, 2019, our investment balance includes $29.7 million short-term investments with contractual maturities of twelve (12) months of less, including interest receivable, and $1.5 million long-term investments with contractual maturities beyond twelve (12) months. In June 2019, the Company’s liquidity was further improved with the receipt of approximately $0.5 million tax refund resulting from the elimination of corporate Alternative Minimum Tax (AMT) under the TCJA. An additional $0.5 million AMT tax refund is expected to be received through 2021. Our ability to achieve profitability depends on a number of factors, including our scientific results and our ability to continue to obtain funded research and development collaborations from industry and government programs, as well as sub-license agreements. We may continue to incur substantial operating losses even if we begin to generate revenues from research and development and licensing. Our primary future cash needs are expected to be for general operating activities, including our business development and research expenses, as well as additional costs as an SEC reporting and NASDAQ listed company. We believe that our existing cash position and investments in short-term and long-term investment grade securities will be adequate to meet our operational, business, and other liquidity requirements for at least the next twelve (12) months. At December 31, 2019, cash and cash equivalents were approximately $4.8 million compared to $2.4 million at December 31, 2018. The carrying value of investment grade securities, including accrued interest at December 31, 2019 was $31.2 million compared to $39.1 million at December 31, 2018. Net cash used in operating activities for the year ended December 31, 2019 of approximately $5.8 million resulted from a net loss of $8.3 million, offset by share-based compensation expense of $1.2 million, amortization of held-to-maturity securities of $0.2 million, BDI research and development activities of $0.3 million and changes in other operating assets and liabilities of $0.8 million. Net cash used in operating activities for the year ended December 31, 2018 of approximately $4.4 million resulted from a net loss of $5.7 million, and changes in other operating assets and liabilities of $0.8 million, offset by stock based compensation expense of $0.5 million, amortization of held-to-maturity securities of $0.7 million, and BDI research and development activities of $0.9 million. Net cash provided by investing activities for the year ended December 31, 2019 was approximately $7.7 million compared to $3.3 million for the year ended December 31, 2018. Cash flows from investing activities in 2019 and 2018 was primarily related to proceeds from maturities, net of purchases of investment grade debt securities. Net cash provided in financing activities for the year ended December 31, 2019 was approximately $0.6 million compared to net cash used in financing activities of $2.3 million for the year ended December 31, 2018. Cash flows provided in financing activities in 2019 were primarily related to proceeds received from the exercise of stock options. Cash flows used in in financing activities in 2018 were primarily related to repurchases of our common stock.
0.133188
0.133524
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<s>[INST] Overview Description of Business Dyadic International, Inc. (“Dyadic”, “we”, “us”, “our” or the “Company”) is a global biotechnology platform company based in Jupiter, Florida with operations in the United States, a satellite office in the Netherlands and currently two research organizations performing services under contract to Dyadic in Finland and Spain. Over the past two decades, the Company has developed a gene expression platform for producing commercial quantities of industrial enzymes and other proteins, and has previously licensed this technology to third parties, such as Abengoa Bioenergy, BASF, Codexis and others, for use in industrial (nonpharmaceutical) applications. This technology is based on the Thermothelomyces heterothallica (formerly Myceliophthora thermophila) fungus, which the Company named C1. The C1 technology is a robust and versatile fungal expression system for the development and production of enzymes and other proteins. On December 31, 2015, the Company sold its industrial technology business to DuPont Danisco (“DuPont”), the industrial biosciences business of DuPont (NYSE: DD) for $75.0 million (the “DuPont Transaction”). As part of the DuPont Transaction, Dyadic retained coexclusive rights to the C1 technology for use in all human and animal pharmaceutical applications, and currently has the exclusive ability to enter into sublicense agreements (subject to the terms of the license and certain exceptions). DuPont retained certain rights to utilize the C1 technology in pharmaceutical applications, including the development and production of pharmaceutical products, for which it will be required to make royalty payments to Dyadic upon commercialization. In certain circumstances, Dyadic may owe a royalty to either DuPont or certain licensors of DuPont, depending upon whether Dyadic elects to utilize certain patents either owned by DuPont or licensed in by DuPont. After the DuPont Transaction, the Company has been focused on the biopharmaceutical industry, specifically in further improving and applying the proprietary C1 technology into a safe and efficient gene expression platform to help speed up the development, lower production costs and improve the performance of biologic vaccines and drugs at flexible commercial scales. We believe that the C1 technology could be beneficial in the development and manufacturing of human and animal vaccines and drugs, such as viruslike particles (VLPs), protein antigens, monoclonal antibodies (mAbs), BiSpecific antibodies, Fab antibody fragments, FcFusion proteins, as well as other therapeutic enzymes and proteins. The Company is aiming to develop products such as innovative vaccines and drugs, biosimilars and/or biobetters. Critical Accounting Policies, Estimates, and Judgments The preparation of these consolidated financial statements in accordance with U.S. generally accepted accounting principles (“GAAP”) requires management to make estimates and judgments that affect the reported amount of assets and liabilities and related disclosure of contingent assets and liabilities at the date of our consolidated financial statements and the reported amounts of revenues and expenses during the applicable period. Actual results may differ from these estimates under different assumptions or conditions. Such differences could be material to the consolidated financial statements. We define critical accounting policies as those that are reflective of significant judgments and uncertainties and which may potentially result in materially different results under different assumptions and conditions. In applying these critical accounting policies, our management uses its judgment to determine the appropriate assumptions to be used in making certain estimates. These estimates are subject to an inherent degree of uncertainty. Our critical accounting policies include the following: Revenue Recognition The Company has no pharmaceutical products approved for sale at this point, and all of our revenue to date has been research revenue from thirdparty collaborations and government grants. The Company is expected to generate future revenue from license agreements and collaborative arrangements, which may include upfront payments for licenses or options to obtain a license, payment for research and development services and milestone payments, in the form of cash or noncash consideration. Revenue related to research collaborations and agreements: The Company typically performs research and development services as specified in each respective agreement [/INST] Positive. </s>
2,020
3,989
1,727,263
frontdoor, inc.
2019-02-28
2018-12-31
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS  The following information should be read in conjunction with “Item 6. Selected Financial Data” and the audited consolidated and combined financial statements and related notes thereto included in Item 8 of this Annual Report on Form 10-K. The following discussion may contain forward-looking statements that reflect our plans, estimates and beliefs. The cautionary statements discussed in “Cautionary Statement Concerning Forward-Looking Statements” and elsewhere in this Annual Report on Form 10-K should be read as applying to all forward-looking statements wherever they appear in this Annual Report on Form 10-K. 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 Annual Report on Form 10-K, particularly in “Cautionary Statement Concerning Forward-Looking Statements” and “Risk Factors” included in Item 1A of this Annual Report on Form 10-K.  Overview  Frontdoor is the largest provider of home service plans in the United States, as measured by revenue, and operates under the American Home Shield, HSA, OneGuard and Landmark brands. Our home service plans help our customers maintain their homes and protect against costly and unexpected breakdowns of essential home systems and appliances. Our home service plan customers subscribe to a yearly service plan agreement that covers the repair or replacement of major components of up to 21 home systems and appliances, including electrical, plumbing, central HVAC systems, water heaters, refrigerators, dishwashers and ranges/ovens/cooktops. We serve over two million customers annually across all 50 states and the District of Columbia.  For the year ended December 31, 2018, we generated revenue, net income and Adjusted EBITDA of $1,258 million, $125 million, and $238 million, respectively. For the year ended December 31, 2017, we generated revenue, net income and Adjusted EBITDA of $1,157 million, $160 million, and $259 million, respectively. For the year ended December 31, 2016, we generated revenue, net income and Adjusted EBITDA of $1,020 million, $124 million, and $218 million, respectively.  For the year ended December 31, 2018, our total operating revenue included 66 percent of revenue derived from existing customer renewals, while 21 percent and 12 percent were derived from new unit sales made in conjunction with existing home resale transactions and direct-to-consumer sales, respectively, and one percent was derived from other revenue streams, principally cancellation fees. For the year ended December 31, 2017, our total operating revenue included 66 percent of revenue derived from existing customer renewals, while 22 percent and 12 percent were derived from new unit sales made in conjunction with existing home resale transactions and direct-to-consumer sales, respectively. For the year ended December 31, 2016, our total operating revenue included 66 percent of revenue derived from existing customer renewals, while 20 percent and 14 percent were derived from new unit sales made in conjunction with existing home resale transactions and direct-to-consumer sales, respectively.  The Spin-off  On July 26, 2017, ServiceMaster announced its intention to effectuate the Spin-off. The audited consolidated and combined financial statements included in Item 8 of this Annual Report on Form 10-K for the periods prior to the Spin-off represent, on a historical cost basis, the combined assets, liabilities, revenue and expenses related to ServiceMaster’s businesses operated under the American Home Shield, HSA, OneGuard and Landmark brand names (the “Separated Business”). Frontdoor was formed as a wholly-owned subsidiary of ServiceMaster on January 2, 2018 for the purpose of holding the Separated Business in connection with the Spin-off. During 2018, ServiceMaster contributed the Separated Business to Frontdoor. On October 1, 2018, the Spin-off was completed by a pro rata distribution to ServiceMaster’s stockholders of approximately 80.2% of our common stock. Each holder of ServiceMaster common stock received one share of our common stock for every two shares of ServiceMaster common stock held at the close of business on September 14, 2018, the record date of the distribution. The Spin-off was completed pursuant to a separation and distribution agreement and other agreements with ServiceMaster related to the Spin-off, including a transition services agreement, a tax matters agreement, an employee matters agreement, and a stockholders and registration rights agreement. See Note 10 to the accompanying consolidated and combined financial statements for information related to these agreements.  Our financial statements include nonrecurring costs incurred to evaluate, plan and execute the Spin-off. These costs are primarily related to third-party consulting and other incremental costs directly associated with the Spin-off process. Our results for the years ended December 31, 2018 and 2017 include Spin-off charges of $24 million and $13 million, respectively. In addition, incremental capital expenditures required to effect the Spin-off in 2018 were $15 million, principally reflecting costs to replicate information technology systems historically shared with ServiceMaster. We expect to incur less than $1 million of Spin-off charges in 2019, which will primarily include costs related to services provided under the transition services agreement.  The Spin-off has resulted in increased operating costs, which could be material to our results of operations. These increased costs are primarily associated with corporate functions such as finance, legal, information technology and human resources. We are currently evaluating the optimal structure of corporate functions to support the strategic objectives of our business as an independent public entity subsequent to the Spin-off. During 2018, we incurred $4 million of dis-synergies. For the full year 2019, we currently project an approximately $3 million increase in dis-synergies compared to 2018 for an annualized increase in operating costs of approximately $7 million, which we expect to then represent our normal operating costs associated with these dis-synergies.  Our financial position, results of operations and cash flows may not be indicative of our condition had we been a separate stand-alone entity during the periods presented, nor are the results stated herein necessarily indicative of our financial position, results of operations and cash flows had we operated as a separate, independent company during the periods presented. The audited consolidated and combined financial statements included elsewhere in this Annual Report on Form 10-K for periods prior to the Spin-off do not reflect any changes that occurred in our financing and operations as a result of the Spin-off.  The audited consolidated and combined financial statements included in Item 8 of this Annual Report on Form 10-K for periods prior to the Spin-off include all revenues, costs, assets and liabilities directly attributable to us. ServiceMaster’s debt and corresponding interest expense have not been allocated to us for periods prior to the Spin-off since we were not the obligor of the debt. The audited consolidated and combined financial statements of operations and comprehensive income include allocations of certain costs from ServiceMaster incurred on our behalf. Such corporate-level costs are being allocated to us using methods based on proportionate formulas such as revenue, headcount, and others. Such corporate costs include costs pertaining to: accounting and finance, legal, human resources, information technology, insurance, marketing, tax services, procurement services and other costs. We consider the expense allocation methodology and results to be reasonable for all periods presented. However, these allocations may not be indicative of the actual level of expense that we would have incurred if we had operated as a separate stand-alone, publicly traded company during the periods presented nor are these costs necessarily indicative of costs we may incur in the future.  Key Factors and Trends Affecting Our Results of Operations  Macroeconomic Conditions  Macroeconomic conditions that may affect customer spending patterns, and thereby our results of operations, include home sales, consumer confidence and employment rates. We believe our ability to acquire customers through the DTC channel mitigates the effect of a downturn in the real estate market, while our nationwide presence limits the risk of poor economic conditions in any particular geography.  Seasonality  Our business is subject to seasonal fluctuations, which drives variations in our revenue, net income and Adjusted EBITDA for interim periods. Seasonal fluctuations are primarily driven by a higher number of central HVAC orders in the summer months. In 2018, approximately 20 percent, 28 percent, 30 percent and 22 percent of our revenue, approximately 11 percent, 36 percent, 40 percent and 13 percent of our net income, and approximately 13 percent, 31 percent, 36 percent and 20 percent of our Adjusted EBITDA was recognized in the first, second, third and fourth quarters, respectively.  Effect of Weather Conditions  The demand for our services, and our results of operations, are affected by weather conditions. Extreme temperatures can lead to an increase in service requests related to home systems, particularly central HVAC systems, resulting in higher claim frequency and costs and lower profitability. For example, we experienced an increase in contract claims cost driven by a higher number of central HVAC work orders as a result of colder winter temperatures in the first quarter of 2018 and higher summer temperatures in the second and third quarters of 2018 as compared to historical averages. Weather conditions that have a potentially favorable impact to our business include mild winters or summers, which can lead to lower home systems claim frequency.  While weather variations as described above may affect our business, major weather events and other Acts of God, such as hurricanes and tornadoes, typically do not increase our obligations to provide service. As a rule, repairs associated with such isolated events are addressed by homeowners’ and other forms of insurance as opposed to home service plans that we offer, and such insurance coverage in fact reduces our obligations to provide service to systems and appliances damaged by insured, catastrophic events.  Tariff and Import/Export Regulations  Changes in U.S. tariff and import/export regulations may impact the costs of home systems, appliances and repair parts. Import duties or restrictions on components and raw materials that are imposed, or the perception that they could occur, may materially and adversely affect our business by increasing our costs. For example, rising costs due to blanket tariffs on imported steel and aluminum could increase the costs of our home systems, appliances and repair parts.  Competition  We compete in the home service plan industry and the broader U.S. home services market. The home service plan industry is a highly competitive industry. The principal methods of competition, and by which we differentiate ourselves from our competitors, are quality and speed of service, contract offerings, brand awareness and reputation, customer satisfaction, pricing and promotions, contractor network and referrals.  Acquisition Activity  We have a track record of sourcing and purchasing targets at attractive prices and successfully integrating them into our business, including the acquisitions of OneGuard and Landmark in 2016. We anticipate that the highly fragmented nature of the home service plan industry will continue to create opportunities for further consolidation. We use acquisitions to cost-effectively grow our home service plan contract count and deepen our customer base in high-growth geographies and may consider strategic acquisitions that will expand our reach into the home services market. Non-GAAP Financial Measures  To supplement our results presented in accordance with U.S. GAAP, we have disclosed non-GAAP financial measures of operating results that exclude or adjust certain items. We present within this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section the non-GAAP financial measure of Adjusted EBITDA. See “Item 6. Selected Financial Data” for a reconciliation of net income to Adjusted EBITDA. Management believes this non-GAAP financial measure provides useful information for its and investors’ evaluation of our business performance and is useful for period-over-period comparisons of the performance of our business. While we believe this non-GAAP financial measure is useful in evaluating our business, it should be considered as supplemental in nature and is not meant to be considered in isolation or as a substitute for the related financial information prepared in accordance with U.S. GAAP. In addition, this non-GAAP financial measure may not be the same as similarly entitled measures reported by other companies.  U.S. Federal Income Tax Reform  On December 22, 2017, U.S. Tax Reform was signed into law. This legislation included numerous changes to existing tax law, including a reduction in the federal corporate income tax rate from 35 percent to 21 percent, which has reduced our effective tax rate and cash tax payments, beginning in 2018. The rate reduction took effect on January 1, 2018; however, U.S. Tax Reform was signed in 2017 and had an immediate one-time effect of an income tax benefit of $20 million for the year ended December 31, 2017. See Note 5 to the audited consolidated and combined financial statements included in Item 8 of this Annual Report on Form 10-K for more details.  Key Business Metrics  We focus on a variety of indicators and key operating and financial metrics to monitor the financial condition, performance and cash flows of the continuing operations of our business. These metrics include: · revenue, · operating expenses, · net income, · earnings per share, · Adjusted EBITDA, · net cash provided from operating activities, · Free Cash Flow, · customer retention rate, and · growth in number of home service plans.  Revenue. Home service plan contracts are typically one year in duration. We recognize revenue at the agreed upon contractual amount over time using the input method in proportion to the costs expected to be incurred in performing services under the contracts. Our revenue is primarily a function of the volume and pricing of the services provided to our customers, as well as the mix of services provided. Our revenue volume is impacted by new unit sales, customer retention and acquisitions. We derive all of our revenue from customers in the United States.  Operating Expenses. In addition to changes in our revenue, our operating results are affected by, among other things, the level of our operating expenses. Our operating expenses primarily include contract claims costs and expenses associated with sales and marketing, customer service and general corporate overhead. A number of our operating expenses are subject to inflationary pressures, such as: wages and salaries, employee benefits and health care; contractor costs; home systems, appliances and repair costs; tariffs; insurance premiums; and various regulatory compliance costs.  Net Income and Earnings Per Share. The presentation of net income and basic and diluted earnings per share provides measures of performance which are useful for investors, analysts and other interested parties in company-to-company operating performance comparisons. Basic earnings per share is computed by dividing net income by the weighted-average number of shares of common stock outstanding during the period. Diluted earnings per share is computed by dividing net income by the weighted-average number of shares of common stock outstanding during the period, increased to include the number of shares of common stock that would have been outstanding had potentially dilutive shares of common stock been issued. The dilutive effect of stock options and restricted stock units (“RSUs”) are reflected in diluted net income per share by applying the treasury stock method.  Adjusted EBITDA. We evaluate performance and allocate resources based primarily on Adjusted EBITDA, which is a financial measure not calculated in accordance with U.S. GAAP. We define Adjusted EBITDA as net income before: provision for income taxes; interest expense; interest income from affiliate; depreciation and amortization expense; non-cash stock-based compensation expense; restructuring charges; Spin-off charges; affiliate royalty expense; (gain) loss on insured home service plan claims; and other non-operating expenses. We believe Adjusted EBITDA is useful for investors, analysts and other interested parties as it facilitates company-to-company operating performance comparisons by excluding potential differences caused by variations in capital structures, taxation, the age and book depreciation of facilities and equipment, restructuring initiatives, Spin-off charges, arrangements with affiliates and equity-based, long-term incentive plans.  Net Cash Provided from Operating Activities and Free Cash Flow. We focus on measures designed to monitor cash flow, including net cash provided from operating activities and Free Cash Flow, which is a financial measure not calculated in accordance with U.S. GAAP and represents net cash provided from operating activities less property additions.  Customer Retention Rate and Growth in Number of Home Service Plans. We report our customer retention rate and growth in number of home service plans in order to track the performance of our business. Home service plans represent our recurring customer base, which includes customers with active contracts for recurring services. Our customer retention rate is calculated as the ratio of ending home service plans to the sum of beginning home service plans, new unit sales and acquired accounts for the applicable period. These measures are presented on a rolling, 12-month basis in order to avoid seasonal anomalies.  Critical Accounting Policies and Estimates  This “Management’s Discussion and Analysis of Financial Condition and Results of Operations” is based upon our audited consolidated and combined financial statements included in Item 8 of this Annual Report on Form 10-K, 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 related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates and judgments, including those related to revenue recognition, contract claims costs, the impairment analysis for goodwill and other indefinite-lived intangible assets, share-based compensation, income taxes, tax contingencies and litigation. We base our estimates on historical experience and on various other factors and assumptions 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.  We believe the following accounting policies are most important to the portrayal of our financial condition and results of operations and require our most significant judgments and estimates.  Revenue Recognition  Home service plan contracts are typically one year in duration. We recognize revenue at the agreed upon contractual amount over time using the input method in proportion to the costs expected to be incurred in performing services under the contracts. Those costs bear a direct relationship to the fulfillment of our obligations under the contracts and are representative of the relative value provided to the customer (proportional performance method).  At contract inception, we assess the goods and services promised in our contracts with customers and identify a performance obligation for each promise to transfer to the customer a good or service (or a bundle of goods and services) that is distinct. To identify the performance obligation, we consider all of the goods and services promised in the contract regardless of whether they are explicitly stated or are implied by customary business practices.  Home Service Plan Claims Accruals  Home service plan claims costs are expensed as incurred. Accruals for home service plan claims are made based on our claims experience and actuarial projections. Accruals are established based on estimates of the ultimate cost to settle claims. Home service plan claims take about three months to settle, on average, and substantially all claims are settled within six months of incurrence. The amount of time required to settle a claim can vary based on a number of factors, including whether a replacement is ultimately required. Our actuary performs an accrual analysis utilizing generally accepted actuarial methods that incorporate cumulative historical claims experience and information provided by us. We regularly review our estimates of claims costs and adjust the estimates when appropriate. We believe the use of actuarial methods to account for these liabilities provides a consistent and effective way to measure these highly judgmental accruals. However, the use of any estimation technique in this area is inherently sensitive given the magnitude of claims involved. We believe our recorded obligations for these expenses are consistently measured. Nevertheless, changes in claims costs can materially affect the estimates for these liabilities.  Corporate Expense Allocation  Our audited consolidated and combined financial statements included in Item 8 of this Annual Report on Form 10-K include transactions with ServiceMaster for services (such as executive functions, information systems, accounting and finance, human resources, and legal and general corporate expenses) that were provided to us by the centralized ServiceMaster organization. Corporate level items also include personnel-related expenses of corporate employees (such as salaries, insurance coverage, stock-based compensation costs, etc.). Throughout the periods prior to the Spin-off covered by the financial statements, the costs of such functions, services and items have been directly charged or allocated to us using methods management believes are reasonable. The methods for allocating functions, services, and items to us are based on proportional allocation bases which include revenue, headcount and others. All such costs have been deemed to have been incurred and settled in the period where the costs were recorded.  Income Taxes  For purposes of our audited consolidated and combined financial statements included in Item 8 of this Annual Report on Form 10-K, for periods prior to the Spin-off our taxes are provided for on a “separate return” basis, although our operations for the period prior to the completion of the Spin-off have historically been included in the tax returns filed by ServiceMaster. Income taxes as presented therein allocate current and deferred income taxes of the business to us in a manner that is systematic, rational, and consistent with the asset and liability method prescribed by ASC 740. Accordingly, as stated in paragraph 30 of ASC 740, the sum of the amounts allocated to the carve-out tax provisions may not equal the historical consolidated provision for us. Under the separate return method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss carryforwards. 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. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in operations in the period that includes the enactment date. Valuation allowances are established when management determines that it is more likely than not that some portion, or all, of the deferred tax asset will not be realized. The financial effect of changes in tax laws or rates is accounted for in the period of enactment. The settlement of tax obligations is assumed in the period incurred and included in net parent investment for periods prior to the completion of the Spin-off.  On October 1, 2018 Frontdoor and its subsidiaries began filing consolidated U.S. federal income tax returns. State and local returns are filed both on a separate company basis and on a combined unitary basis with Frontdoor. Current and deferred income taxes are provided for on a separate company basis. We account for income taxes using an asset and liability approach for the expected future tax consequences of events that have been recognized in our financial statements or tax returns.  We record a liability for unrecognized tax benefits resulting from uncertain tax positions taken or expected to be taken in tax returns. We recognize potential interest and penalties related to its uncertain tax positions in income tax expense.  Goodwill and Intangible Assets  In accordance with applicable accounting standards, goodwill and indefinite-lived intangible assets are not amortized and are subject to assessment for impairment by applying a fair-value based test on an annual basis or more frequently if circumstances indicate a potential impairment. An assessment for impairment is performed on October 1 of every year. There were no goodwill or trade name impairment charges recorded during the years ended December 31, 2018, 2017 or 2016.  Newly Issued Accounting Standards  New accounting rules and disclosure requirements can significantly impact our reported results and the comparability of our financial statements. See Note 2 to the audited consolidated and combined financial statements included in Item 8 of this Annual Report on Form 10-K for further information on newly issued accounting standards.  Results of Operations for the Years Ended December 31, 2018 and 2017   ________________________________ * not meaningful Revenue  We reported revenue of $1,258 million and $1,157 million for the years ended December 31, 2018 and 2017, respectively. Revenue by major customer acquisition channel is as follows:     _________________________________ * not meaningful  Revenue increased nine percent for the year ended December 31, 2018 compared to the year ended December 31, 2017, primarily driven by higher renewal revenue due to overall growth in the number of home service plans as well as improved price realization. The increase in real estate revenue reflects improved price realization, primarily due to a mix shift to higher priced home service plan offerings. The increase in direct-to-consumer revenue reflects growth in new sales resulting from increased investments in marketing.  Growth in number of home service plans and customer retention rate are presented below.     Cost of Services Rendered  We reported cost of services rendered of $686 million and $589 million for the years ended December 31, 2018 and 2017, respectively. The following table provides a summary of changes in cost of services rendered:    ___________________________________ (1) Represents the gain on an arrangement with a captive insurance affiliate of our former parent whereby certain American Home Shield home service plan claims were insured prior to the Spin-off. Our relationship with this captive insurance affiliate was terminated in connection with the Spin-off.  For the year ended December 31, 2018, the increase in contract claims includes an increase in the underlying costs of repairs totaling $23 million, particularly in the appliance and plumbing trades, as well as a higher number of work orders, primarily driven by colder winter temperatures in the first quarter and significantly warmer summer temperatures in the second and third quarters of 2018 as compared to historical averages, which increased claims costs by $17 million. Additionally, the impact of higher replacements, primarily appliances, in 2018 increased claims costs by $15 million. Results also include a net $3 million adjustment related to adverse development of prior year claims. Other includes an increase in bad debt expense of $2 million.  Selling and Administrative Expenses  For the years ended December 31, 2018 and 2017, we reported selling and administrative expenses of $338 million and $312 million, respectively, which comprised selling, marketing and customer service costs of $263 million and $245 million, respectively, and general and administrative expenses of $75 million and $67 million, respectively. The following table provides a summary of changes in selling and administrative expenses:     For the year ended December 31, 2018, the increase in sales and marketing costs was driven by targeted spending to drive sales growth. The increase in customer service costs was primarily driven by incremental investments in customer care centers to deliver an improved level of customer service. Incremental ongoing costs related to the Spin-off of $4 million were incurred, which primarily related to the separation of information technology systems historically shared with ServiceMaster. Other includes an increase in professional fees of $4 million.  Depreciation Expense  Depreciation expense was $12 million and $9 million in the years ended December 31, 2018 and 2017, respectively. The increase was primarily due to additional property and equipment related to the headquarters relocation and information technology costs related to the separation, principally reflecting costs to replicate information technology systems historically shared with ServiceMaster.  Amortization Expense  Amortization expense was $8 million for each of the years ended December 31, 2018 and 2017.  Restructuring Charges  We incurred restructuring charges of $3 million and $7 million for the years ended December 31, 2018 and 2017, respectively.  In 2018, restructuring charges comprised $2 million of non-personnel charges primarily related to the relocation to our corporate headquarters and $1 million of severance costs, which primarily represent an allocation of severance costs related to actions taken to enhance capabilities and reduce costs in ServiceMaster’s corporate functions that provided company-wide administrative services to support operations.  In 2017, restructuring charges comprised $5 million of severance costs which primarily represent an allocation of severance costs and stock-based compensation expense as part of the severance agreement with ServiceMaster’s former CEO and CFO, and allocations of $1 million of lease termination costs and $1 million of asset write-off and other costs related to the relocation to our corporate headquarters.  Spin-Off Charges  We incurred Spin-off charges of $24 million and $13 million for the years ended December 31, 2018 and 2017, respectively. These charges include nonrecurring costs incurred to evaluate, plan and execute the Spin-off. In 2018, Spin-off charges primarily comprised $19 million of third-party consulting fees and $5 million of other incremental costs directly related to the Spin-off process. In 2017, Spin-off charges primarily comprised $12 million of third-party consulting fees and $1 million of other incremental costs directly related to the Spin-off process.  Affiliate Royalty Expense  Affiliate royalty expense represents royalty expense with ServiceMaster for the use of their trade names. We incurred royalty expense of $1 million and $2 million for the years ended December 31, 2018 and 2017, respectively. The decrease was due to the termination of the trademark license agreement with ServiceMaster in connection with the Spin-off. We will not incur these expenses in future periods.  Interest Expense  Interest expense was $23 million and $1 million for the years ended December 31, 2018 and 2017, respectively. The increase in interest expense was driven by our financing transactions totaling $1 billion that occurred in 2018 in connection with the Spin-off. See Note 13 to the audited consolidated and combined financial statements included in Item 8 of this Annual Report on Form 10-K for more details.  Interest Income from Affiliate  Interest income from affiliate was $2 million and $3 million for the years ended December 31, 2018 and 2017, respectively, and represents interest earned on interest-bearing related party notes receivable included within Net parent investment in the audited consolidated and combined statements of financial position included in Item 8 of this Annual Report on Form 10-K. These notes were settled concurrently with the consummation of the Spin-off.  Interest and Net Investment Income  Interest and net investment income was $2 million for each of the years ended December 31, 2018 and 2017 and was composed of net investment gains and interest and dividend income realized on our investment portfolio.  Provision for Income Taxes  The effective tax rate on income was 25.1 percent and 27.2 percent for the years ended December 31, 2018 and 2017, respectively. The effective tax rates on income for the years ended December 31, 2018 and 2017 were reduced primarily by the reduction in the U.S. federal corporate income tax rate from 35 percent to 21 percent. See Note 5 to the audited consolidated and combined financial statements included in Item 8 of this Annual Report on Form 10-K for more details  Our audited consolidated and combined financial statements included in Item 8 of this Annual Report on Form 10-K do not reflect any amounts due to ServiceMaster for income tax related matters as it is assumed that all such amounts due to ServiceMaster were settled at the end of each reporting period.  Net Income  Our net income was $125 million and $160 million for the years ended December 31, 2018 and 2017, respectively. The $36 million decrease for the year ended December 31, 2018 was driven by the aforementioned operating results, offset, in part, by an $18 million decrease in the provision for income taxes as a result of lower pre-tax income and U.S. Tax Reform.  Adjusted EBITDA  The following table provides a summary of changes in our Adjusted EBITDA. For a reconciliation of net income to Adjusted EBITDA, see “Item 6. Selected Financial Data.”    For the year ended December 31, 2018, the increase in contract claims includes an increase in the underlying costs of repairs totaling $23 million, particularly in the appliance and plumbing trades, as well as a higher number of work orders, primarily driven by colder winter temperatures in the first quarter and significantly warmer summer temperatures in the second and third quarters of 2018 as compared to historical averages, which increased claims costs by $17 million. Additionally, the impact of higher replacements, primarily appliances, in 2018 increased claims costs by $15 million. Results also include a net $3 million adjustment related to adverse development of prior year claims.  For the year ended December 31, 2018, the increase in sales and marketing costs was driven by targeted spending to drive sales growth. The increase in customer service costs was primarily driven by incremental investments in customer care centers to deliver an improved level of customer service. Incremental ongoing costs related to the Spin-off of $4 million were incurred, which primarily related to the separation of information technology systems historically shared with ServiceMaster. Other primarily includes an increase in professional fees of $4 million and an increase in bad debt expense of $2 million.  Results of Operations for the Years Ended December 31, 2017 and 2016    ___________________________________ * not meaningful Revenue  We reported revenue of $1,157 million and $1,020 million for the years ended December 31, 2017 and 2016, respectively. Revenue by major customer acquisition channel is as follows:    _________________________________ * not meaningful  The 2017 and 2016 revenue results reflect an increase in new unit sales, improved price realization and approximately $56 million and $22 million, respectively, as a result of the OneGuard and Landmark acquisitions in 2016.  Growth in number of home service plans and customer retention rate are presented below.     ___________________________________  (1) As of December 31, 2017 and 2016, excluding the impact of acquisitions, the growth in renewable home service plans was six percent and seven percent, respectively, and the customer retention rate was 76 percent and 75 percent, respectively. Cost of Services Rendered  We reported cost of services rendered of $589 million and $526 million for the years ended December 31, 2017 and 2016, respectively. The following table provides a summary of changes in cost of services rendered:     ___________________________________ (1) Includes approximately $24 million for the year ended December 31, 2017 as a result of the acquisitions of OneGuard and Landmark in 2016. (2) Represents the gain on an arrangement with a captive insurance affiliate of our former parent whereby certain American Home Shield home service plan claims were insured prior to the Spin-off.  For the year ended December 31, 2017, the increase in contract claims costs was primarily due to normal inflationary pressure on the underlying cost of repairs, offset, in part, by a lower number of work orders driven by cooler summer temperatures in 2017.  Selling and Administrative Expenses  For the years ended December 31, 2017 and 2016, we reported selling and administrative expenses of $312 million and $286 million, respectively, which comprised general and administrative expenses of $67 million and $68 million, respectively, and selling, marketing and customer service costs of $245 million and $218 million, respectively. The following table provides a summary of changes in selling and administrative expenses:   For the year ended December 31, 2017, the increase in sales and marketing costs was driven by increased sales commissions and incremental marketing spending to drive growth. We incurred incremental selling and administrative expenses as a result of the OneGuard and Landmark acquisitions. The increase in customer service costs was due to higher labor costs resulting from an acceleration of pre-season hiring and training in preparation for the high-volume summer season and an overall increase in call center staffing levels to improve response times.  Depreciation Expense  Depreciation expense was $9 million and $8 million in the years ended December 31, 2017 and 2016, respectively. The increase in 2017 was primarily due to increased property and equipment that resulted from the acquisitions of OneGuard and Landmark in 2016.  Amortization Expense  Amortization expense was $8 million and $6 million in the years ended December 31, 2017 and 2016, respectively. The increase in 2017 was primarily due to additional amortization expense related to definite-lived intangible assets that resulted from the acquisitions of OneGuard and Landmark in 2016.  Restructuring Charges  We incurred restructuring charges of $7 million and $3 million for the years ended December 31, 2017 and 2016, respectively.  In 2017, restructuring charges comprised $5 million of severance costs which primarily represent an allocation of severance costs and stock-based compensation expense as part of the severance agreement with ServiceMaster’s former CEO and CFO, and allocations of $1 million of lease termination costs and $1 million of asset write-off and other costs related to the relocation to our corporate headquarters.  In 2016, restructuring charges comprised $1 million of severance and other costs related to an initiative to enhance capabilities and reduce costs in ServiceMaster’s headquarters functions that provided administrative services for our operations, $1 million of lease termination and other costs related to the decision to consolidate the stand-alone operations of Home Security of America, Inc. (“HSA”), acquired in February 2014, with those of the American Home Shield business and $1 million of charges related to the disposal of certain HSA property and equipment.  Spin-Off Charges  We incurred Spin-off charges of $13 million for the year ended December 31, 2017. These charges include nonrecurring costs incurred to evaluate, plan and execute the Spin-off and comprised $12 million of third-party consulting fees and $1 million of other incremental costs related to Spin-off process.  Affiliate Royalty Expense  Affiliate royalty expense represents royalty expense with ServiceMaster for the use of their trade names. We incurred royalty expense of $2 million for each of the years ended December 31, 2017 and 2016.  Interest Expense  Interest expense was $1 million and less than $1 million for the years ended December 31, 2017 and 2016, respectively, and represents interest expense on seller financed debt that was used to fund a portion of the acquisitions of OneGuard and Landmark as well as the interest expense on capital lease obligations.  Interest Income from Affiliate  Interest income from affiliate was $3 million and $2 million for the years ended December 31, 2017 and 2016, respectively, and represents interest earned on interest-bearing related party notes receivable included within Net parent investment in the audited consolidated and combined statements of financial position included in Item 8 of this Annual Report on Form 10-K.  Interest and Net Investment Income  Interest and net investment income was $2 million and $5 million for the years ended December 31, 2017 and 2016, respectively, and was composed of net investment gains and interest and dividend income realized on our investment portfolio. The decrease in 2017 was primarily the result of sales of marketable securities that occurred in 2016.  Provision for Income Taxes  Our effective tax rate on income was 27.2 percent and 36.6 percent for the years ended December 31, 2017 and 2016, respectively. The effective tax rate on income for the year ended December 31, 2017 was favorably impacted by the remeasurement of deferred tax assets and liabilities due to the 2018 reduction to the federal tax rate. Additional information on income taxes, including our effective tax rate reconciliation and liabilities for uncertain tax positions, can be found in Note 5 to the audited consolidated and combined financial statements included in Item 8 of this Annual Report on Form 10-K  Our financial statements for periods prior to the Spin-off do not reflect any amounts due to ServiceMaster for income tax related matters as it is assumed that all such amounts due to ServiceMaster were settled on December 31 of each year.  Net Income  Our net income was $160 million and $124 million for the years ended December 31, 2017 and 2016, respectively. The $36 million increase in 2017 compared to 2016 was driven by the aforementioned operating results and an $11 million decrease in the provision for income taxes.  Adjusted EBITDA  The following table provides a summary of changes in our Adjusted EBITDA. For a reconciliation of net income to Adjusted EBITDA, see “Item 6. Selected Financial Data.”     The increase in contract claims costs was primarily due to normal inflationary pressure on the underlying cost of repairs, offset, in part, by a lower number of work orders driven by cooler summer temperatures in 2017. The increase in sales and marketing costs was driven by increased sales commissions and incremental marketing spending to drive growth. We incurred incremental selling and administrative expenses as a result of the OneGuard and Landmark acquisitions. The increase in customer service costs was due to higher labor costs resulting from an acceleration of pre-season hiring and training in preparation for the high-volume summer season and an overall increase in call center staffing levels to improve response times. The decrease in interest and net investment income was primarily the result of sales of marketable securities that occurred in 2016.   Liquidity and Capital Resources  Liquidity  A substantial portion of our liquidity needs are due to debt service requirements on our indebtedness. The Credit Agreement, as well as the Indenture, contain covenants that limit or restrict our ability, including the ability of certain of our subsidiaries, to incur additional indebtedness, repurchase debt, incur liens, sell assets, make certain payments (including dividends) and enter into transactions with affiliates. As of December 31, 2018, we were in compliance with the covenants under the agreements that were in effect on such date.  Historically, the primary source of liquidity for our business has been the cash flow provided by operations which was, prior to the Spin-off, transferred to ServiceMaster to support its overall cash management strategy. Prior to the Spin-off, transfers of cash to and from ServiceMaster have been reflected in Net Parent Investment in the historical combined statements of financial position and combined statements of cash flows. ServiceMaster’s cash has not been assigned to us for any of the periods prior to the Spin-off presented in the audited consolidated and combined statements of financial position included in Part 8 of this Annual Report on Form 10-K because those cash balances are not directly attributable to us.  In connection with the Spin-off, our capital structure and sources of liquidity have changed significantly from our historical capital structure. We no longer participate in cash management with ServiceMaster, but rather our ability to fund our cash needs depends on our ongoing ability to generate and raise cash in the future. Although we believe that our future cash provided from operations, together with available capacity under our Revolving Credit Facility and our access to capital markets, will provide adequate resources to fund our operating and financing needs, our access to, and the availability of, financing on acceptable terms in the future will be affected by many factors, including: (i) our credit rating, (ii) the liquidity of the overall capital markets and (iii) the current state of the economy. Moreover, to preserve the tax-free treatment of the Spin-off, we may not be able to engage in certain strategic or capital-raising transactions following the Spin-off, such as issuing equity securities beyond certain thresholds, which may limit our access to capital markets, ability to raise capital through equity issuances, and ability to make acquisitions using our equity as currency, potentially requiring us to issue more debt than would otherwise be optimal. There can be no assurances that we will continue to have access to capital markets on terms acceptable to us. See “Risk Factors” included in Item 1A of this Annual Report on Form 10-K for a further discussion.  Cash and short- and long-term marketable securities totaled $305 million and $309 million as of December 31, 2018 and December 31, 2017, respectively. As of December 31, 2018, there were no letters of credit outstanding and there was $250 million of available borrowing capacity under the Revolving Credit Facility.  In connection with the Spin-off and effective as of October 1, 2018, the inter-company balance due to ServiceMaster of $144 million recorded in Due to Parent in the condensed combined statements of financial position at September 30, 2018 was settled in cash with ServiceMaster. Additionally, in connection with the Spin-off and effective as of October 1, 2018, ServiceMaster contributed $81 million of cash to us. The effect of these transactions was a net reduction of Cash and cash equivalents of $63 million.  Cash and short- and long-term marketable securities include balances associated with regulatory requirements in our business. See “-Limitations on Distributions and Dividends by Subsidiaries.” Our investment portfolio has been invested in high-quality debt securities. We closely monitor the performance of these investments. From time to time, we review the statutory reserve requirements to which our regulated entities are subject and any changes to such requirements. These reviews may result in identifying current reserve levels above or below minimum statutory reserve requirements, in which case we may adjust our reserves. The reviews may also identify opportunities to satisfy certain regulatory reserve requirements through alternate financial vehicles.  We may from time to time repurchase or otherwise retire or extend our debt and/or take other steps to reduce our debt or otherwise improve our financial position, results of operations or cash flows. These actions may include open market debt repurchases, negotiated repurchases, other retirements of outstanding debt and/or opportunistic refinancing of debt. The amount of debt that may be repurchased or otherwise retired or refinanced, if any, and the price of such repurchases, retirements or refinancings will depend on market conditions, trading levels of our debt, our cash position, compliance with debt covenants and other considerations.  Credit Facilities and Senior Notes  On August 16, 2018, in connection with the Spin-off, we entered into the $650 million Term Loan Facility and the $250 million Revolving Credit Facility and issued $350 million of 2026 Notes. Borrowings under the Term Loan Facility and the 2026 Notes were incurred as partial consideration for the contribution of the Separated Business to us. We did not receive any cash proceeds as a result of these transactions.  On October 24, 2018, we entered into an interest rate swap agreement effective October 31, 2018 that expires on August 16, 2025. The notional amount of the agreement was $350 million. Under the terms of the agreement, we will pay a fixed rate of interest of 3.0865% on the $350 million notional amount, and we will receive a floating rate of interest (based on one-month LIBOR, subject to a floor of zero percent) on the notional amount. Therefore, during the term of the agreement, the effective interest rate on $350 million of the Term Loan Facility is fixed at a rate of 3.0865%, plus the incremental borrowing margin of 2.50%.  Limitations on Distributions and Dividends by Subsidiaries  We depend on our subsidiaries to distribute funds to us so that we may pay obligations and expenses, including satisfying obligations with respect to indebtedness. The ability of our subsidiaries to make distributions and dividends to us depends on their operating results, cash requirements, financial condition and general business conditions, as well as restrictions under the laws of our subsidiaries’ jurisdictions.  Our subsidiaries are permitted under the terms of the Credit Agreement and other indebtedness to incur additional indebtedness that may restrict or prohibit the making of distributions, the payment of dividends or the making of loans by such subsidiaries to us.  Furthermore, there are third-party restrictions on the ability of certain of our subsidiaries to transfer funds to us. These restrictions are related to regulatory requirements. The payments of ordinary and extraordinary dividends by certain of our subsidiaries (through which we conduct our business) are subject to significant regulatory restrictions under the laws and regulations of the states in which they operate. Among other things, such laws and regulations require certain subsidiaries to maintain minimum capital and net worth requirements and may limit the amount of ordinary and extraordinary dividends and other payments that these subsidiaries can pay to us. As of December 31, 2018 and 2017, the total net assets subject to these third-party restrictions was $187 million and $169 million, respectively. We expect that such limitations will be in effect for the foreseeable future. In Texas, we are relieved of the obligation to post 75 percent of our otherwise required reserves because we operate a captive insurer approved by Texas regulators in order to satisfy such obligations. None of our subsidiaries are obligated to make funds available to us through the payment of dividends.  Cash Flows  Cash flows from operating, investing and financing activities for the years ended December 31, 2018, 2017 and 2016, as reflected in the audited consolidated and combined statements of cash flows included in Item 8 of this Annual Report on Form 10-K, are summarized in the following table.    Operating Activities  Net cash provided from operating activities was $189 million for the year ended December 31, 2018, compared to $194 million for the year ended December 31, 2017 and $155 million for the year ended December 31, 2016.  Net cash provided from operating activities in 2018 comprised $157 million in earnings adjusted for non-cash charges and a $32 million decrease in cash required for working capital. The decrease in cash required for working capital was driven by growth in our underlying business and the favorable impacts of accrued interest and taxes.  Net cash provided from operating activities in 2017 comprised $163 million in earnings adjusted for non-cash charges and a $30 million decrease in cash required for working capital. The decrease in cash required for working capital was driven by growth in our underlying business.  Net cash provided from operating activities in 2016 comprised $142 million in earnings adjusted for non-cash charges and a $13 million decrease in cash required for working capital. The decrease in cash required for working capital was driven by growth in our underlying business.  Investing Activities  Net cash used for investing activities was $10 million for the year ended December 31, 2018, compared to $11 million for the year ended December 31, 2017 and $55 million for the year ended December 31, 2016.  Capital expenditures increased to $27 million in 2018 from $15 million in 2017 and $11 million in 2016 and included the headquarters relocation, information technology costs related to the separation and recurring capital needs and information technology projects. In 2018, capital expenditures required to effect the Spin-off were $15 million, principally reflecting costs to replicate information technology systems historically shared with ServiceMaster. We expect capital expenditures for the full year 2019 relating to recurring capital needs and the continuation of investments in information systems and productivity enhancing technology to be approximately $30 million to $40 million. We have no additional material capital commitments at this time.  There were no cash payments for acquisitions in 2018 and 2017, compared with $87 million in 2016. On June 27, 2016, we acquired OneGuard for $61 million, consisting of net cash consideration of $52 million and deferred payments of $9 million. On November 30, 2016, we acquired Landmark for $39 million, consisting of net cash consideration of $35 million and deferred payments of $5 million. We expect to continue to periodically evaluate strategic acquisitions.  Cash flows provided from purchases, sales and maturities of securities, net, in 2018, 2017 and 2016 were $17 million, $3 million and $43 million, respectively, and were driven by the maturity and sale of marketable securities.  Financing Activities  Net cash used for financing activities was $165 million for the year ended December 31, 2018, compared to $68 million for the year ended December 31, 2017 and $88 million for the year ended December 31, 2016.  Payments on seller financed debt and capital lease obligations were $10 million, $5 million and $1 million in 2018, 2017 and 2016, respectively.  Net transfers to Parent included in financing activities were $137 million, $63 million and $87 million in 2018, 2017 and 2016, respectively.  Payments of debt issuance costs of $16 million and the discount paid on the debt issuance of $2 million were incurred in connection with the debt financing transactions in 2018.  Contractual Obligations  The following table presents our contractual obligations and commitments as of December 31, 2018.   _________________________________ * These items are reported in the audited consolidated and combined statements of financial position included in Item 8 of this Annual Report on Form 10-K. (1) These amounts represent future interest payments related to existing debt obligations based on interest rates and principal maturities specified in the associated debt agreements. As of December 31, 2018, payments related to the Term Loan Facility are based on applicable rates at December 31, 2018 plus the specified margin in the Credit Agreement for each period presented. As of December 31, 2018, the estimated debt balance (including capital leases) as of each fiscal year end from 2019 through 2023 is $992 million, $985 million, $979 million, $972 million and $966 million, respectively, and the weighted-average interest rate on the estimated debt balances at each fiscal year end from 2019 through 2023 is 5.8%. See Note 13 to the audited consolidated and combined financial statements included in Item 8 of this Annual Report on Form 10-K for the terms and maturities of existing debt obligations. (2) These amounts primarily represent future payments relating to real estate operating leases.  Financial Position  The following discussion describes changes in our financial position from December 31, 2017 to December 31, 2018.  Marketable securities decreased from prior year levels, driven by the sale of marketable securities.  Receivables and deferred revenue decreased from prior year levels as a result of the adoption of ASC 606. Contracts with customers are generally for a period of one year or less and are generally renewable. Prior to the adoption of ASC 606 we recorded a receivable and deferred revenue for the entire home service plan contract at the commencement date. Upon adoption of ASC 606, we record the receivable related to revenue recognized once we have an unconditional right to invoice and receive payment in the future related to the services provided.  Property and equipment increased from prior year levels, reflecting purchases for the relocation of our corporate headquarters, information technology costs related to the separation and recurring capital needs and information technology projects.  Long-term debt increased from prior year levels, reflecting the debt financing transactions in 2018. See Note 13 to the audited consolidated and combined financial statements included in Item 8 of this Annual Report on Form 10-K for the terms and maturities of existing debt obligations.  Off-Balance Sheet Arrangements  As of December 31, 2018, we did not have any significant off-balance sheet arrangements.  We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, established for the purpose of facilitating off- balance sheet arrangements or other contractually narrow or limited purposes. Accordingly, we are not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships. 
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<s>[INST] The following information should be read in conjunction with “Item 6. Selected Financial Data” and the audited consolidated and combined financial statements and related notes thereto included in Item 8 of this Annual Report on Form 10K. The following discussion may contain forwardlooking statements that reflect our plans, estimates and beliefs. The cautionary statements discussed in “Cautionary Statement Concerning ForwardLooking Statements” and elsewhere in this Annual Report on Form 10K should be read as applying to all forwardlooking statements wherever they appear in this Annual Report on Form 10K. 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 Annual Report on Form 10K, particularly in “Cautionary Statement Concerning ForwardLooking Statements” and “Risk Factors” included in Item 1A of this Annual Report on Form 10K.  Overview  Frontdoor is the largest provider of home service plans in the United States, as measured by revenue, and operates under the American Home Shield, HSA, OneGuard and Landmark brands. Our home service plans help our customers maintain their homes and protect against costly and unexpected breakdowns of essential home systems and appliances. Our home service plan customers subscribe to a yearly service plan agreement that covers the repair or replacement of major components of up to 21 home systems and appliances, including electrical, plumbing, central HVAC systems, water heaters, refrigerators, dishwashers and ranges/ovens/cooktops. We serve over two million customers annually across all 50 states and the District of Columbia.  For the year ended December 31, 2018, we generated revenue, net income and Adjusted EBITDA of $1,258 million, $125 million, and $238 million, respectively. For the year ended December 31, 2017, we generated revenue, net income and Adjusted EBITDA of $1,157 million, $160 million, and $259 million, respectively. For the year ended December 31, 2016, we generated revenue, net income and Adjusted EBITDA of $1,020 million, $124 million, and $218 million, respectively.  For the year ended December 31, 2018, our total operating revenue included 66 percent of revenue derived from existing customer renewals, while 21 percent and 12 percent were derived from new unit sales made in conjunction with existing home resale transactions and directtoconsumer sales, respectively, and one percent was derived from other revenue streams, principally cancellation fees. For the year ended December 31, 2017, our total operating revenue included 66 percent of revenue derived from existing customer renewals, while 22 percent and 12 percent were derived from new unit sales made in conjunction with existing home resale transactions and directtoconsumer sales, respectively. For the year ended December 31, 2016, our total operating revenue included 66 percent of revenue derived from existing customer renewals, while 20 percent and 14 percent were derived from new unit sales made in conjunction with existing home resale transactions and directtoconsumer sales, respectively.  The Spinoff  On July 26, 2017, ServiceMaster announced its intention to effectuate the Spinoff. The audited consolidated and combined financial statements included in Item 8 of this Annual Report on Form 10K for the periods prior to the Spinoff represent, on a historical cost basis, the combined assets, liabilities, revenue and expenses related to ServiceMaster’s businesses operated under the American Home Shield, HSA, OneGuard and Landmark brand names (the “Separated Business”). Frontdoor was formed as a whollyowned subsidiary of ServiceMaster on January 2, 2018 for the purpose of holding the Separated Business in connection with the Spinoff. During 2018, ServiceMaster contributed the Separated Business to Frontdoor. On October 1, 2018, the Spinoff was completed by a pro rata distribution to ServiceMaster’s stockholders of approximately [/INST] Positive. </s>
2,019
9,279
1,727,263
frontdoor, inc.
2020-02-28
2019-12-31
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following information should be read in conjunction with “Item 6. Selected Financial Data” and the audited consolidated and combined financial statements and related notes thereto included in Item 8 of this Annual Report on Form 10-K. The following discussion may contain forward-looking statements that reflect our plans, estimates and beliefs. The cautionary statements discussed in “Cautionary Statement Concerning Forward-Looking Statements” and elsewhere in this Annual Report on Form 10-K should be read as applying to all forward-looking statements wherever they appear in this Annual Report on Form 10-K. 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 Annual Report on Form 10-K, particularly in “Cautionary Statement Concerning Forward-Looking Statements” and “Risk Factors” included in Item 1A of this Annual Report on Form 10-K. For a discussion of our results of operations for the year ended December 31, 2018 compared to the year ended December 31, 2017, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II of our 2018 Annual Report on Form 10-K filed with the SEC on February 28, 2019, which specific discussion is incorporated herein by reference. Overview Frontdoor is the largest provider of home service plans in the United States, as measured by revenue, and operates under the American Home Shield, HSA, OneGuard and Landmark brands. Our home service plans help our customers maintain their homes and protect against costly and unexpected breakdowns of essential home systems and appliances. Our home service plan customers subscribe to a yearly service plan agreement that covers the repair or replacement of major components of up to 21 home systems and appliances, including electrical, plumbing, central HVAC systems, water heaters, refrigerators, dishwashers and ranges/ovens/cooktops. In 2019, we launched Candu, our on-demand home services brand, and acquired Streem, a technology startup that uses augmented reality, computer vision and machine learning to help home service professionals more quickly and accurately diagnose breakdowns and complete repairs. We serve over two million customers annually across all 50 states and the District of Columbia. For the year ended December 31, 2019, we generated revenue, net income and Adjusted EBITDA of $1,365 million, $153 million and $303 million, respectively. For the year ended December 31, 2018, we generated revenue, net income and Adjusted EBITDA of $1,258 million, $125 million and $238 million, respectively. For the year ended December 31, 2019, our total operating revenue included 68 percent of revenue derived from existing customer renewals, while 19 percent and 12 percent were derived from new unit sales made in conjunction with existing home resale transactions and direct-to-consumer sales, respectively, and one percent was derived from other revenue streams. For the year ended December 31, 2018, our total operating revenue included 66 percent of revenue derived from existing customer renewals, while 21 percent and 12 percent were derived from new unit sales made in conjunction with existing home resale transactions and direct-to-consumer sales, respectively, and one percent was derived from other revenue streams. The Spin-off On October 1, 2018, ServiceMaster completed the spin-off of its businesses operated under the American Home Shield, HSA, OneGuard and Landmark brand names (the “Separated Business”) into a stand-alone publicly traded company (the “Spin-off”). The audited consolidated and combined financial statements included in Item 8 of this Annual Report on Form 10-K for periods prior to the Spin-off represent, on a historical cost basis, the combined assets, liabilities, revenue and expenses related to the Separated Business. Frontdoor was formed as a wholly-owned subsidiary of ServiceMaster on January 2, 2018 for the purpose of holding the Separated Business in connection with the Spin-off. During 2018, ServiceMaster contributed the Separated Business to Frontdoor. The Spin-off was completed by a pro rata distribution to ServiceMaster’s stockholders of approximately 80.2 percent of our common stock. Each holder of ServiceMaster common stock received one share of our common stock for every two shares of ServiceMaster common stock held at the close of business on September 14, 2018, the record date of the distribution. The Spin-off was completed pursuant to a separation and distribution agreement and other agreements with ServiceMaster related to the Spin-off, including a transition services agreement, a tax matters agreement, an employee matters agreement and a stockholder and registration rights agreement. See Note 11 to the audited consolidated and combined financial statements included in Item 8 of this Annual Report on Form 10-K for information related to these agreements. On March 20, 2019, ServiceMaster agreed to transfer its remaining 16,734,092 shares of Frontdoor stock to a financial institution pursuant to an exchange agreement. Subsequent to that date, the financial institution conducted a secondary offering of those shares. The transfer was completed on March 27, 2019, resulting in the full separation of Frontdoor from ServiceMaster and the disposal of ServiceMaster's entire ownership and voting interest in Frontdoor. Our financial statements include nonrecurring costs incurred to evaluate, plan and execute the Spin-off. These costs are primarily related to third-party consulting and other incremental costs directly associated with the Spin-off process. Our results for the years ended December 31, 2019 and 2018 include Spin-off charges of $1 million and $24 million, respectively. In addition, incremental capital expenditures required to effect the Spin-off in 2019 and 2018 were $2 million and $15 million, respectively, reflecting costs to replicate technology systems historically shared with ServiceMaster. We do not expect to incur Spin-off charges in 2020. The Spin-off has resulted in increased operating costs (“dis-synergies”), which could be material to our results of operations. These dis-synergies are primarily associated with corporate functions such as finance, legal, technology and human resources. We incurred incremental dis-synergies of $4 million in each of the years ended 2019 and 2018 for an annualized increase in operating costs of approximately $8 million, which we expect to represent our normal operating costs associated with these dis-synergies. Our historical financial position, results of operations and cash flows may not be indicative of our condition had we been a separate stand-alone entity during the periods presented, nor are the results stated herein necessarily indicative of our financial position, results of operations and cash flows had we operated as a separate, independent company during the periods presented. The audited consolidated and combined financial statements included elsewhere in this Annual Report on Form 10-K for periods prior to the Spin-off do not reflect any changes that occurred in our financing and operations as a result of the Spin-off. The audited consolidated and combined financial statements included in Item 8 of this Annual Report on Form 10-K for periods prior to the Spin-off include all revenues, costs, assets and liabilities directly attributable to us. ServiceMaster’s debt and corresponding interest expense have not been allocated to us for periods prior to the Spin-off since we were not the obligor of the debt. The audited consolidated and combined financial statements of operations and comprehensive income include allocations of certain costs from ServiceMaster incurred on our behalf. Such corporate-level costs were allocated to us using methods based on proportionate formulas such as revenue, headcount, and others. Such corporate costs include costs pertaining to: accounting and finance, legal, human resources, technology, insurance, marketing, tax services, procurement services and other costs. We consider the expense allocation methodology and results to be reasonable for all periods presented. However, these allocations may not be indicative of the actual level of expense that we would have incurred if we had operated as a separate stand-alone, publicly traded company during the periods presented nor are these costs necessarily indicative of costs we may incur in the future. Key Factors and Trends Affecting Our Results of Operations Macroeconomic Conditions Macroeconomic conditions that may affect customer spending patterns, and thereby our results of operations, include home sales, consumer confidence and employment rates. We believe our ability to acquire customers through the direct-to-consumer channel helps to mitigate the effect of a downturn in the real estate market, while our nationwide presence limits the risk of poor economic conditions in any particular geography. Seasonality Our business is subject to seasonal fluctuations, which drives variations in our revenue, net income and Adjusted EBITDA for interim periods. Seasonal fluctuations are primarily driven by a higher number of central HVAC work orders in the summer months. In 2019, approximately 20 percent, 28 percent, 30 percent and 22 percent of our revenue, approximately 9 percent, 39 percent, 40 percent and 12 percent of our net income, and approximately 14 percent, 35 percent, 35 percent and 16 percent of our Adjusted EBITDA was recognized in the first, second, third and fourth quarters, respectively. Effect of Weather Conditions The demand for our services, and our results of operations, are affected by weather conditions. Extreme temperatures can lead to an increase in service requests related to home systems, particularly central HVAC systems, resulting in higher claim frequency and costs and lower profitability. For example, we experienced an increase in contract claims costs driven by a higher number of central HVAC work orders due to colder winter temperatures in the first quarter of 2018 and higher summer temperatures in the second and third quarters of 2018 as compared to historical averages. Weather conditions that have a potentially favorable impact to our business include mild winters or summers, which can lead to lower home systems claim frequency. For example, seasonally mild temperatures were a factor in the decrease in contract claims costs throughout 2019. While weather variations as described above may affect our business, major weather events and other Acts of God, such as hurricanes, flooding and tornadoes, typically do not increase our obligations to provide service. As a rule, repairs associated with such isolated events are addressed by homeowners’ and other forms of insurance as opposed to home service plans that we offer, and such insurance coverage in fact reduces our obligations to provide service to systems and appliances damaged by insured, catastrophic events. Tariff and Import/Export Regulations Changes in U.S. tariff and import/export regulations may impact the costs of home systems, appliances and repair parts. Import duties or restrictions on components and raw materials that are imposed, or the perception that they could occur, may materially and adversely affect our business by increasing our costs. For example, rising costs due to blanket tariffs on imported steel and aluminum could increase the costs of our home systems, appliances and repair parts. Competition We compete in the home service plan industry and the broader U.S. home services market. The home service plan industry is a highly competitive industry. The principal methods of competition, and the areas in which we differentiate ourselves from our competitors, are quality and speed of service, contract offerings, brand awareness and reputation, customer satisfaction, pricing and promotions, contractor network and referrals. Acquisition Activity We have a track record of sourcing and purchasing other businesses and successfully integrating them into our business. We anticipate that the highly fragmented nature of the home service plan industry will continue to create strategic opportunities for further consolidation, and, with our scale, we believe we will be the acquirer of choice in the industry. In particular, we intend to focus strategically on underserved regions where we can enhance and expand service capabilities. Historically, we have used acquisitions to cost-effectively grow our customer base in high-growth geographies, and we intend to continue to do so. We may also explore opportunities to make strategic acquisitions that will expand our service offering in the broader home services segment. We also expect to use acquisitions to enhance our technology capabilities. In 2019, we acquired Streem to support the service experience for our customers, reduce costs and create potential new revenue opportunities across a variety of channels. Streem uses augmented reality, computer vision and machine learning to help home service professionals more quickly and accurately diagnose breakdowns and complete repairs. The technology enables homeowners to use their smartphone cameras to instantly connect with a service professional who can remotely see the item that needs attention and capture a variety of important details about the item, potentially helping to reduce the time required for completing repairs and even eliminating the need for a technician to visit the home by offering a simple do-it-yourself solution. We expect to use Streem’s services in our core home service plan business and in Candu’s on-demand business to deliver a superior service experience and reduce our costs. Non-GAAP Financial Measures To supplement our results presented in accordance with U.S. GAAP, we have disclosed non-GAAP financial measures of operating results that exclude or adjust certain items. We present within this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section the non-GAAP financial measure of Adjusted EBITDA. See “Item 6. Selected Financial Data” for a reconciliation of net income to Adjusted EBITDA. Management uses Adjusted EBITDA to facilitate operating performance comparisons from period to period. We believe this non-GAAP financial measure provides investors, analysts and other interested parties useful information to evaluate our business performance as it facilitates company-to-company operating performance comparisons. While we believe this non-GAAP financial measure is useful in evaluating our business, it should be considered as supplemental in nature and is not meant to be considered in isolation or as a substitute for the related financial information prepared in accordance with U.S. GAAP. In addition, this non-GAAP financial measure may not be the same as similarly entitled measures reported by other companies, limiting its usefulness as a comparative measure. Key Business Metrics We focus on a variety of indicators and key operating and financial metrics to monitor the financial condition, performance and cash flows of the continuing operations of our business. These metrics include: revenue, operating expenses, net income, earnings per share, Adjusted EBITDA, Adjusted EBITDA Margin, net cash provided from operating activities, Free Cash Flow, growth in number of home service plans, and customer retention rate. Revenue. Home service plan contracts are typically one year in duration. We recognize revenue at the agreed upon contractual amount over time using the input method in proportion to the costs expected to be incurred in performing services under the contracts. Our revenue is primarily a function of the volume and pricing of the services provided to our customers, as well as the mix of services provided. Our revenue volume is impacted by new unit sales, customer retention and acquisitions. We derive all of our revenue from customers in the United States. Operating Expenses. In addition to changes in our revenue, our operating results are affected by, among other things, the level of our operating expenses. Our operating expenses primarily include contract claims costs and expenses associated with sales and marketing, customer service and general corporate overhead. A number of our operating expenses are subject to inflationary pressures, such as: salaries and wages, employee benefits and health care; contractor costs; home systems, appliances and repair costs; tariffs; insurance premiums; and various regulatory compliance costs. Net Income and Earnings Per Share. The presentation of net income and basic and diluted earnings per share provides measures of performance which are useful for investors, analysts and other interested parties in company-to-company operating performance comparisons. Basic earnings per share is computed by dividing net income by the weighted-average number of shares of common stock outstanding during the period. Diluted earnings per share is computed by dividing net income by the weighted-average number of shares of common stock outstanding during the period, increased to include the number of shares of common stock that would have been outstanding had potentially dilutive shares of common stock been issued. The dilutive effect of stock options, restricted stock units (“RSUs”), performance shares and restricted stock awards are reflected in diluted net income per share by applying the treasury stock method. Adjusted EBITDA and Adjusted EBITDA Margin. We evaluate performance and allocate resources based primarily on Adjusted EBITDA, which is a financial measure not calculated in accordance with U.S. GAAP. We define Adjusted EBITDA as net income before: provision for income taxes; interest expense; interest income from affiliate; depreciation and amortization expense; non-cash stock-based compensation expense; restructuring charges; Spin-off charges; secondary offering costs; affiliate royalty expense; (gain) loss on insured home service plan claims; and other non-operating expenses. We define “Adjusted EBITDA Margin” as Adjusted EBITDA divided by revenue. We believe Adjusted EBITDA and Adjusted EBITDA Margin are useful for investors, analysts and other interested parties as they facilitate company-to-company operating performance comparisons by excluding potential differences caused by variations in capital structures, taxation, the age and book depreciation of facilities and equipment, restructuring initiatives, Spin-off charges, arrangements with affiliates and equity-based, long-term incentive plans. Net Cash Provided from Operating Activities and Free Cash Flow. We focus on measures designed to monitor cash flow, including net cash provided from operating activities and Free Cash Flow, which is a financial measure not calculated in accordance with U.S. GAAP and represents net cash provided from operating activities less property additions. Growth in Number of Home Service Plans and Customer Retention Rate. We report our growth in number of home service plans and customer retention rate in order to track the performance of our business. Home service plans represent our recurring customer base, which includes customers with active contracts for recurring services. Our customer retention rate is calculated as the ratio of ending home service plans to the sum of beginning home service plans, new unit sales and acquired accounts for the applicable period. These measures are presented on a rolling, 12-month basis in order to avoid seasonal anomalies. Critical Accounting Policies and Estimates This “Management’s Discussion and Analysis of Financial Condition and Results of Operations” is based upon our audited consolidated and combined financial statements included in Item 8 of this Annual Report on Form 10-K, 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 related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates and judgments, including those related to revenue recognition, contract claims costs, the impairment analysis for goodwill and other indefinite-lived intangible assets, share-based compensation, income taxes, tax contingencies and litigation. We base our estimates on historical experience and on various other factors and assumptions 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. We believe the following accounting policies are most important to the portrayal of our financial condition and results of operations and require our most significant judgments and estimates. Revenue Recognition Home service plan contracts are typically one year in duration. We recognize revenue at the agreed upon contractual amount over time using the input method in proportion to the costs expected to be incurred in performing services under the contracts. Those costs bear a direct relationship to the fulfillment of our obligations under the contracts and are representative of the relative value provided to the customer. At contract inception, we assess the goods and services promised in our contracts with customers and identify a performance obligation for each promise to transfer to the customer a good or service (or a bundle of goods and services) that is distinct. To identify the performance obligation, we consider all of the goods and services promised in the contract regardless of whether they are explicitly stated or are implied by customary business practices. Home Service Plan Claims Accruals Home service plan claims costs are expensed as incurred. Accruals for home service plan claims are made using internal actuarial projections, which are based on current claims and historical claims experience. Accruals are established based on estimates of the ultimate cost to settle claims. Home service plan claims take approximately three months to settle, on average, and substantially all claims are settled within six months of incurrence. The amount of time required to settle a claim can vary based on a number of factors, including whether a replacement is ultimately required. In addition to our estimates, we engage a third-party actuary to perform an accrual analysis utilizing generally accepted actuarial methods that incorporate cumulative historical claims experience and information provided by us. We regularly review our estimates of claims costs along with the third-party analysis and adjust our estimates when appropriate. We believe the use of actuarial methods to account for these liabilities provides a consistent and effective way to measure these judgmental accruals. However, the use of any estimation technique in this area is inherently sensitive given the magnitude of claims involved. We believe our recorded obligations for these expenses are consistently measured. Nevertheless, changes in claims costs can materially affect the estimates for these liabilities. Corporate Expense Allocation Our audited consolidated and combined financial statements included in Item 8 of this Annual Report on Form 10-K include transactions with ServiceMaster for services (such as executive functions, information systems, accounting and finance, human resources, and legal and general corporate expenses) that were provided to us by the centralized ServiceMaster organization. Corporate level items also include personnel-related expenses of corporate employees (such as salaries, insurance coverage, stock-based compensation costs, etc.). Throughout the periods prior to the Spin-off covered by the financial statements, the costs of such functions, services and items have been directly charged or allocated to us using methods management believes are reasonable. The methods for allocating functions, services, and items to us are based on proportional allocation bases which include revenue, headcount and others. All such costs have been deemed to have been incurred and settled in the period when the costs were recorded. Income Taxes For purposes of our audited consolidated and combined financial statements included in Item 8 of this Annual Report on Form 10-K, for periods prior to the Spin-off, our taxes are provided for on a “separate return” basis, although our operations for the period prior to the completion of the Spin-off have historically been included in the tax returns filed by ServiceMaster. Income taxes as presented therein allocate current and deferred income taxes of the business to us in a manner that is systematic, rational and consistent with the asset and liability method prescribed by ASC 740. Accordingly, as stated in paragraph 30 of ASC 740, the sum of the amounts allocated to the carve-out tax provisions may not equal the historical consolidated provision for us. Under the separate return method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss carryforwards. 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. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in operations in the period that includes the enactment date. Valuation allowances are established when management determines that it is more likely than not that some portion, or all, of the deferred tax asset will not be realized. The financial effect of changes in tax laws or rates is accounted for in the period of enactment. The settlement of tax obligations is assumed in the period incurred and included in net parent investment for periods prior to the completion of the Spin-off. On October 1, 2018, Frontdoor and its subsidiaries began filing consolidated U.S. federal income tax returns. State and local returns are filed both on a separate company basis and on a combined unitary basis with Frontdoor. Current and deferred income taxes are provided for on a separate company basis. We account for income taxes using an asset and liability approach for the expected future tax consequences of events that have been recognized in our financial statements or tax returns. We record a liability for unrecognized tax benefits resulting from uncertain tax positions taken or expected to be taken in tax returns. We recognize potential interest and penalties related to its uncertain tax positions in income tax expense. Goodwill and Intangible Assets In accordance with applicable accounting standards, goodwill and indefinite-lived intangible assets are not amortized and are subject to assessment for impairment by applying a fair-value-based test on an annual basis, or more frequently, if circumstances indicate a potential impairment. An assessment for impairment is performed on October 1 of every year. There were no goodwill or trade name impairment charges recorded during the years ended December 31, 2019 or 2018. Newly Issued Accounting Standards New accounting rules and disclosure requirements can significantly impact our reported results and the comparability of our financial statements. See Note 2 to the audited consolidated and combined financial statements included in Item 8 of this Annual Report on Form 10-K for further information on newly issued accounting standards. ‎ Results of Operations for the Years Ended December 31, 2019 and 2018 ________________________________ * not meaningful Revenue We reported revenue of $1,365 million and $1,258 million for the years ended December 31, 2019 and 2018, respectively. Revenue by major customer acquisition channel is as follows: _________________________________ * not meaningful (1)First-year revenue only. Revenue increased eight percent for the year ended December 31, 2019 compared to the year ended December 31, 2018, primarily driven by higher renewal revenue due to overall growth in the number of home service plans as well as improved price realization. Real estate revenue was relatively flat, as improved price realization was offset by a decline in new unit sales. The increase in direct-to-consumer revenue primarily reflects growth in new unit sales, mostly driven by increased investments in marketing. Growth in number of home service plans and customer retention rate are presented below. Cost of Services Rendered We reported cost of services rendered of $687 million and $686 million for the years ended December 31, 2019 and 2018, respectively. The following table provides a summary of changes in cost of services rendered: ___________________________________ (1)Represents the gain on an arrangement with a captive insurance affiliate of our former parent whereby certain American Home Shield home service plan claims were insured prior to the Spin-off. Our relationship with this captive insurance affiliate was terminated in connection with the Spin-off. For the year ended December 31, 2019, the decrease in contract claims costs includes a $30 million impact related to process improvement and cost reduction initiatives and a $22 million impact from seasonally mild weather. This favorability was offset, in part, by a $25 million increase in the underlying costs of repairs driven by inflation and tariffs. In addition, contract claims costs include a $10 million net favorable impact for adjustments related to contract claims costs development, which comprises a favorable $3 million adjustment during 2019 related to prior year claims and a net $7 million adjustment during 2018 related to the adverse development of claims from periods prior to 2018. Other includes an increase in bad debt expense of $4 million. Selling and Administrative Expenses For the years ended December 31, 2019 and 2018, we reported selling and administrative expenses of $392 million and $338 million, respectively, which comprised sales, marketing and customer service costs of $278 million and $259 million, respectively, and general and administrative expenses of $114 million and $79 million, respectively. The following table provides a summary of changes in selling and administrative expenses: For the year ended December 31, 2019, the increase in sales, marketing and customer service costs was primarily driven by higher targeted marketing spend to drive sales growth in the direct-to-consumer channel. Incremental ongoing costs related to the Spin-off of $4 million were incurred, which primarily related to the separation of technology systems which were historically shared with ServiceMaster. General and administrative costs include higher personnel costs of $10 million, primarily consisting of salaries and wages, higher insurance-related costs of $7 million, higher incentive compensation expense of $5 million and a $3 million increase in other general and administrative costs, primarily consisting of professional fees. Depreciation Expense Depreciation expense was $18 million and $12 million in the years ended December 31, 2019 and 2018, respectively. The increase was primarily due to additional property and equipment related to the relocation of our corporate headquarters and technology costs related to the Spin-off, principally reflecting costs to replicate technology systems historically shared with ServiceMaster. Amortization Expense Amortization expense was $6 million and $8 million in the years ended December 31, 2019 and 2018, respectively. Restructuring Charges We incurred restructuring charges of $1 million and $3 million for the years ended December 31, 2019 and 2018, respectively. In 2019, restructuring charges comprised severance costs and non-personnel charges primarily related to the decision to consolidate the operations of Landmark with those of OneGuard, which is expected to be completed in the first quarter of 2020. In 2018, restructuring charges comprised $2 million of non-personnel charges primarily related to the relocation to our corporate headquarters and $1 million of severance costs, which primarily represent an allocation of severance costs related to actions taken to enhance capabilities and reduce costs in ServiceMaster’s corporate functions that provided company-wide administrative services to support operations. Spin-Off Charges We incurred Spin-off charges of $1 million and $24 million for the years ended December 31, 2019 and 2018, respectively. These charges include nonrecurring costs incurred to evaluate, plan and execute the Spin-off. In 2019, Spin-off charges primarily comprised third-party consulting fees. In 2018, Spin-off charges primarily comprised $19 million of third-party consulting fees and $5 million of other incremental costs directly related to the Spin-off process. Interest Expense Interest expense was $62 million and $23 million for the years ended December 31, 2019 and 2018, respectively. The increase in interest expense primarily comprised interest related to our financing transactions totaling $1 billion that occurred in 2018 in connection with the Spin-off. See Note 14 to the audited consolidated and combined financial statements included in Item 8 of this Annual Report on Form 10-K for more details. Interest and Net Investment Income Interest and net investment income was $6 million and $2 million for the years ended December 31, 2019 and 2018, respectively, and primarily comprised interest on our investment portfolio. Provision for Income Taxes The effective tax rate on income was 24.9 percent and 25.1 percent for the years ended December 31, 2019 and 2018, respectively. Our audited consolidated and combined financial statements included in Item 8 of this Annual Report on Form 10-K do not reflect any amounts due to ServiceMaster for income tax related matters as it is assumed that all such amounts due to ServiceMaster were settled at the end of each reporting period. Net Income Net income was $153 million and $125 million for the years ended December 31, 2019 and 2018, respectively. The $28 million increase for the year ended December 31, 2019 was driven by the aforementioned operating results, offset, in part, by a $9 million increase in the provision for income taxes as a result of higher income before income taxes. Adjusted EBITDA Adjusted EBITDA was $303 million and $238 million for the years ended December 31, 2019 and 2018, respectively. The following table provides a summary of changes in our Adjusted EBITDA. For a reconciliation of net income to Adjusted EBITDA, see “Item 6. Selected Financial Data.” For the year ended December 31, 2019, the decrease in contract claims costs includes a $30 million impact related to process improvement and cost reduction initiatives and a $22 million impact from seasonally mild weather. This favorability was offset, in part, by a $25 million increase in the underlying costs of repairs driven by inflation and tariffs. In addition, contract claims costs include a $10 million net favorable impact for adjustments related to contract claims costs development, which comprises a favorable $3 million adjustment during 2019 related to prior year claims and a net $7 million adjustment during 2018 related to the adverse development of claims from periods prior to 2018. For the year ended December 31, 2019, the increase in sales, marketing and customer service costs was primarily driven by higher targeted marketing spend to drive sales growth in the direct-to-consumer channel. Incremental ongoing costs related to the Spin-off of $4 million were incurred, which primarily related to the separation of technology systems which were historically shared with ServiceMaster. General and administrative costs include higher personnel costs of $10 million, primarily consisting of salaries and wages, higher insurance-related costs of $7 million, higher incentive compensation expense of $5 million and a $3 million increase in other general and administrative costs, primarily consisting of professional fees. ‎ Liquidity and Capital Resources Liquidity A substantial portion of our liquidity needs are due to debt service requirements on our indebtedness. The Credit Agreement, as well as the Indenture, contain covenants that limit or restrict our ability, including the ability of certain of our subsidiaries, to incur additional indebtedness, repurchase debt, incur liens, sell assets, make certain payments (including dividends) and enter into transactions with affiliates. As of December 31, 2019, we were in compliance with the covenants under the agreements that were in effect on such date. In connection with the Spin-off, our capital structure and sources of liquidity changed significantly from our historical capital structure. Although we believe that our future cash provided from operations, together with available capacity under our Revolving Credit Facility and our access to capital markets, will provide adequate resources to fund our operating and financing needs, our access to, and the availability of, financing on acceptable terms in the future will be affected by many factors, including: (i) our credit rating, (ii) the liquidity of the overall capital markets and (iii) the current state of the economy. Moreover, to preserve the tax-free treatment of the Spin-off, we may not be able to engage in certain strategic or capital-raising transactions following the Spin-off, such as issuing equity securities beyond certain thresholds, which may limit our access to capital markets, ability to raise capital through equity issuances, and ability to make acquisitions using our equity as currency, potentially requiring us to issue more debt than would otherwise be optimal. There can be no assurances that we will continue to have access to capital markets on terms acceptable to us. See “Risk Factors” included in Item 1A of this Annual Report on Form 10-K for a further discussion. Cash and short-term marketable securities totaled $434 million and $305 million as of December 31, 2019 and 2018, respectively. As of December 31, 2019, there were no letters of credit outstanding and there was $250 million of available borrowing capacity under the Revolving Credit Facility. Cash and short-term marketable securities include balances associated with regulatory requirements in our business. See “-Limitations on Distributions and Dividends by Subsidiaries.” Our investment portfolio has been invested in high-quality debt securities. We closely monitor the performance of these investments. From time to time, we review the statutory reserve requirements to which our regulated entities are subject and any changes to such requirements. These reviews may result in identifying current reserve levels above or below minimum statutory reserve requirements, in which case we may adjust our reserves. The reviews may also identify opportunities to satisfy certain regulatory reserve requirements through alternate financial vehicles. During 2020, we intend to repurchase or otherwise retire or extend our debt and/or take other steps to reduce our debt or otherwise improve our financial position, gross leverage, results of operations or cash flows. These actions may include open market debt repurchases, negotiated repurchases, other retirements of outstanding debt and/or opportunistic refinancing of debt. The amount of debt that may be repurchased or otherwise retired or refinanced, if any, and the price of such repurchases, retirements or refinancings will depend on market conditions, trading levels of our debt, our cash position, compliance with debt covenants and other considerations. Credit Facilities and Senior Notes On August 16, 2018, in connection with the Spin-off, we entered into the $650 million Term Loan Facility and the $250 million Revolving Credit Facility and issued $350 million of 2026 Notes. Borrowings under the Term Loan Facility and the 2026 Notes were incurred as partial consideration for the contribution of the Separated Business to us. We did not receive any cash proceeds as a result of these transactions. On October 24, 2018, we entered into an interest rate swap agreement effective October 31, 2018 that expires on August 16, 2025. The notional amount of the agreement was $350 million. Under the terms of the agreement, we will pay a fixed rate of interest of 3.0865 percent on the $350 million notional amount, and we will receive a floating rate of interest (based on one-month LIBOR, subject to a floor of zero percent) on the notional amount. Therefore, during the term of the agreement, the effective interest rate on $350 million of the Term Loan Facility is fixed at a rate of 3.0865 percent, plus the incremental borrowing margin of 2.50 percent. Limitations on Distributions and Dividends by Subsidiaries We depend on our subsidiaries to distribute funds to us so that we may pay obligations and expenses, including satisfying obligations with respect to indebtedness. The ability of our subsidiaries to make distributions and dividends to us depends on their operating results, cash requirements, financial condition and general business conditions, as well as restrictions under the laws of our subsidiaries’ jurisdictions. Our subsidiaries are permitted under the terms of the Credit Agreement and other indebtedness to incur additional indebtedness that may restrict or prohibit the making of distributions, the payment of dividends or the making of loans by such subsidiaries to us. Furthermore, there are third-party restrictions on the ability of certain of our subsidiaries to transfer funds to us. These restrictions are related to regulatory requirements. The payments of ordinary and extraordinary dividends by certain of our subsidiaries (through which we conduct our business) are subject to significant regulatory restrictions under the laws and regulations of the states in which they operate. Among other things, such laws and regulations require certain subsidiaries to maintain minimum capital and net worth requirements and may limit the amount of ordinary and extraordinary dividends and other payments that these subsidiaries can pay to us. As of December 31, 2019 and 2018, the total net assets subject to these third-party restrictions was $168 million and $187 million, respectively. We expect that such limitations will be in effect for the foreseeable future. In Texas, we are relieved of the obligation to post 75 percent of our otherwise required reserves because we operate a captive insurer approved by Texas regulators in order to satisfy such obligations. None of our subsidiaries are obligated to make funds available to us through the payment of dividends. Cash Flows Cash flows from operating, investing and financing activities for the years ended December 31, 2019 and 2018, as reflected in the audited consolidated and combined statements of cash flows included in Item 8 of this Annual Report on Form 10-K, are summarized in the following table. Operating Activities Net cash provided from operating activities was $200 million for the year ended December 31, 2019, compared to $189 million for the year ended December 31, 2018. Net cash provided from operating activities in 2019 comprised $189 million in earnings adjusted for non-cash charges and a $11 million decrease in cash required for working capital. The decrease in cash required for working capital was driven by growth in our underlying business and the timing of trade payables. Net cash provided from operating activities in 2018 comprised $157 million in earnings adjusted for non-cash charges and a $32 million decrease in cash required for working capital. The decrease in cash required for working capital was driven by growth in our underlying business and the favorable impacts of accrued interest and taxes. Investing Activities Net cash used for investing activities was $61 million for the year ended December 31, 2019, compared to $10 million for the year ended December 31, 2018. Capital expenditures decreased to $22 million in 2019 from $27 million in 2018 and included recurring capital needs and technology projects. In 2019 and 2018, we incurred incremental capital expenditures required to effect the Spin-off of $2 million and $15 million, respectively, principally reflecting costs to replicate technology systems historically shared with ServiceMaster. We expect capital expenditures for the full year 2020 relating to recurring capital needs and the continuation of investments in information systems and productivity enhancing technology to be approximately $30 million to $40 million. We have no additional material capital commitments at this time. Cash payments for business acquisitions, net of cash acquired, were $38 million in 2019, consisting of $35 million in net cash paid to acquire Streem and $3 million in cash paid to acquire another business, both of which represent ongoing strategic investments in our business. Cash flows provided from purchases, sales and maturities of securities, net, in 2019 and 2018 were $3 million and $17 million, respectively, and were driven by the maturity and sale of marketable securities. Cash flows used for other investing activities were $4 million in 2019 and represent ongoing strategic investments in our business. Financing Activities Net cash used for financing activities was $7 million for the year ended December 31, 2019, compared to $165 million for the year ended December 31, 2018. Payments on debt and finance lease obligations were $7 million and $10 million in 2019 and 2018, respectively. Net transfers to Parent included in financing activities were $137 million in 2018. Payments of debt issuance costs of $16 million and the discount paid on the debt issuance of $2 million were incurred in 2018 as part of our financing transactions that occurred in connection with the Spin-off. Contractual Obligations The following table presents our contractual obligations and commitments as of December 31, 2019. _________________________________ * These items are reported in the audited consolidated statements of financial position included in Item 8 of this Annual Report on Form 10-K. (1)These amounts represent future interest payments related to existing debt obligations based on interest rates and principal maturities specified in the associated debt agreements. As of December 31, 2019, payments related to the Term Loan Facility are based on applicable rates at December 31, 2019 plus the specified margin in the Credit Agreement for each period presented. As of December 31, 2019, the estimated debt balance (including finance leases) as of each fiscal year end from 2020 through 2024 is $986 million, $980 million, $973 million, $966 million and $959 million, respectively, and the weighted-average interest rate on the estimated debt balances at each fiscal year end from 2020 through 2024 is five percent. See Note 14 to the audited consolidated and combined financial statements included in Item 8 of this Annual Report on Form 10-K for the terms and maturities of existing debt obligations. (2)These amounts primarily represent future payments relating to real estate operating leases. Financial Position The following discussion describes changes in our financial position from December 31, 2018 to December 31, 2019. Cash and cash equivalents increased from prior year levels, primarily due to cash provided from operating activities. Intangible Assets, net increased from prior year levels, primarily due to the acquisition of Streem. See Note 7 to the audited consolidated and combined financial statements included in Item 8 of this Annual Report on Form 10-K for further information regarding acquisitions. The Operating lease right-of-use (“ROU”) assets and Operating lease liabilities were recorded effective as of January 1, 2019 as a result of the adoption of ASC 842. Upon adoption of ASC 842, we recognized an ROU asset and lease liability for all leases with terms of 12 months or more. See Note 5 to the audited consolidated and combined financial statements included in Item 8 of this Annual Report on Form 10-K for further information regarding our leases. Total shareholders’ equity was a deficit of $179 million as of December 31, 2019 compared to a deficit of $344 million as of December 31, 2018. The increase was primarily driven by the $153 million of net income generated in 2019 which reduced our accumulated deficit. See the consolidated and combined statements of changes in equity included in Item 8 of this Annual Report on Form 10-K for further information. Off-Balance Sheet Arrangements As of December 31, 2019, we did not have any significant off-balance sheet arrangements. We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, established for the purpose of facilitating off- balance sheet arrangements or other contractually narrow or limited purposes. Accordingly, we are not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.
0.001276
0.001474
0
<s>[INST] For a discussion of our results of operations for the year ended December 31, 2018 compared to the year ended December 31, 2017, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II of our 2018 Annual Report on Form 10K filed with the SEC on February 28, 2019, which specific discussion is incorporated herein by reference. Overview Frontdoor is the largest provider of home service plans in the United States, as measured by revenue, and operates under the American Home Shield, HSA, OneGuard and Landmark brands. Our home service plans help our customers maintain their homes and protect against costly and unexpected breakdowns of essential home systems and appliances. Our home service plan customers subscribe to a yearly service plan agreement that covers the repair or replacement of major components of up to 21 home systems and appliances, including electrical, plumbing, central HVAC systems, water heaters, refrigerators, dishwashers and ranges/ovens/cooktops. In 2019, we launched Candu, our ondemand home services brand, and acquired Streem, a technology startup that uses augmented reality, computer vision and machine learning to help home service professionals more quickly and accurately diagnose breakdowns and complete repairs. We serve over two million customers annually across all 50 states and the District of Columbia. For the year ended December 31, 2019, we generated revenue, net income and Adjusted EBITDA of $1,365 million, $153 million and $303 million, respectively. For the year ended December 31, 2018, we generated revenue, net income and Adjusted EBITDA of $1,258 million, $125 million and $238 million, respectively. For the year ended December 31, 2019, our total operating revenue included 68 percent of revenue derived from existing customer renewals, while 19 percent and 12 percent were derived from new unit sales made in conjunction with existing home resale transactions and directtoconsumer sales, respectively, and one percent was derived from other revenue streams. For the year ended December 31, 2018, our total operating revenue included 66 percent of revenue derived from existing customer renewals, while 21 percent and 12 percent were derived from new unit sales made in conjunction with existing home resale transactions and directtoconsumer sales, respectively, and one percent was derived from other revenue streams. The Spinoff On October 1, 2018, ServiceMaster completed the spinoff of its businesses operated under the American Home Shield, HSA, OneGuard and Landmark brand names (the “Separated Business”) into a standalone publicly traded company (the “Spinoff”). The audited consolidated and combined financial statements included in Item 8 of this Annual Report on Form 10K for periods prior to the Spinoff represent, on a historical cost basis, the combined assets, liabilities, revenue and expenses related to the Separated Business. Frontdoor was formed as a whollyowned subsidiary of ServiceMaster on January 2, 2018 for the purpose of holding the Separated Business in connection with the Spinoff. During 2018, ServiceMaster contributed the Separated Business to Frontdoor. The Spinoff was completed by a pro rata distribution to ServiceMaster’s stockholders of approximately 80.2 percent of our common stock. Each holder of ServiceMaster common stock received one share of our common stock for every two shares of ServiceMaster common stock held at the close of business on September 14, 2018, the record date of the distribution. The Spinoff was completed pursuant to a separation and distribution agreement and other agreements with ServiceMaster related to the Spinoff, including a transition services agreement, a tax matters agreement, an employee matters agreement and a stockholder and registration rights agreement. See Note 11 to the audited consolidated and combined financial statements included in Item 8 of this Annual Report on Form 10K for information related to these agreements. On March 20, 2019, ServiceMaster agreed to transfer its remaining 16,734, [/INST] Positive. </s>
2,020
7,493
1,718,227
Construction Partners, Inc.
2018-12-14
2018-09-30
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. This discussion and analysis of our financial condition and results of operations is intended to assist in understanding and assessing the trends and significant changes in our results of operations and financial condition. Historical results may not be indicative of future performance. This discussion includes forward-looking statements that reflect our plans, estimates and beliefs. Such statements involve risks and uncertainties. Our actual results may differ materially from those contemplated by these forward-looking statements as a result of various factors, including those set forth under the headings “Risk Factors” and “Cautionary Statement Regarding Forward-Looking Statements.” This discussion should be read in conjunction with our audited consolidated financial statements and the notes thereto included elsewhere in this Annual Report on Form 10-K. In this discussion, we use certain non-GAAP financial measures. Explanation of these non-GAAP financial measures and reconciliation to the most directly comparable GAAP financial measures are included in this "Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Investors should not consider non-GAAP financial measures in isolation or as substitutes for financial information presented in compliance with GAAP. Overview We are one of the fastest growing civil infrastructure companies in the United States specializing in the building and maintenance of transportation networks. Our operations leverage a highly skilled workforce, strategically located HMA plants, substantial construction assets and select material deposits. We provide construction products and services to both public and private infrastructure projects, with an emphasis on highways, roads, bridges, airports and commercial and residential sites in the southeastern United States. Our public projects are funded by federal, state and local governments and include projects for roads, highways, bridges, airports and other forms of infrastructure. Public transportation infrastructure projects historically have been a relatively stable portion of state and federal budgets and represent a significant share of the United States construction market. Federal funds are allocated on a state-by-state basis, and each state is required to match a portion of the federal funds they receive. Federal highway spending uses funds predominantly from the Highway Trust Fund, which derives its revenues from fuel taxes and other user fees. In addition to public infrastructure projects, we provide a wide range of large sitework construction and HMA paving services to private construction customers, including commercial and residential developers and local businesses. How We Assess Performance of Our Business Revenues We derive our revenues predominantly by providing construction products and services for both public and private infrastructure projects, with an emphasis on highways, roads, bridges, airports and commercial and residential sites. Our projects represent a mix of federal, state, municipal and private customers. We also derive revenues from the sale of HMA and aggregates to customers. Revenues derived from projects are recognized on the percentage-of-completion basis, measured by the relationship of total cost incurred compared to total estimated contract costs (cost-to-cost method). Changes in job performance, job conditions and estimated profitability, including those arising from contract penalty provisions and final contract settlements, may result in revisions to estimated costs and income, and are recognized in the period in which the revisions are determined. Revenues derived from the sale of HMA and aggregates are recognized when risks associated with ownership have passed to the customer. Gross Profit Gross profit represents revenues less cost of revenues. Cost of revenues consists of all direct and indirect costs on construction contracts, including raw materials, labor, equipment costs, depreciation, lease expenses, subcontract costs and other expenses at our HMA plants and aggregate mining facilities. Our cost of revenues is directly affected by fluctuations in commodity prices, primarily liquid asphalt and diesel fuel. From time to time, when appropriate, we limit our exposure to changes in commodity prices by entering into forward purchase commitments. In addition, our public infrastructure contracts often provide for price adjustments based on fluctuations in certain commodity-related product costs. These price adjustment provisions are in place for most of our public infrastructure contracts, and we seek to include similar provisions in our private contracts. Depreciation, Depletion and Amortization We carry property, plant and equipment on our balance sheet at cost, net of accumulated depreciation, depletion and amortization. Depreciation on property, plant and equipment is computed on a straight-line basis over the estimated useful life of the asset. Amortization expense is the periodic expense related to leasehold improvements and intangible assets. Leasehold improvements are amortized over the lesser of the life of the underlying asset or the remaining lease term. Our intangible assets were recognized as a result of certain acquisitions and are generally amortized on a straight-line basis over the estimated useful lives of the assets. Quarry reserves are depleted in accordance with the units-of-production method as aggregate is extracted, using the initial allocation of cost based on proven and probable reserves. General and Administrative Expenses General and administrative expenses consist primarily of salaries and personnel costs for our administration, finance and accounting, legal, information systems, human resources and certain managerial employees. Additional expenses include audit, consulting and professional fees, travel, insurance, office space rental costs, property taxes and other corporate and overhead expenses. Gain on Sale of Equipment, net In the normal course of business, we sell construction equipment for various reasons, including when the cost of maintaining the asset exceeds the cost of replacing it. The gain or loss on sale of equipment reflects the difference between the carrying value at the date of disposal and the net consideration received from the sale of equipment during the period. Interest Expense, net Interest expense, net primarily represents interest incurred on our long-term debt, such as the Compass Term Loan and the Compass Revolving Credit Facility, as well as the cost of interest swap agreements and amortization of deferred debt issuance costs. These amounts are partially offset by interest income earned on short-term investments of cash balances in excess of our current operating needs. Other Key Performance Indicators Adjusted EBITDA and Adjusted EBITDA Margin Adjusted EBITDA represents net income before interest expense, net, provision for income taxes, depreciation, depletion and amortization, equity-based compensation expense, loss on extinguishment of debt and certain management fees and expenses, and excludes income recognized in connection with the Settlement (1). Adjusted EBITDA Margin represents Adjusted EBITDA as a percentage of revenues for each period. These metrics are supplemental measures of our operating performance that are neither required by, nor presented in accordance with, GAAP. These measures should not be considered as an alternative to net income or any other performance measure derived in accordance with GAAP as an indicator of our operating performance. We present Adjusted EBITDA and Adjusted EBITDA Margin because management uses these measures as key performance indicators, and we believe they are measures frequently used by securities analysts, investors and other parties to evaluate companies in our industry. These measures have limitations as analytical tools and should not be considered in isolation or as substitutes for analysis of our results as reported under GAAP. Our calculation of Adjusted EBITDA and Adjusted EBITDA Margin may not be comparable to similarly named measures reported by other companies. Potential differences between our measure of Adjusted EBITDA compared to other similar companies’ measures of Adjusted EBITDA may include differences in capital structures, tax positions and the age and book depreciation of intangible and tangible assets. The following table presents a reconciliation of net income, the most directly comparable measure calculated in accordance with GAAP, to Adjusted EBITDA, and the calculation of Adjusted EBITDA Margin for each of the periods presented. (1) Represents pre-tax income recognized in connection with the Settlement (see Note 21 - Settlement Agreement to the consolidated financial statements included elsewhere in this Annual Report on Form 10-K). (2) Reflects fees and reimbursement of certain travel expenses under a management services agreement with SunTx (see Note 18 - Related Parties to the consolidated financial statements included elsewhere in this Annual Report on Form 10-K). Results of Operations Fiscal Year Ended September 30, 2018 Compared to Fiscal Year Ended September 30, 2017 The following table sets forth selected financial data for the fiscal years ended September 30, 2018 ("fiscal 2018") and September 30, 2017 ("fiscal 2017"): Revenues. Revenues for fiscal 2018 increased $111.9 million, or 19.7%, to $680.1 million from $568.2 million for fiscal 2017. The increase in revenues was primarily due to a $191.0 million higher backlog at the beginning of fiscal 2018 compared to the beginning of fiscal 2017, the increase in available work in our existing markets, and $51.4 million of revenues from two acquisitions and two greenfield expansions we completed subsequent to September 30, 2017. Gross Profit. Gross profit for fiscal 2018 increased $8.5 million, or 9.4%, to $99.5 million from $91.0 million for fiscal 2017. The higher gross profit was the result of the 19.7% revenue increase for fiscal 2018 compared to fiscal 2017. The decrease in gross profit as a percentage of revenues was due to the negative impact of rising asphalt cement prices on margins from internal and external sales of HMA. General and Administrative Expenses. General and administrative expenses include costs related to our operational offices that are not allocated to direct contract costs and expenses related to our corporate offices. General and administrative expenses for fiscal 2018 increased $7.4 million, or 15.5%, to $55.3 million from $47.9 million for fiscal 2017. The increase in general and administrative expenses for fiscal 2018 compared to fiscal 2017 was attributable to (i) a $4.2 million increase in management payroll and benefit costs as a result of the two acquisitions and two greenfield expansions we completed subsequent to September 30, 2017, and other growth, and (ii) a $1.3 million increase in professional expenses and insurance costs related to increased regulatory and reporting requirements due to becoming a public company. Interest Expense, Net. Interest expense, net for fiscal 2018 decreased $2.7 million, or 67.9%, to $1.3 million compared to $4.0 million for fiscal 2017. The decrease in interest expense, net was due to lower interest rates applicable to our variable interest loans during fiscal 2018 compared to fiscal 2017 and a lower amortization of deferred debt issuance costs of $0.1 million compared to $0.7 million during the same periods. This reduction in interest rates was due to lower effective interest rates under the Compass Credit Agreement, which we entered into on June 30, 2017. In addition, to hedge against future changes in the variable interest rates, we entered into interest rate swap agreements tied to our variable rate debt. These interest rate swap agreements do not qualify for hedge accounting treatment in accordance with GAAP; therefore, changes in fair value are reflected within interest expense on the Consolidated Statements of Income. During fiscal 2018, the change in the fair value of the interest rate swaps resulted in a $0.4 million credit to interest expense. Loss on Extinguishment of Debt. We recorded a $1.6 million loss on extinguishment of debt during fiscal 2017 resulting from the unamortized deferred debt issuance costs related to the CIT Credit Facility (as defined in Note 12 - Debt to the consolidated financial statements included elsewhere in this Annual Report on Form 10-K) and other debt refinanced at June 30, 2017. There were no transactions during fiscal 2018 resulting in a loss on extinguishment of debt. Settlement Income. During fiscal 2018, we recorded settlement income of $14.8 million reflecting the net present value of future payments to be received in connection with the Settlement. Pursuant to the Settlement, we will receive aggregate net payments of approximately $15.7 million, payable in four equal installments between January 2019 and July 2020, in exchange for releasing and waiving all current and future claims against a third party. Provision for Income Taxes. Our effective tax rate decreased to 17.2% for fiscal 2018, from 36.1% for fiscal 2017. Our lower effective tax rate for fiscal 2018 was primarily due to the impacts of comprehensive tax legislation enacted by the U.S. government on December 22, 2017, known as the Tax Cuts and Jobs Act (the “Tax Act”). The Tax Act includes broad and complex changes to the U.S. tax code, including a reduction in the U.S. federal corporate tax rate from 35% to 21% effective January 1, 2018. Specifically, we completed the Company's accounting for the income tax effects of the Tax Act during fiscal 2018 and recorded a discrete tax benefit of $4.6 million related to the Tax Act, primarily due to adjusting its U.S. deferred tax liabilities by the same amount, reflecting the reduction in the U.S. federal corporate tax rate. This net reduction in deferred tax liabilities also included the estimated impact on the Company’s net state deferred tax assets. Accordingly, the effective tax rate for fiscal 2018 reflects a federal income tax provision based on a blended U.S. statutory tax rate of 24.5%, which is calculated based on a proration of the applicable tax rates before and after the effective date of the Tax Act during fiscal 2018, and the effect of applicable state income taxes. The effective tax rate for fiscal 2018 was also reduced by a $1.4 million permanent tax benefit resulting from the deduction of the excess fair market value of options exercised under the 2010 Non-Plan Stock Option Agreement over the exercise price. Earnings from Investment in Joint Venture. During fiscal 2018, we earned $1.3 million of pre-tax income from our 50% interest in the earnings of a joint venture. We entered into the joint venture with a third party in November 2017 for the sole purpose of performing a construction project for the Alabama Department of Transportation. We did not have an interest in a joint venture during fiscal 2017. Net Income. Net income increased $24.8 million, or 95.0%, to $50.8 million for fiscal 2018 compared to $26.0 million for fiscal 2017. This increase in net income was a result of (i) the Settlement income and earnings from investment in a joint venture during fiscal 2018 with no comparable amounts during fiscal 2017; (ii) a $1.6 million loss on extinguishment of debt during fiscal 2017 with no comparable amount during fiscal 2018; (iii) a reduction in interest expense and (iv) benefits of a lower effective tax rate during fiscal 2018 compared to fiscal 2017, all as described above. The increase in gross profit for fiscal 2018 compared to fiscal 2017 was substantially offset by the increase in general and administrative expenses during the same periods. Adjusted EBITDA and Adjusted EBITDA Margin. Adjusted EBITDA and Adjusted EBITDA Margin were $75.5 million and 11.1%, respectively, for fiscal 2018, compared to $69.3 million and 12.2%, respectively, for fiscal 2017. The increase in Adjusted EBITDA primarily resulted from the increase in gross profit and depreciation for fiscal 2018 compared to fiscal 2017, partially offset by the increase in general and administrative expense and the decline in gain on sale of equipment. The decrease in Adjusted EBITDA Margin is the result of lower gross profit as a percent of revenue and the decline in the gain on sale of equipment, partially offset by lower general and administrative expenses as a percentage of revenue in fiscal 2018 compared to fiscal 2017. See the description of Adjusted EBITDA and Adjusted EBITDA Margin, as well as a reconciliation of Adjusted EBITDA to net income under the heading “How We Assess Performance of Our Business”. Inflation and Price Changes Inflation had an immaterial impact on our results of operations for the fiscal years ended September 30, 2018 and 2017 due to relatively low inflation in the United States in recent years and our ability to recover increasing costs by obtaining higher prices for our products, including sale price escalator clauses in most of our public infrastructure sector contracts. Inflation risk varies with the level of activity in our industry, the number, size and strength of competitors and the availability of products to supply a local market. Liquidity and Capital Resources Cash Flows Analysis The following table sets forth our cash flows for the periods indicated. Operating Activities Cash provided by operating activities, net of acquisition, was $66.1 million for fiscal 2018, an increase of $19.2 million compared to $46.9 million for fiscal 2017. The increase was primarily due to a $24.8 million increase in net income for fiscal 2018 compared to fiscal 2017, partially offset by a $5.7 million reduction in changes in operating assets and liabilities for those same periods. The decrease in changes in operating assets and liabilities included (i) a $10.3 million greater decrease in accrued expenses and other liabilities, (ii) a $14.2 million greater increase in other assets and other current assets, primarily due to the Settlement income, and (iii) a $9.0 million lesser increase in net billings in excess of costs and estimated earnings on uncompleted contracts, partially offset by a $28.9 million greater reduction in contracts receivable including retainage, net, reflecting fluctuations resulting from the timing of performing and closing projects. Our working capital results from both public and private sector projects. Customers in the private sector typically pay more slowly than customers in the public sector, and private sector contracts often contain retention provisions that allow the customer to withhold a percentage of the revenues earned until the completion of the project. Investing Activities Cash used in investing activities was $89.6 million for fiscal 2018 compared to $30.7 million for fiscal 2017. The increase reflects a $40.5 million increase in cash used in business acquisitions, net of cash acquired, and a $18.4 million increase in purchases of property, plant and equipment to execute our greenfield activities and other organic growth opportunities. Financing Activities Cash provided by financing activities was $95.1 million for fiscal 2018 compared to $39.8 million of cash used in financing activities during fiscal 2017. Fiscal 2018 included $98.0 million of proceeds from our initial public offering of Class A common stock, net of offering costs. Fiscal 2017 included the payment of a $31.3 million dividend. Compass Credit Agreement On June 30, 2017, Construction Partners Holdings, our wholly owned subsidiary, entered into the Compass Credit Agreement, with Compass Bank as agent (the “Agent”), sole lead arranger and sole bookrunner, providing for a $50.0 million Compass Term Loan and a $30.0 million Compass Revolving Credit Facility. In connection with the Scruggs Acquisition, the Company amended the Compass Credit Agreement on May 15, 2018 and borrowed an additional $22.0 million under the Compass Term Loan to fund a portion of the purchase price. The principal amount of the Compass Term Loan, including the additional borrowing, must be paid in quarterly installments of $3.6 million. All amounts borrowed under the Compass Credit Agreement mature on July 1, 2022. Construction Partners Holdings’ obligations under the Compass Credit Agreement are guaranteed by the Company and all of Construction Partners Holdings’ direct and indirect subsidiaries and are secured by first priority security interests in substantially all of the Company’s assets. Under the Compass Credit Agreement, borrowings can be designated as base rate loans or Euro-Dollar Loans. The interest rate on base rate loans fluctuates and is equal to (i) the highest of: (a) the rate of interest in effect for such day as publicly announced from time to time by the Agent as its “prime rate,” (b) the federal funds rate plus 0.50% and (c) the quotient of the LIBOR for deposits in U.S. dollars as obtained from Reuters, Bloomberg or another commercially available source designated by the Agent two Euro-Dollar Business Days (as defined in the Compass Credit Agreement) before the first day of the applicable interest period divided by 1.00, minus the Euro-Dollar Reserve Percentage (as defined in the Compass Credit Agreement), plus 1.0% for a one-month interest period, plus (ii) the applicable rate, which ranges from 2.0% to 2.25%. The interest rate for Euro-Dollar loans fluctuates and is equal to the sum of the applicable rate, which ranges from 2.0% to 2.25%, plus LIBOR for the interest period selected by the Agent. At September 30, 2018 and September 30, 2017, the interest rate on outstanding borrowings under the Compass Term Loan and Compass Revolving Credit Facility was 4.242% and 3.235%, respectively. At September 30, 2018 and September 30, 2017, we had availability of $14.0 million and $11.3 million, respectively, under the Compass Revolving Credit Facility, including reduction for outstanding letters of credit. In order to hedge against changes in interest rates, on June 30, 2017, we entered into an amortizing $25.0 million notional interest rate swap agreement applicable to outstanding debt under the Compass Term Loan, under which we pay a fixed percentage rate of 2.015% and receive a credit based on the applicable LIBOR rate. In connection with the amendment to the Compass Amendment and the additional borrowing on May 15, 2018, we entered into an additional $11.0 million notional interest rate swap agreement applicable to the $22.0 million of additional debt under the Compass Term Loan. Under this additional swap agreement, we pay a fixed percentage rate of 3.01% and receive a credit based on the applicable LIBOR rate. At September 30, 2018 and September 30, 2017, the aggregate notional value of these interest rate swap agreements was $28.7 million and $23.8 million, respectively, and the fair value was $0.3 million and $(0.2) million, respectively, which is included within other assets or other liabilities on our Consolidated Balance Sheets. We must pay a commitment fee of 0.35% per annum on the aggregate unused revolving commitments under the Compass Credit Agreement. We also must pay fees with respect to any letters of credit issued under the Compass Credit Agreement. The Compass Credit Agreement contains usual and customary negative covenants for agreements of this type, including, but not limited to, restrictions on our ability to make acquisitions, make loans or advances, make capital expenditures and investments, create or incur indebtedness, create liens, wind up or dissolve, consolidate, merge or liquidate, or sell, transfer or dispose of assets. The Compass Credit Agreement requires us to satisfy certain financial covenants, including a minimum fixed charge coverage ratio of 1.20 to 1.00. At September 30, 2018 and September 30, 2017, our fixed charge ratio was 1.51 to 1.00 and 1.63 to 1.00, respectively. The Compass Credit Agreement also requires us to maintain a consolidated leverage ratio not to exceed 2.00 to 1.00, subject to certain adjustments as further described in the Compass Credit Agreement. At September 30, 2018 and September 30, 2017, our consolidated leverage ratio was 0.88 to 1.00 and 0.95 to 1.00, respectively. The Compass Credit Agreement includes customary events of default, including, among other things, payment default, covenant default, breach of representation or warranty, bankruptcy, cross-default, material ERISA events, certain changes of control, material money judgments and failure to maintain subsidiary guarantees. The Compass Credit Agreement prevents us from paying dividends or otherwise distributing cash to our stockholders unless, after giving effect to such dividend, we would be in compliance with the financial covenants and, at the time any such dividend is made, no default or event of default exists or would result from the payment of such dividend. At September 30, 2018 and September 30, 2017, we were in compliance with all covenants under the Compass Credit Agreement. Capital Requirements and Sources of Liquidity During fiscal 2018 and fiscal 2017, our capital expenditures were approximately $42.8 million and $24.4 million, respectively. Our capital expenditures are typically made during the same fiscal year in which they are approved. At September 30, 2018, our commitments for capital expenditures were not material to our financial condition or results of operations on a consolidated basis. For fiscal 2019, we expect total capital expenditures to be approximately $39.0 million to $42.0 million. Our capital expenditure budget is an estimate and is subject to change. As described further below, we believe that cash flows from operations combined with existing cash on hand and amounts available under our credit facilities will be sufficient to fund our working capital needs and planned capital expenditures for the next twelve months. Historically, we have had significant cash requirements in order to organically expand our business into new geographic markets. Our cash requirements include costs related to increased capital expenditures, purchase of materials and production of materials and cash to fund our organic expansion into new markets. Our working capital needs are driven by the seasonality and growth of our business, with our cash requirements increasing in periods of growth. Additional cash requirements resulting from our growth include the costs of additional personnel, production and distribution facilities, enhancing our information systems and, in the future, our integration of any acquisitions and our compliance with laws and rules applicable to public companies. We have historically relied upon cash available through credit facilities, in addition to cash from operations, to finance our working capital requirements and to support our growth. We regularly monitor potential capital sources, including equity and debt financings, in an effort to meet our planned capital expenditures and liquidity requirements. Our future success will depend on our ability to access outside sources of capital. We believe that our operating cash flow and available borrowings under the Compass Revolving Credit Facility will be sufficient to fund our operations for at least the next twelve months. However, future cash flows are subject to a number of variables, and significant additional capital expenditures will be required to conduct our operations. There can be no assurance that operations and other capital resources will provide cash in sufficient amounts to maintain planned or future levels of capital expenditures. In the event that we make one or more 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 and/or seek additional capital. If we seek additional capital, we may do so through borrowings under the Compass Revolving Credit Facility, joint ventures, asset sales, offerings of debt or equity securities or other means. We cannot guarantee that this additional capital will be available on acceptable terms or at all. If we are unable to obtain the funds we need, we may not be able to complete acquisitions that may be favorable to us or finance the capital expenditures necessary to conduct our operations. Off-Balance Sheet Arrangements The Company enters into operating leases for property and equipment in the normal course of business. See Note 19 - Commitments and Contingencies to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for additional information. Other than the operating leases described therein, we do not currently have any off-balance sheet arrangements that have, or are reasonably likely to have, a current or future effect on our financial condition, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources that would be material to investors. Critical Accounting Policies and Estimates The discussion of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. We evaluate our estimates and assumptions on an ongoing basis. The results of our analysis form the basis for making assumptions 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, and the impact of such differences may be material to our consolidated financial statements. Critical accounting policies are those policies that, in management’s view, are the most important in the portrayal of our financial condition and results of operations. The notes to the consolidated financial statements also include disclosure of significant accounting policies. The methods, estimates and judgments that we use in applying our accounting policies have a significant impact on the results that we report in our consolidated financial statements. These critical accounting policies require us to make difficult and subjective judgments, often as a result of the need to make estimates regarding matters that are inherently uncertain. Our most critical accounting policies and estimates include those involved in the recognition of revenues and provision for income tax expense. Those critical accounting policies and estimates that require the most significant judgment are discussed further below. Revenue Recognition The majority of our public construction contracts are fixed unit price contracts. Under fixed unit price contracts, we are committed to providing materials or services required by a contract at fixed unit prices (for example, dollars per ton of asphalt placed). Our private customer contracts are primarily fixed total price contracts, also known as lump sum contracts, which require that the total amount of work be performed for a single price. Revenues from these construction contracts are recognized using the percentage-of-completion accounting method. Under this method, revenues are recognized as costs are incurred in an amount equal to cost plus the related expected profit based on the ratio of costs incurred to estimated final costs. This cost-to-cost measure is used because management considers it to be the best available measure of progress on these contracts. Contract costs consist of direct costs on contracts, including labor, materials, amounts payable to subcontractors and those indirect costs related to contract performance, such as equipment costs, insurance and employee benefits. Contract cost is recorded as incurred, and revisions in contract revenues and cost estimates are reflected in the accounting period when known. Provisions for estimated losses on uncompleted contracts are made in the period in which such losses are determined. Changes in job performance, job conditions and estimated profitability, including those changes arising from contract change orders, penalty provisions and final contract settlements may result in revisions to costs and income and are recognized in the period in which the revisions are determined. Change orders are modifications of an original contract that effectively change the existing provisions of the contract without adding new provisions or terms. Change orders may include changes in specifications or designs, manner of performance, facilities, equipment, materials, sites and period of completion of the work. Either we or our customers may initiate change orders. We consider unapproved change orders to be contract variations for which we have a change of scope for which we believe we are contractually entitled to a higher price, but where a price change associated with the scope change has not yet been agreed upon with the customer. Costs associated with unapproved change orders are included in the estimated cost to complete the contracts and are treated as project costs as incurred. We recognize revenues equal to costs incurred on unapproved change orders when realization of price approval is probable. Unapproved change orders involve the use of estimates, and it is reasonably possible that revisions to the estimated costs and recoverable amounts may be required in future reporting periods to reflect changes in estimates or final agreements with customers. Change orders that are unapproved as to both price and scope are evaluated as claims. We consider claims to be amounts in excess of agreed contract prices that we seek to collect from our customers or others for customer-caused delays, errors in specifications and designs, contract terminations, change orders that are either in dispute or are unapproved as to both scope and price, or other causes of unanticipated additional contract costs. Claims are included in the calculation of revenues when realization is probable and amounts can be reliably determined. To support these requirements, the existence of the following items must be satisfied: (i) the contract or other evidence provides a legal basis for the claim or a legal opinion has been obtained, stating that, under the circumstances, there is a reasonable basis to support the claim; (ii) additional costs are caused by circumstances that were unforeseen at the contract date and are not the result of deficiencies in our performance; (iii) costs associated with the claim are identifiable or otherwise determinable and are reasonable in view of the work performed; and (iv) the evidence supporting the claim is objective and verifiable, not based on management’s subjective evaluation of the situation or on unsupported representations. Revenues in excess of contract costs incurred on claims are recognized when an agreement is reached with the customer as to the value of the claim, which in some instances may not occur until after completion of work under the contract. Costs associated with claims are included in the estimated costs to complete the contracts and are treated as project costs when incurred. For the majority of our contracts, upon completion and final acceptance of the services that we were contracted to perform, we receive our final payment upon completion of the necessary contract closing documents, and our obligations to the owner are complete at that point. The accuracy of our revenues and profit recognition in a given period depends on the accuracy of our estimates of the revenues and costs to finish uncompleted contracts. Our estimates for all of our significant contracts use a highly detailed “bottom up” approach. However, our projects can be highly complex and, in almost every case, the profit margin estimates for a contract will either increase or decrease to some extent from the amount that was originally estimated at the time of bid. Because we have a large number of projects of varying levels of size and complexity in process at any given time, these changes in estimates can sometimes offset each other without materially impacting our overall profitability. However, large changes in revenues or cost estimates can have a significant effect on profitability. There are a number of factors that can contribute to changes in estimates of contract cost and profitability. The most significant of these include the completeness and accuracy of the original bid, recognition of costs associated with scope changes, extended overhead due to customer-related and weather-related delays, subcontractor and supplier performance issues and site conditions that differ from those assumed in the original bid to the extent contract remedies are unavailable. The foregoing factors, as well as the stage of completion of contracts in process and the mix of contracts at different margins, may cause fluctuations in gross profit between periods, and these fluctuations may be significant. Contracts Receivable, Including Retainage Contracts receivable are generally based on amounts billed to the customer and currently due in accordance with our contracts. Many of the contracts under which we perform work contain retainage provisions. Retainage refers to amounts that we have billed to the customer, but are being held for payment by the customer pending satisfactory completion of the project. Retainage on active contracts is classified as a current asset regardless of the term of the contract and is generally collected within one year of the completion of a contract. At September 30, 2018 and September 30, 2017, contracts receivable included $16.8 million and $13.2 million, respectively, of retainage, which was being contractually withheld by customers until completion of the associated contracts. Because the majority of our construction contracts are entered into with federal, state or municipal government customers, credit risk is minimal. We confirm that funds have been appropriated by the government project owner prior to commencing work on such projects. While most of our public contracts are subject to termination at the election of the government entity, in the event of any such termination, we are entitled to receive the contract price for completed work and reimbursement of termination-related costs. Credit risk with private owners is minimized because of statutory mechanic's liens, which give us high priority in the event of lien foreclosures following financial difficulties of private owners. We maintain an allowance for doubtful accounts, which has historically been sufficient to cover accounts that are not collected. Valuation of Long-Lived Assets and Goodwill Long-lived assets, which include property, equipment and acquired intangible assets, such as goodwill, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Impairment evaluations involve fair values and management estimates of useful asset lives and future cash flows. Actual useful lives and cash flows could be different from those estimated by management, and this could have a material effect on our operating results and financial position. For the fiscal years ended September 30, 2018 and 2017, there were no events or changes in circumstances that would indicate a material impairment of our long-lived assets. Goodwill must be tested for impairment at least annually. We performed our most recent annual impairment test of goodwill on July 1, 2018. Our test indicated that there was no impairment of goodwill. The valuation is impacted by a number of factors, but the key factors are the price of our common stock, recently completed transactions from both public companies and private transactions and our estimated forecast of future cash flows. The valuation approaches contain uncertainty regarding the estimates used. One of the largest uncertainties relates to federal, state and local government spending, which management expects to increase in the upcoming years. There are a number of other uncertainties with respect to our future financial performance that could impact estimated future cash flows, including those discussed under the heading “Risk Factors” elsewhere in this Annual Report on Form 10-K. Based on our valuation approaches, we determined that for each of our reporting units with goodwill, its fair value substantially exceeded its carrying value, and thus concluded that the carrying value of goodwill was not impaired at July 1, 2018 or July 1, 2017. At September 30, 2018 and September 30, 2017, we had goodwill with a carrying amount of $32.9 million and $30.6 million, respectively. Income Taxes Deferred tax assets and liabilities are recognized based on the differences between the financial statement carrying amounts and the tax basis of assets and liabilities. We regularly review our deferred tax assets for recoverability and, where necessary, establish a valuation allowance. Valuation allowances are established to reduce deferred tax assets if we determine that it is more likely than not that some or all of the deferred tax assets will not be realized in future periods. To assess this likelihood, we use historical three-year results of operations, estimates and judgments regarding our future taxable income and consider the jurisdiction in which the taxable income is generated to determine whether a valuation allowance is required. Such evidence can include our current financial position, results of operations, actual and forecasted results, the reversal of deferred tax liabilities, tax planning strategies and the current and forecasted business economics of our industry. Additionally, we record uncertain tax positions at their net recognizable amount, based on the amount that management deems is more likely than not to be sustained upon ultimate settlement with the tax authorities in jurisdictions in which we operate. On the basis of our evaluations, at September 30, 2018 and September 30, 2017, no valuation allowance was recorded on our net deferred tax assets, and we had no material uncertain tax positions. If our estimates or assumptions regarding our current and deferred tax items are inaccurate or are modified, these changes could have potentially material impacts on our earnings. Accrued Insurance Cost We carry insurance policies to cover various risks, primarily general liability, automobile liability and workers compensation, under which we are liable to reimburse the insurance company for a portion of each claim paid, ranging from $100,000 to $500,000 per occurrence. Prior to October 1, 2017, this amount was $250,000 per occurrence. We accrue for probable losses, both reported and unreported, that are reasonably estimable using actuarial methods based on historic trends and modified, if necessary, by recent events. Changes in our loss assumptions caused by changes in actual experience would affect our assessment of the ultimate liability and could have an effect on our operating results and financial position up to $500,000 per occurrence for general liability, automobile liability and workers' compensation claims. We provide employee medical insurance under policies that are both fixed-premium, fully-insured policies and self-insured policies that are administered by the insurance company. Under the self-insured policies, we are liable to reimburse the insurance company for actual claims paid plus an administrative fee. We purchase separate stop-loss insurance, which limits the individual participant claim loss to amounts ranging from $75,000 to $160,000. Share-Based Payments and Other Equity Transactions Our equity incentive plans are administered by the Compensation Committee of our Board of Directors, which historically set stock option exercise prices based on then recent unregistered sales of our common stock prior to our initial public offering. We recognize compensation expense for stock option awards based on valuation studies. Prior to the completion of our initial public offering, there had not been an established market for shares of our common stock. While we have issued new equity to unrelated parties, and we use such facts in the determination of the fair value of our shares, we believe that the historic lack of a secondary market for our common stock and our limited history issuing stock to unrelated parties currently make it impracticable to estimate our common stock’s expected volatility. Therefore, it is not possible to reasonably estimate the grant-date fair value of our options using our own historical price data. Accordingly, we have applied the provisions of Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 718 in accounting for the options using the calculated value method. During fiscal 2018 and fiscal 2017, we estimated expected volatility based on the average volatility of five companies within three different Standard Industrial Classifications that management believed had comparable profiles. Forfeitures are estimated using historical experience and projected employee turnover. These estimates require a considerable degree of judgment and affect the amount of stock-based compensation expense we recognize. If we determine that another method to estimate expected volatility or expected term is more reasonable than our current methods, or if another method for calculating fair value is prescribed by authoritative guidance, the fair value calculated for future stock-based awards could change significantly from past awards, even if the principal terms of the awards are similar. Higher volatility and longer expected terms result in an increase to stock-based compensation determined at the date of grant. The expected dividend rate and expected risk-free interest rate are not as significant to our calculation of fair value. A hypothetical 10% increase or decrease to any of the above assumptions would have had an immaterial impact on the amount of stock-based compensation expense we recognized in each of the periods presented. However, although changes in assumptions relative to expenses related to stock options granted outside of our equity incentive plan would be considered immaterial to us, future years could result in a more significant difference if we were to grant additional stock options, the value of our common stock increases significantly or our estimated volatility is higher. Emerging Growth Company The JOBS Act permits an “emerging growth company” like us to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies. We have irrevocably elected to “opt out” of this provision and, as a result, we will comply with new or revised accounting standards as required when they are adopted. Seasonality The use and consumption of our products and services fluctuate due to seasonality. Our products are used, and our construction operations and production facilities are located, outdoors. Therefore, seasonal changes and other weather-related conditions, in particular extended snowy, rainy or cold weather in the winter, spring or fall and major weather events, such as hurricanes, tornadoes, tropical storms and heavy snows, can adversely affect our business and operations through a decline in both the use of our products and demand for our services. In addition, construction materials production and shipment levels follow activity in the construction industry, which typically occurs in the spring, summer and fall. Warmer and drier weather during the third and fourth quarters of our fiscal year typically result in higher activity and revenues during those quarters. The first and second quarters of our fiscal year typically have lower levels of activity due to adverse weather conditions. Commodity Price Risk We are subject to commodity price risk with respect to price changes in liquid asphalt and energy, including fossil fuels and electricity for aggregates and asphalt paving mix production, natural gas for HMA production and diesel fuel for distribution vehicles and production-related mobile equipment. In order to manage or reduce commodity price risk, we monitor the costs of these commodities at the time of bid and price them into our contracts accordingly. Furthermore, liquid asphalt escalator provisions in most of our public contracts, and in some of our private and commercial contracts, limit our exposure to price fluctuations in this commodity. In addition, we enter into various firm purchase commitments, with terms generally less than one year, for certain raw materials. Interest Rate Risk We are exposed to interest rate risk on certain of our short- and long-term debt obligations used to finance our operations and acquisitions. We have LIBOR-based floating rate borrowings under the Compass Credit Agreement, which expose us to variability in interest payments due to changes in the reference interest rates. From time to time, we use derivative instruments as hedges against the impact of interest rate changes on future earnings and cash flows. In order to hedge against changes in interest rates and to manage fluctuations in cash flows resulting from interest rate risk, on June 30, 2017, we entered into an amortizing interest rate swap agreement applicable to $25.0 million outstanding debt under the Compass Term Loan, for which we pay a fixed rate of 2.015% and receive a credit based on the applicable LIBOR rate. In connection with the amendment to the Compass Amendment and the additional borrowing on May 15, 2018, we entered into an additional $11.0 million notional interest rate swap agreement applicable to the $22.0 million additional debt under the Compass Term Loan. Under this additional swap agreement, we pay a fixed percentage rate of 3.01% and receive a credit based on the applicable LIBOR rate. At September 30, 2018, we had a total of $62.3 million of variable rate borrowings outstanding. Holding other factors constant and absent the interest rate swap agreement described above, a hypothetical 1% change in our borrowing rates would result in a $0.6 million change in our annual interest expense based on our variable rate debt at September 30, 2018.
0.051294
0.051566
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<s>[INST] Overview We are one of the fastest growing civil infrastructure companies in the United States specializing in the building and maintenance of transportation networks. Our operations leverage a highly skilled workforce, strategically located HMA plants, substantial construction assets and select material deposits. We provide construction products and services to both public and private infrastructure projects, with an emphasis on highways, roads, bridges, airports and commercial and residential sites in the southeastern United States. Our public projects are funded by federal, state and local governments and include projects for roads, highways, bridges, airports and other forms of infrastructure. Public transportation infrastructure projects historically have been a relatively stable portion of state and federal budgets and represent a significant share of the United States construction market. Federal funds are allocated on a statebystate basis, and each state is required to match a portion of the federal funds they receive. Federal highway spending uses funds predominantly from the Highway Trust Fund, which derives its revenues from fuel taxes and other user fees. In addition to public infrastructure projects, we provide a wide range of large sitework construction and HMA paving services to private construction customers, including commercial and residential developers and local businesses. How We Assess Performance of Our Business Revenues We derive our revenues predominantly by providing construction products and services for both public and private infrastructure projects, with an emphasis on highways, roads, bridges, airports and commercial and residential sites. Our projects represent a mix of federal, state, municipal and private customers. We also derive revenues from the sale of HMA and aggregates to customers. Revenues derived from projects are recognized on the percentageofcompletion basis, measured by the relationship of total cost incurred compared to total estimated contract costs (costtocost method). Changes in job performance, job conditions and estimated profitability, including those arising from contract penalty provisions and final contract settlements, may result in revisions to estimated costs and income, and are recognized in the period in which the revisions are determined. Revenues derived from the sale of HMA and aggregates are recognized when risks associated with ownership have passed to the customer. Gross Profit Gross profit represents revenues less cost of revenues. Cost of revenues consists of all direct and indirect costs on construction contracts, including raw materials, labor, equipment costs, depreciation, lease expenses, subcontract costs and other expenses at our HMA plants and aggregate mining facilities. Our cost of revenues is directly affected by fluctuations in commodity prices, primarily liquid asphalt and diesel fuel. From time to time, when appropriate, we limit our exposure to changes in commodity prices by entering into forward purchase commitments. In addition, our public infrastructure contracts often provide for price adjustments based on fluctuations in certain commodityrelated product costs. These price adjustment provisions are in place for most of our public infrastructure contracts, and we seek to include similar provisions in our private contracts. Depreciation, Depletion and Amortization We carry property, plant and equipment on our balance sheet at cost, net of accumulated depreciation, depletion and amortization. Depreciation on property, plant and equipment is computed on a straightline basis over the estimated useful life of the asset. Amortization expense is the periodic expense related to leasehold improvements and intangible assets. Leasehold improvements are amortized over the lesser of the life of the underlying asset or the remaining lease term. Our intangible assets were recognized as a result of certain acquisitions and are generally amortized on a straightline basis over the estimated useful lives of the assets. Quarry reserves are depleted in accordance with the unitsofproduction method as aggregate is extracted, using the initial allocation of cost based on proven and probable reserves. General and Administrative Expenses General and administrative expenses consist primarily of salaries and personnel costs for our administration, finance and accounting, legal, information systems, human resources and certain managerial employees. Additional expenses include audit, consulting and professional fees, travel, insurance, office space rental costs, property taxes and other corporate and overhead expenses. Gain on Sale of Equipment, net In the normal course of business, we sell construction equipment for various reasons, including when the cost of maintaining the asset exceeds the cost of replacing it. The gain or loss on sale of equipment reflects the difference between the carrying value at the date of dispos [/INST] Positive. </s>
2,018
7,748
1,718,227
Construction Partners, Inc.
2019-12-13
2019-09-30
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. This discussion and analysis of our financial condition and results of operations is intended to assist in understanding and assessing the trends and significant changes in our results of operations and financial condition. Historical results may not be indicative of future performance. This discussion includes forward-looking statements that reflect our plans, estimates and beliefs. Such statements involve risks and uncertainties. Our actual results may differ materially from those contemplated by these forward-looking statements as a result of various factors, including those set forth under the headings “Risk Factors” and “Cautionary Statement Regarding Forward-Looking Statements.” This discussion should be read in conjunction with our audited consolidated financial statements and the notes thereto included elsewhere in this report. In this discussion, we use certain non-GAAP financial measures. Explanation of these non-GAAP financial measures and reconciliation to the most directly comparable GAAP financial measures are included in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Investors should not consider non-GAAP financial measures in isolation or as substitutes for financial information presented in compliance with GAAP. Overview We are one of the fastest growing civil infrastructure companies in the United States, specializing in the building and maintenance of transportation networks. Our operations leverage a highly skilled workforce, strategically located HMA plants, substantial construction assets and select material deposits. We provide construction products and services to both public and private infrastructure projects, with an emphasis on highways, roads, bridges, airports and commercial and residential sites in the southeastern United States. Our public projects are funded by federal, state and local governments and include projects for roads, highways, bridges, airports and other forms of infrastructure. Public transportation infrastructure projects historically have been a relatively stable portion of state and federal budgets and represent a significant share of the United States construction market. Federal funds are allocated on a state-by-state basis, and each state is required to match a portion of the federal funds that it receives. Federal highway spending uses funds predominantly from the Highway Trust Fund, which derives its revenues from fuel taxes and other user fees. In addition to public infrastructure projects, we provide a wide range of large site work construction and HMA paving services to private construction customers, including commercial and residential developers and local businesses. How We Assess Performance of Our Business Revenues We derive our revenues predominantly by providing construction products and services for both public and private infrastructure projects, with an emphasis on highways, roads, bridges, airports and commercial and residential sites. Our projects represent a mix of federal, state, municipal and private customers. We also derive revenues from the sale of HMA, aggregates, and liquid asphalt cement to customers. Revenues derived from projects are recognized as performance obligations are satisfied over time (formerly known as the percentage-of-completion method), measured by the relationship of total cost incurred compared to total estimated contract costs (cost-to-cost input method). Changes in job performance, job conditions and estimated profitability, including those arising from contract penalty provisions and final contract settlements, may result in revisions to estimated costs and income, and are recognized in the period in which the revisions are determined. Revenues derived from the sale of HMA, aggregates, and liquid asphalt cement are recognized when risks associated with ownership have passed to the customer. Gross Profit Gross profit represents revenues less cost of revenues. Cost of revenues consists of all direct and indirect costs on construction contracts, including raw materials, labor, equipment costs, depreciation, lease expenses, subcontract costs and other expenses at our HMA plants, aggregate mining facilities, and liquid asphalt cement terminal. Our cost of revenues is directly affected by fluctuations in commodity prices, primarily liquid asphalt and diesel fuel. From time to time, when appropriate, we limit our exposure to changes in commodity prices by entering into forward purchase commitments. In addition, our public infrastructure contracts often provide for price adjustments based on fluctuations in certain commodity-related product costs. These price adjustment provisions are in place for most of our public infrastructure contracts, and we seek to include similar provisions in our private contracts. Depreciation, Depletion and Amortization We carry property, plant and equipment on our balance sheet at cost, net of accumulated depreciation, depletion and amortization. Depreciation on property, plant and equipment is computed on a straight-line basis over the estimated useful life of the asset. Amortization expense is the periodic expense related to leasehold improvements and intangible assets. Leasehold improvements are amortized over the lesser of the life of the underlying asset or the remaining lease term. Our intangible assets were recognized as a result of certain acquisitions and are generally amortized on a straight-line basis over the estimated useful lives of the assets. Quarry reserves are depleted in accordance with the units-of-production method as aggregate is extracted, using the initial allocation of cost based on proven and probable reserves. General and Administrative Expenses General and administrative expenses consist primarily of salaries and personnel costs for our administration, finance and accounting, legal, information systems, human resources and certain managerial employees. Additional expenses include audit, consulting and professional fees, travel, insurance, office space rental costs, property taxes and other corporate and overhead expenses. Gain on Sale of Equipment, net In the normal course of business, we sell construction equipment for various reasons, including when the cost of maintaining the asset exceeds the cost of replacing it. The gain or loss on sale of equipment reflects the difference between the carrying value at the date of disposal and the net consideration received from the sale of equipment during the period. Interest Expense, net Interest expense, net primarily represents interest incurred on our long-term debt, such as the Term Loan and the Revolving Credit Facility, as well as the cost of interest swap agreements and amortization of deferred debt issuance costs. These amounts are partially offset by interest income earned on short-term investments of cash balances in excess of our current operating needs. Other Key Performance Indicators - Adjusted EBITDA and Adjusted EBITDA Margin Adjusted EBITDA represents net income before (i) interest expense, net, (ii) provision for income taxes, (iii) depreciation, depletion and amortization, (iv) equity-based compensation expense, (v) loss on extinguishment of debt and (vi) certain management fees and expenses, and excludes income recognized in connection with the Settlement described in Note 20 - Settlement Agreement to the consolidated financial statements included elsewhere in this report. Adjusted EBITDA Margin represents Adjusted EBITDA as a percentage of revenues for each period. These metrics are supplemental measures of our operating performance that are neither required by, nor presented in accordance with, GAAP. These measures have limitations as analytical tools and should not be considered in isolation or as an alternative to net income or any other performance measure derived in accordance with GAAP as an indicator of our operating performance. We present Adjusted EBITDA and Adjusted EBITDA Margin because management uses these measures as key performance indicators, and we believe that securities analysts, investors and others use these measures to evaluate companies in our industry. Our calculation of Adjusted EBITDA and Adjusted EBITDA Margin may not be comparable to similarly named measures reported by other companies. Potential differences may include differences in capital structures, tax positions and the age and book depreciation of intangible and tangible assets. The following table presents a reconciliation of Adjusted EBITDA to net income, the most directly comparable measure calculated in accordance with GAAP, and the calculation of Adjusted EBITDA Margin for the periods presented (in thousands, except percentages): (1)Represents pre-tax income recognized in connection with the Settlement (see Note 20 - Settlement Agreement to the consolidated financial statements included elsewhere in this report). (2)Reflects fees and reimbursement of certain travel expenses under a management services agreement with SunTx (see Note 17 - Related Parties to the consolidated financial statements included elsewhere in this report). Results of Operations - Fiscal Year Ended September 30, 2019 Compared to Fiscal Year Ended September 30, 2018 The following table sets forth selected financial data for the fiscal years ended September 30, 2019 (“fiscal 2019”) and September 30, 2018 (“fiscal 2018”): Revenues. Revenues for fiscal 2019 increased $103.1 million, or 15.2%, to $783.2 million from $680.1 million for fiscal 2018. The increase in revenues was primarily due to a $44.6 million higher backlog at the beginning of fiscal 2019 compared to the beginning of fiscal 2018, the increase in available work in our existing markets, and $51.6 million of revenue from recent acquisitions, including (i) fiscal 2019 revenue attributable to acquisitions we completed during fiscal year 2019 and (ii) revenue earned during fiscal 2019 attributable to acquisitions that were completed during fiscal 2018 until the one-year anniversary date of such acquisitions. Gross Profit. Gross profit for fiscal 2019 increased $18.4 million, or 18.5%, to $118.0 million from $99.5 million for fiscal 2018. The higher gross profit was the result of the 15.2% revenue increase and an increase in gross profit margin to 15.1% for fiscal 2019 from 14.6% for fiscal 2018, due to higher utilization of our plants and equipment, as well as the contribution of the liquid asphalt terminal. General and Administrative Expenses. General and administrative expenses include costs related to our operational offices that are not allocated to direct contract costs and expenses related to our corporate offices. General and administrative expenses for fiscal 2019 increased $7.4 million, or 13.4%, to $62.7 million from $55.3 million for fiscal 2018. The increase in general and administrative expenses for fiscal 2019 compared to fiscal 2018 was primarily the result of (i) a $2.6 million increase in overhead expenses attributable to acquisitions that we completed during or subsequent to fiscal 2018, (ii) $0.7 million in costs related to the Secondary Offering, and (iii) an increase in the cost of professional services and insurance, reflecting our growth and increased reporting and regulatory requirements as a public company for a full fiscal year. General and administrative expenses as a percentage of revenue declined 0.2% from fiscal 2018 to fiscal 2019. Interest Expense, Net. Interest expense, net for fiscal 2019 increased $0.6 million, or 46.5%, to $1.9 million compared to $1.3 million for fiscal 2018. The increase in interest expense, net reflects a $1.3 million increase in interest expense, partially offset by a $0.7 million increase in interest income. The increase in interest expense was due to (i) an increase in the average principal debt balance outstanding for fiscal 2019 compared to fiscal 2018 as a result of borrowing for an acquisition in May 2018 and an increase in interest rates, and (ii) a $0.6 million charge to interest expense related to a change in the fair value of our interest rate swaps during fiscal 2019, compared to a $0.4 million credit during fiscal 2018. The increase in interest income was due to the higher average cash balance during fiscal 2019, resulting from proceeds attributable to our IPO in May 2018 and an increase in interest rates earned on our deposits. Settlement Income. During fiscal 2018, we recorded income of $14.8 million reflecting the net present value of future payments to be received in connection with the Settlement. Pursuant to the Settlement, we will receive aggregate net payments of approximately $15.7 million, payable in four equal installments between January 2019 and July 2020, in exchange for releasing and waiving all current and future claims against a third party. Provision for Income Taxes. Our effective tax rate increased to 24.4% for fiscal 2019, from 17.2% for fiscal 2018. The Tax Cuts and Jobs Act (the “Tax Act”), which was effective January 1, 2018, included broad and complex changes to the United States tax code, including a reduction in the United States federal corporate income tax rate from 35.0% to 21.0%. As a result of this change, the Company recorded its income tax provision for fiscal 2018 based on a blended U.S. statutory rate of 24.5%, which represents prorated applicable tax rates before and after the effective date of the Tax Act and the effect of applicable state income taxes. The effective tax rate for fiscal 2019 reflects a federal income tax provision based on the U.S. statutory tax rate of 21.0% and the effect of applicable state income taxes. The effects of the higher blended U.S. statutory tax rate of 24.5% for fiscal 2018 compared the U.S. statutory tax rate of 21.0% for fiscal 2019 was offset by (i) a $4.6 million provisional discrete tax benefit related to the Tax Act, primarily due to an adjustment in our U.S. deferred tax liabilities by the same amount and (ii) a $1.3 million permanent tax benefit resulting from the deduction of the excess of fair market value of options exercised during fiscal 2018 over the exercise price. No such tax benefits were applicable to fiscal 2019. This net reduction in deferred tax liabilities also included the estimated impact on the Company’s net state deferred tax assets. Earnings from Investment in Joint Venture. During fiscal 2019 and 2018, we earned $1.3 million and $1.2 million of pre-tax income, respectively, from our 50% interest in the earnings of a joint venture. We entered into the joint venture with a third party in November 2017 for the sole purpose of performing a construction project for the Alabama DOT. Net Income. Net income decreased $7.7 million, or 15.1%, to $43.1 million for fiscal 2019 compared to $50.8 million for fiscal 2018. This decrease in net income was a result of (i) the $10.6 million settlement income, net of tax, recognized during fiscal 2018, (ii) higher general and administrative expenses during fiscal 2019 and (iii) an increase in the effective income tax rate during fiscal 2019 compared to fiscal 2018. The decrease was partially offset by an increase in gross profit, as described above. Adjusted EBITDA and Adjusted EBITDA Margin. Adjusted EBITDA and Adjusted EBITDA Margin were $92.3 million and 11.8%, respectively, for fiscal 2019, compared to $75.5 million and 11.1%, respectively, for fiscal 2018. The increase in Adjusted EBITDA primarily results from the increase in gross profit and depreciation for fiscal 2019 compared to fiscal 2018, partially offset by an increase in general and administrative expense and a decline in gain on sale of equipment. The increase in the Adjusted EBITDA Margin is the result of a higher gross profit percentage and a lower general and administrative expenses as a percentage of revenue in fiscal 2019 compared to fiscal 2018, partially offset by a decline in the gain on sale of equipment. For a description of Adjusted EBITDA and Adjusted EBITDA Margin, as well as a reconciliation of Adjusted EBITDA to net income, see “How We Assess Performance of Our Business.” Inflation and Price Changes Inflation had an immaterial impact on our results of operations for the fiscal years ended September 30, 2019 and 2018 due to relatively low inflation in the United States in recent years and our ability to recover increasing costs by obtaining higher prices for our products, including sale price escalator clauses in most of our public infrastructure sector contracts. Inflation risk varies with the level of activity in our industry, the number, size and strength of competitors and the availability of products to supply a local market. Liquidity and Capital Resources Cash Flows Analysis The following table sets forth our cash flows for the periods indicated (in thousands): Operating Activities Cash provided by operating activities, net of acquisitions, was $55.3 million for fiscal 2019, a decrease of $10.8 million compared to $66.1 million for fiscal 2018. The decrease was primarily due to a $7.7 million decrease in net income for fiscal 2019 compared to fiscal 2018 and a $13.4 million reduction in changes in operating assets and liabilities, partially offset by a $10.2 million increase in adjustments to reconcile net income to cash flows from operating activities for those same periods. The changes in operating assets and liabilities included (i) a $20.6 million increase in contracts receivable including retainage for fiscal 2019 compared to a $9.3 million decrease for fiscal 2018 due to higher overall revenue, (ii) a $8.8 million increase in inventory, of which $6.5 million related to our acquisition and operation of a liquid asphalt terminal and other acquisitions during fiscal 2019, (iii) a $1.0 million decrease in other current assets for fiscal 2019 compared to a $8.9 million increase for fiscal 2018, primarily due to our recognition of $7.9 million of receivables during fiscal 2018 in connection with Settlement income, (iv) an $8.0 million decrease in other assets for fiscal 2019 compared to a $7.9 million increase for fiscal 2018, primarily reflecting recognition of receivables in connection with Settlement income during fiscal 2018 and $7.2 million in payments received pursuant to the Settlement during fiscal 2019, (v) a $7.6 million decrease in net billing in excess of costs and estimated earnings on uncompleted contracts for fiscal 2019 compared to a $2.0 million increase for fiscal 2018, primarily due to the timing of performing and closing the projects, and (vi) a $2.1 increase in accrued expenses and other current liabilities for fiscal 2019 compared to a $4.8 million decrease for fiscal 2018. Investing Activities Cash used in investing activities was $60.2 million for fiscal 2019 compared to $89.6 million for fiscal 2018. The decrease reflects (i) a $37.5 million decrease in cash used in business acquisitions, net of cash acquired during fiscal 2019 compared to fiscal 2018, (ii) a $2.5 million distribution received from a joint venture investment during fiscal 2019, and (iii) a partial offset by a $10.9 million purchase of a liquid asphalt terminal during fiscal 2019. Financing Activities Cash used by financing activities was $13.6 million for fiscal 2019 compared to $95.1 million of cash provided in financing activities during fiscal 2018. Fiscal 2018 included $98.0 million of proceeds from our IPO, net of offering costs. BBVA Credit Agreement We and each of our subsidiaries are parties to the BBVA Credit Agreement. The BBVA Credit Agreement provides for the Term Loan and the Revolving Credit Facility. At September 30, 2019 and 2018, we had $44.7 million and $57.3 million, respectively, of principal outstanding under the Term Loan, $5.0 million and $5.0 million, respectively, of principal outstanding under the Revolving Credit Facility, and availability of $14.4 million and $14.0 million, respectively, under the Revolving Credit Facility, including reduction for outstanding letters of credit. The obligations of our subsidiaries under the Term Loan and the Revolving Credit Facility are secured by a first priority security interest in substantially all of our assets and are guaranteed by the Company, as the ultimate parent company of the borrower entities. In August 2019, the BBVA Credit Agreement was amended to, among other things, modify the interest rate and fee structure, as well as the repayment schedule and amounts. Currently, the BBVA Credit Agreement provides for a four-tier escalating interest rate for both the Term Loan and the Revolving Credit Facility that is tied to the London Interbank Offered Rate (“LIBOR”). The baseline rate for such borrowings is LIBOR plus 1.20%, and the rate may increase up to LIBOR plus 1.70% if the Company’s consolidated leverage ratio exceeds 2.00%. Prior to the August 2019 amendment, the interest rate on any particular borrowing was calculated based on one of several indices set forth in the agreement, plus an applied markup of 2.0% to 2.25%. At September 30, 2019 and 2018, the interest rate on outstanding borrowings under the Term Loan and Revolving Credit Facility was 3.244% and 4.242%, respectively. Principal repayments under the Term Loan are made in quarterly installments in an amount equal to 2.50% of the original amount borrowed, a reduction from the 5.00% rate that we paid prior to the August 2019 amendment. We pay a commitment fee of 0.20% per annum on the aggregate unused commitment amount under the Revolving Credit Facility, a reduction from 0.35% prior to the August 2019 amendment, as well as fees with respect to any letters of credit issued thereunder. As of September 30, 2019, all amounts borrowed under the BBVA Credit Agreement were scheduled to mature on July 1, 2022. The BBVA Credit Agreement contains usual and customary negative covenants for agreements of this type, including, but not limited to, restrictions on the Company’s ability to make acquisitions, make loans or advances, make capital expenditures and investments, pay dividends, create or incur indebtedness, create liens, wind up or dissolve, consolidate, merge or liquidate, or sell, transfer or dispose of assets. The BBVA Credit Agreement also requires the Company to satisfy certain financial covenants, including a minimum fixed charge coverage ratio of 1.20-to-1.00 and a maximum consolidated leverage ratio of 2.75-to-1.00, subject to certain adjustments. Prior to the August 2019 amendment, the maximum consolidated leverage ratio was 2.00-to-1.00. At September 30, 2019 and 2018, our fixed charge ratio was 4.04-to-1.00 and 1.51-to-1.00, respectively, and our consolidated leverage ratio was 0.66-to-1.00 and 0.88-to-1.00, respectively. At both September 30, 2019 and 2018, the Company was in compliance with all covenants under the BBVA Credit Agreement. From time to time, we have entered into interest rate swap agreements to hedge against the risk of changes in interest rates. On June 30, 2017, we entered into an interest rate swap agreement with a notional amount of $25.0 million, under which we pay a fixed percentage rate of 2.015% and receive a credit based on the applicable LIBOR rate. On May 15, 2018, we entered into an additional $11.0 million notional interest rate swap agreement applicable to the $22.0 million amount borrowed under the Term Loan on that date, under which we pay a fixed percentage rate of 3.01% and receive a credit based on the applicable LIBOR rate. These interest rate swap agreements do not meet the criteria for hedge accounting treatment in accordance with GAAP. At September 30, 2019 and 2018, the aggregate notional value of these interest rate swap agreements was $21.5 million and $28.7 million, respectively, and the fair value was $(0.3) million and $0.3 million, respectively, which is included within other assets or other liabilities on our Consolidated Balance Sheets. The BBVA Credit Agreement was amended subsequent to September 30, 2019. For more information about the amendment, see Note 22 - Subsequent Events to the consolidated financial statements included elsewhere in this report. Capital Requirements and Sources of Liquidity During fiscal 2019 and fiscal 2018, our capital expenditures were approximately $42.5 million and $42.8 million, respectively. Our capital expenditures are typically made during the same fiscal year in which they are approved. At September 30, 2019, our commitments for capital expenditures were not material to our financial condition or results of operations on a consolidated basis. For fiscal 2020, we expect total capital expenditures to be $44.0 million to $47.0 million, excluding amounts paid to purchase certain equipment previously subject to operating leases during the first quarter of fiscal 2020. For more information on these purchases, see Note 22 - Subsequent Events. Our capital expenditure budget is an estimate and is subject to change. As described further below, we believe that cash flows from operations combined with existing cash on hand and amounts available under our credit facilities will be sufficient to fund our working capital needs and planned capital expenditures for the next 12 months. Historically, we have had significant cash requirements in order to organically expand our business into new geographic markets. Our cash requirements include costs related to increased capital expenditures, purchase of materials and production of materials and cash to fund our organic expansion into new markets. Our working capital needs are driven by the seasonality and growth of our business, with our cash requirements increasing in periods of growth. Additional cash requirements resulting from our growth include the costs of additional personnel, production and distribution facilities, enhancing our information systems and, in the future, our integration of any acquisitions and our compliance with laws and rules applicable to public companies. We have historically relied upon cash available through credit facilities, in addition to cash from operations, to finance our working capital requirements and to support our growth. We regularly monitor potential capital sources, including equity and debt financings, in an effort to meet our planned capital expenditures and liquidity requirements. Our future success will depend on our ability to access outside sources of capital. We believe that our operating cash flow and available borrowings under the Revolving 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, and significant additional capital expenditures will be required to conduct our operations. There can be no assurance that operations and other capital resources will provide cash in sufficient amounts to maintain planned or future levels of capital expenditures. In the event that we make one or more 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 and/or seek additional capital. If we seek additional capital, we may do so through borrowings under the Revolving Credit Facility, joint ventures, asset sales, offerings of debt or equity securities or other means. We cannot guarantee that this additional capital will be available on acceptable terms or at all. If we are unable to obtain the funds we need, we may not be able to complete acquisitions that may be favorable to us or finance the capital expenditures necessary to conduct our operations. Off-Balance Sheet Arrangements We enter into operating leases for property and equipment in the normal course of business. See Note 18 - Commitments and Contingencies to our consolidated financial statements included elsewhere in this report for additional information. Other than the operating leases described therein, we do not currently have any off-balance sheet arrangements that have, or are reasonably likely to have, a current or future effect on our financial condition, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources that would be material to investors. Critical Accounting Policies and Estimates The discussion of our financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. We evaluate our estimates and assumptions on an ongoing basis. The results of our analysis form the basis for making assumptions 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, and the impact of such differences may be material to our consolidated financial statements. Critical accounting policies are those policies that, in management’s view, are the most important in the portrayal of our financial condition and results of operations. The notes to the consolidated financial statements also include disclosure of significant accounting policies. The methods, estimates and judgments that we use in applying our accounting policies have a significant impact on the results that we report in our consolidated financial statements. These critical accounting policies require us to make difficult and subjective judgments, often as a result of the need to make estimates regarding matters that are inherently uncertain. Our most critical accounting policies and estimates include those involved in the recognition of revenues and provision for income tax expense. Those critical accounting policies and estimates that require the most significant judgment are discussed further below. Revenue Recognition The majority of our public construction contracts are fixed unit price contracts. Under fixed unit price contracts, we are committed to providing materials or services required by a contract at fixed unit prices (for example, dollars per ton of asphalt placed). Our private customer contracts are primarily fixed total price contracts, also known as lump sum contracts, which require that the total amount of work be performed for a single price. Revenues from these construction contracts are recognized as performance obligations are satisfied over time (formerly known as the percentage-of-completion method), measured by the relationship of total cost incurred compared to total estimated contract costs (cost-to-cost input method). Under this method, revenues are recognized as costs are incurred in an amount equal to cost plus the related expected profit based on the ratio of costs incurred to estimated final costs. This cost-to-cost method is used because management considers it to be the best available measure of progress on these contracts. Contract costs consist of direct costs on contracts, including labor, materials, amounts payable to subcontractors and those indirect costs related to contract performance, such as equipment costs, insurance and employee benefits. Contract cost is recorded as incurred, and revisions in contract revenues and cost estimates are reflected in the accounting period when known. Provisions for estimated losses on uncompleted contracts are made in the period in which such losses are determined. Changes in job performance, job conditions and estimated profitability, including those changes arising from contract change orders, penalty provisions and final contract settlements may result in revisions to costs and income and are recognized in the period in which the revisions are determined. Change orders are modifications of an original contract that effectively change the existing provisions of the contract without adding new provisions or terms. Change orders may include changes in specifications or designs, manner of performance, facilities, equipment, materials, sites and period of completion of the work. Either we or our customers may initiate change orders. We consider unapproved change orders to be contract variations for which we have a change of scope for which we believe we are contractually entitled to a higher price, but where a price change associated with the scope change has not yet been agreed upon with the customer. Costs associated with unapproved change orders are included in the estimated cost to complete the contracts and are treated as project costs as incurred. We recognize revenues equal to costs incurred on unapproved change orders when realization of price approval is probable. Unapproved change orders involve the use of estimates, and it is reasonably possible that revisions to the estimated costs and recoverable amounts may be required in future reporting periods to reflect changes in estimates or final agreements with customers. Change orders that are unapproved as to both price and scope are evaluated as claims. We consider claims to be amounts in excess of agreed contract prices that we seek to collect from our customers or others for customer-caused delays, errors in specifications and designs, contract terminations, change orders that are either in dispute or are unapproved as to both scope and price, or other causes of unanticipated additional contract costs. Claims are included in the calculation of revenues when realization is probable and amounts can be reliably determined. To support these requirements, the existence of the following items must be satisfied: (i) the contract or other evidence provides a legal basis for the claim or a legal opinion has been obtained, stating that, under the circumstances, there is a reasonable basis to support the claim; (ii) additional costs are caused by circumstances that were unforeseen at the contract date and are not the result of deficiencies in our performance; (iii) costs associated with the claim are identifiable or otherwise determinable and are reasonable in view of the work performed; and (iv) the evidence supporting the claim is objective and verifiable, not based on management’s subjective evaluation of the situation or on unsupported representations. Revenues in excess of contract costs incurred on claims are recognized when an agreement is reached with the customer as to the value of the claim, which in some instances may not occur until after completion of work under the contract. Costs associated with claims are included in the estimated costs to complete the contracts and are treated as project costs when incurred. For the majority of our contracts, upon completion and final acceptance of the services that we were contracted to perform, we receive our final payment upon completion of the necessary contract closing documents, and our obligations to the owner are complete at that point. The accuracy of our revenues and profit recognition in a given period depends on the accuracy of our estimates of the revenues and costs to finish uncompleted contracts. Our estimates for all of our significant contracts use a highly detailed “bottom up” approach. However, our projects can be highly complex and, in almost every case, the profit margin estimates for a contract will either increase or decrease to some extent from the amount that was originally estimated at the time of bid. Because we have a large number of projects of varying levels of size and complexity in process at any given time, these changes in estimates can sometimes offset each other without materially impacting our overall profitability. However, large changes in revenues or cost estimates can have a significant effect on profitability. The accuracy of our revenue and profit recognition in a given period depends on the accuracy of our estimates of the cost to complete each project. Cost estimates for all of our projects use a detailed approach, and we believe our experience allows us to create materially reliable estimates. There are a number of factors that can contribute to changes in estimates of contract cost and profitability. The most significant of these include: •the completeness and accuracy of the original bid; •costs associated with scope changes; •changes in costs of labor and/or materials; •extended overhead and other costs due to owner, weather and other delays; •subcontractor performance issues; •changes in productivity expectations; •site conditions that differ from those assumed in the original bid; •changes from original design on design-build projects; •the availability and skill level of workers in the geographic location of the project; •a change in the availability and proximity of equipment and materials; •our ability to fully and promptly recover on affirmative claims and back charges for additional contract costs; and •the customer’s ability to properly administer the contract. The foregoing factors, as well as the stage of completion of contracts in process and the mix of contracts at different margins, may cause fluctuations in gross profit between periods, and these fluctuations may be significant. Contracts Receivable, Including Retainage Contracts receivable are generally based on amounts billed to the customer and currently due in accordance with our contracts. Many of the contracts under which we perform work contain retainage provisions. Retainage refers to amounts that we have billed to the customer, but are being held for payment by the customer pending satisfactory completion of the project. Retainage on active contracts is classified as a current asset regardless of the term of the contract and is generally collected within one year of the completion of a contract. At September 30, 2019 and 2018, contracts receivable included $19.8 million and $16.8 million, respectively, of retainage, which was being contractually withheld by customers until completion of the associated contracts. Because the majority of our construction contracts are entered into with federal, state or municipal government customers, credit risk is minimal. We confirm that funds have been appropriated by the government project owner prior to commencing work on such projects. While most of our public contracts are subject to termination at the election of the government entity, in the event of any such termination, we are entitled to receive the contract price for completed work and reimbursement of termination-related costs. Credit risk with private owners is minimized because of statutory mechanic’s liens, which give us high priority in the event of lien foreclosures following financial difficulties of private owners. We maintain an allowance for doubtful accounts, which has historically been sufficient to cover accounts that are not collected. Valuation of Long-Lived Assets and Goodwill Long-lived assets, which include property, equipment and acquired intangible assets, such as goodwill, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Impairment evaluations involve fair values and management estimates of useful asset lives and future cash flows. Actual useful lives and cash flows could be different from those estimated by management, and this could have a material effect on our operating results and financial position. For the fiscal years ended September 30, 2019 and 2018, there were no events or changes in circumstances that would indicate a material impairment of our long-lived assets. Goodwill must be tested for impairment at least annually. We performed our most recent annual impairment test of goodwill on July 1, 2019. Our test indicated that there was no impairment of goodwill. We first evaluate our market capitalization compared to the net assets of the Company overall. Our final determination of valuation is impacted by a number of factors, but the key factors are the price of our common stock, recently completed transactions from both public companies and private transactions and our estimated forecast of future cash flows. The valuation approaches contain uncertainty regarding the estimates used. Our market capitalization could be impacted because we are a controlled company, which impacts the control premium we apply to the market price of our common stock. One of the largest uncertainties relates to federal, state and local government spending, which management expects to increase in the upcoming years. There are a number of other uncertainties with respect to our future financial performance that could impact estimated future cash flows, including those discussed under the heading “Risk Factors” elsewhere in this report. Based on our valuation approaches, we determined that our one reporting unit substantially exceeded its carrying value, and thus concluded that the carrying value of goodwill was not impaired at July 1, 2019 or 2018. At September 30, 2019 and 2018, we had goodwill with a carrying amount of $38.5 million and $32.9 million, respectively. Income Taxes Deferred tax assets and liabilities are recognized based on the differences between the financial statement carrying amounts and the tax basis of assets and liabilities. We regularly review our deferred tax assets for recoverability and, where necessary, establish a valuation allowance. Valuation allowances are established to reduce deferred tax assets if we determine that it is more likely than not that some or all of the deferred tax assets will not be realized in future periods. To assess this likelihood, we use historical three-year results of operations, estimates and judgments regarding our future taxable income and consider the jurisdiction in which the taxable income is generated to determine whether a valuation allowance is required. Such evidence can include our current financial position, results of operations, actual and forecasted results, the reversal of deferred tax liabilities, tax planning strategies and the current and forecasted business economics of our industry. Additionally, we record uncertain tax positions at their net recognizable amount, based on the amount that management deems is more likely than not to be sustained upon ultimate settlement with the tax authorities in jurisdictions in which we operate. On the basis of our evaluations, at September 30, 2019 and 2018, no valuation allowance was recorded on our net deferred tax assets, and we had no material uncertain tax positions. If our estimates or assumptions regarding our current and deferred tax items are inaccurate or are modified, these changes could have potentially material impacts on our earnings. Accrued Insurance Cost We carry insurance policies to cover various risks, primarily general liability, automobile liability and workers compensation, under which we are liable to reimburse the insurance company for a portion of each claim paid, ranging from $100,000 to $500,000 per occurrence. We accrue for probable losses, both reported and unreported, that are reasonably estimable using actuarial methods based on historic trends and modified, if necessary, by recent events. Changes in our loss assumptions caused by changes in actual experience would affect our assessment of the ultimate liability and could have an effect on our operating results and financial position up to $500,000 per occurrence for general liability, automobile liability and workers’ compensation claims. We provide employee medical insurance under policies that are both fixed-premium, fully-insured policies and self-insured policies that are administered by the insurance company. Under the self-insured policies, we are liable to reimburse the insurance company for actual claims paid plus an administrative fee. We purchase separate stop-loss insurance, which limits the individual participant claim loss to amounts ranging from $75,000 to $160,000. Share-Based Payments and Other Equity Transactions Our equity incentive plans are administered by the Compensation Committee of our Board of Directors. We account for our equity-based compensation plans using a fair value-based method of accounting, whereby compensation cost is measured at the grant date based on the value of the award and is recognized over the service period, which is typically the vesting period. Other Accounting Policies and New Accounting Pronouncements See Note 2 - Significant Accounting Policies and Note 3 - Accounting Standards, to the consolidated financial statements for the fiscal year ended September 30, 2019, which are contained in Part II, Item 8 of this report and are incorporated by reference herein. Emerging Growth Company The JOBS Act permits an “emerging growth company” like us to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies. We have irrevocably elected to “opt out” of this provision and, as a result, we will comply with new or revised accounting standards as required when they are adopted. Seasonality The use and consumption of our products and services fluctuate due to seasonality. Our products are used, and our construction operations and production facilities are located, outdoors. Therefore, seasonal changes and other weather-related conditions, in particular extended snowy, rainy or cold weather in the winter, spring or fall and major weather events, such as hurricanes, tornadoes, tropical storms and heavy snows, can adversely affect our business and operations through a decline in both the use of our products and demand for our services. In addition, construction materials production and shipment levels follow activity in the construction industry, which typically occurs in the spring, summer and fall. Warmer and drier weather during the third and fourth quarters of our fiscal year typically result in higher activity and revenues during those quarters. The first and second quarters of our fiscal year typically have lower levels of activity due to adverse weather conditions. Commodity Price Risk We are subject to commodity price risk with respect to price changes in liquid asphalt and energy, including fossil fuels and electricity for aggregates and asphalt paving mix production, natural gas for HMA production and diesel fuel for distribution vehicles and production-related mobile equipment. In order to manage or reduce commodity price risk, we monitor the costs of these commodities at the time of bid and price them into our contracts accordingly. Furthermore, liquid asphalt escalator provisions in most of our public contracts, and in some of our private and commercial contracts, limit our exposure to price fluctuations in this commodity. In addition, we enter into various firm purchase commitments, with terms generally less than one year, for certain raw materials. Interest Rate Risk We are exposed to interest rate risk on certain of our short- and long-term debt obligations used to finance our operations and acquisitions. We have LIBOR-based floating rate borrowings under the BBVA Credit Agreement, which expose us to variability in interest payments due to changes in the reference interest rates. From time to time, we use derivative instruments as hedges against the impact of interest rate changes on future earnings and cash flows. In order to hedge against changes in interest rates and to manage fluctuations in cash flows resulting from interest rate risk, on June 30, 2017, we entered into an amortizing interest rate swap agreement applicable to $25.0 million outstanding debt under the Term Loan, for which we pay a fixed rate of 2.015% and receive a credit based on the applicable LIBOR rate. In connection with the amendment to the BBVA Credit Agreement and the additional borrowing on May 15, 2018, we entered into an additional $11.0 million notional interest rate swap agreement applicable to the $22.0 million additional debt under the Term Loan. Under this additional swap agreement, we pay a fixed percentage rate of 3.01% and receive a credit based on the applicable LIBOR rate. At September 30, 2019, we had a total of $49.7 million of variable rate borrowings outstanding. Holding other factors constant and absent the interest rate swap agreements described above, a hypothetical 1% change in our borrowing rates would result in a $0.5 million change in our annual interest expense based on our variable rate debt at September 30, 2019.
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0.011391
0
<s>[INST] Overview We are one of the fastest growing civil infrastructure companies in the United States, specializing in the building and maintenance of transportation networks. Our operations leverage a highly skilled workforce, strategically located HMA plants, substantial construction assets and select material deposits. We provide construction products and services to both public and private infrastructure projects, with an emphasis on highways, roads, bridges, airports and commercial and residential sites in the southeastern United States. Our public projects are funded by federal, state and local governments and include projects for roads, highways, bridges, airports and other forms of infrastructure. Public transportation infrastructure projects historically have been a relatively stable portion of state and federal budgets and represent a significant share of the United States construction market. Federal funds are allocated on a statebystate basis, and each state is required to match a portion of the federal funds that it receives. Federal highway spending uses funds predominantly from the Highway Trust Fund, which derives its revenues from fuel taxes and other user fees. In addition to public infrastructure projects, we provide a wide range of large site work construction and HMA paving services to private construction customers, including commercial and residential developers and local businesses. How We Assess Performance of Our Business Revenues We derive our revenues predominantly by providing construction products and services for both public and private infrastructure projects, with an emphasis on highways, roads, bridges, airports and commercial and residential sites. Our projects represent a mix of federal, state, municipal and private customers. We also derive revenues from the sale of HMA, aggregates, and liquid asphalt cement to customers. Revenues derived from projects are recognized as performance obligations are satisfied over time (formerly known as the percentageofcompletion method), measured by the relationship of total cost incurred compared to total estimated contract costs (costtocost input method). Changes in job performance, job conditions and estimated profitability, including those arising from contract penalty provisions and final contract settlements, may result in revisions to estimated costs and income, and are recognized in the period in which the revisions are determined. Revenues derived from the sale of HMA, aggregates, and liquid asphalt cement are recognized when risks associated with ownership have passed to the customer. Gross Profit Gross profit represents revenues less cost of revenues. Cost of revenues consists of all direct and indirect costs on construction contracts, including raw materials, labor, equipment costs, depreciation, lease expenses, subcontract costs and other expenses at our HMA plants, aggregate mining facilities, and liquid asphalt cement terminal. Our cost of revenues is directly affected by fluctuations in commodity prices, primarily liquid asphalt and diesel fuel. From time to time, when appropriate, we limit our exposure to changes in commodity prices by entering into forward purchase commitments. In addition, our public infrastructure contracts often provide for price adjustments based on fluctuations in certain commodityrelated product costs. These price adjustment provisions are in place for most of our public infrastructure contracts, and we seek to include similar provisions in our private contracts. Depreciation, Depletion and Amortization We carry property, plant and equipment on our balance sheet at cost, net of accumulated depreciation, depletion and amortization. Depreciation on property, plant and equipment is computed on a straightline basis over the estimated useful life of the asset. Amortization expense is the periodic expense related to leasehold improvements and intangible assets. Leasehold improvements are amortized over the lesser of the life of the underlying asset or the remaining lease term. Our intangible assets were recognized as a result of certain acquisitions and are generally amortized on a straightline basis over the estimated useful lives of the assets. Quarry reserves are depleted in accordance with the unitsofproduction method as aggregate is extracted, using the initial allocation of cost based on proven and probable reserves. General and Administrative Expenses General and administrative expenses consist primarily of salaries and personnel costs for our administration, finance and accounting, legal, information systems, human resources and certain managerial employees. Additional expenses include audit, consulting and professional fees, travel, insurance, office space rental costs, property taxes and other corporate and overhead expenses. Gain on Sale of Equipment, net In the normal course of business, we sell construction equipment for various [/INST] Positive. </s>
2,019
7,466
1,733,998
Northwest Natural Holding Co
2019-03-01
2018-12-31
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS On October 1, 2018, we completed a reorganization into a holding company structure. We believe that our holding company structure is an agile and efficient platform from which to pursue, finance, and oversee new opportunities, such as in the water sector, while also providing legal separation between regulated natural gas distribution operations and other businesses. In this reorganization, shareholders of NW Natural (the predecessor publicly held parent company) became shareholders of NW Holdings, on a one-for-one basis, with the same number of shares and same ownership percentage as they held in NW Natural immediately prior to the reorganization. NW Natural became a wholly-owned subsidiary of NW Holdings. Additionally, certain subsidiaries of NW Natural were transferred to NW Holdings. As required under accounting guidance, these subsidiaries are presented as discontinued operations in the consolidated results of NW Natural within this report. NW Holdings is a holding company headquartered in Portland, Oregon and owns NW Natural, NWN Water, and other businesses and activities. NW Natural is NW Holdings’ largest subsidiary. NW Natural's natural gas distribution activities are reported in the natural gas distribution (NGD) segment, formerly titled and reported as the utility segment. All other business activities, including certain gas storage activities, water businesses, and other investments and activities are aggregated and reported as other at their respective registrant. References in this discussion to "Notes" are to the Notes to the Consolidated Financial Statements in Item 8 of this report. In addition, NW Holdings has reported discontinued operations results related to the pending sale of Gill Ranch Storage, LLC (Gill Ranch). NW Natural Gas Storage, LLC (NWN Gas Storage), currently an indirect wholly-owned subsidiary of NW Holdings, entered into a Purchase and Sale Agreement during the second quarter of 2018 that provides for the sale of all membership interests in Gill Ranch. Gill Ranch owns a 75% interest in the natural gas storage facility located near Fresno, California known as the Gill Ranch Gas Storage Facility. Pacific Gas and Electric Company (PG&E) owns the remaining 25% interest in the Gill Ranch Gas Storage Facility. For more information, see "Results of Operations - Pending Sale of Gill Ranch Storage" below. The following is management’s assessment of NW Holdings' and NW Natural's financial condition, including the principal factors that affect results of operations. The discussion covers the years ended December 31, 2018, 2017, and 2016 and refers to the consolidated results of NW Holdings, the substantial majority of which consist of the operating results of NW Natural. When significant activity exists at NW Holdings that does not exist at NW Natural, additional disclosure has been provided. NW Holdings' direct and indirect wholly-owned subsidiaries include: • Northwest Natural Gas Company (NW Natural); ◦ Northwest Energy Corporation (Energy Corp); ▪ NWN Gas Reserves LLC (NWN Gas Reserves); • NW Natural Energy, LLC (NWN Energy); ◦ NW Natural Gas Storage, LLC (NWN Gas Storage); ▪ Gill Ranch Storage, LLC (Gill Ranch), which is presented as a discontinued operation; • NNG Financial Corporation (NNG Financial); ◦ KB Pipeline Company (KB); • NW Natural Water Company, LLC (NWN Water); ◦ Falls Water Co., Inc. (Falls Water); ◦ Salmon Valley Water Company; ◦ Cascadia Water, LLC (Cascadia); ◦ NW Natural Water of Oregon, LLC (NWN Water of Oregon); ◦ NW Natural Water of Washington, LLC (NWN Water of Washington); ◦ NW Natural Water of Idaho, LLC (NWN Water of Idaho); and ▪ Gem State Water Company, LLC (Gem State) The NGD segment includes our NW Natural local gas distribution business, NWN Gas Reserves, which is a wholly-owned subsidiary of Energy Corp, and the NGD-portion of NW Natural's Mist storage facility in Oregon. Other activities aggregated and reported as other at NW Natural include the non-NGD storage activity at Mist as well as asset management services and the appliance retail center operations. Other activities aggregated and reported as other at NW Holdings include NWN Energy's equity investment in Trail West Holding, LLC (TWH), which is pursuing the development of a proposed natural gas pipeline through its wholly-owned subsidiary, Trail West Pipeline, LLC (TWP); NNG Financial's investment in Kelso-Beaver Pipeline (KB Pipeline); and NWN Water, which owns and continues to pursue investments in the water sector. See Note 4 for further discussion of our business segment and other, as well as our direct and indirect wholly-owned subsidiaries. NON-GAAP FINANCIAL MEASURES. In addition to presenting the results of operations and earnings amounts in total, certain financial measures are expressed in cents per share or exclude the effects of certain items, which are non-GAAP financial measures. We present net income or loss and earnings or loss per share adjusted for certain items along with the U.S. GAAP measures to illustrate their magnitude on ongoing business and operational results. Although the excluded amounts are properly included in the determination of net income or loss and earnings or loss per share under U.S. GAAP, we believe the amount and nature of these items make period to period comparisons of operations difficult or potentially confusing. We use such non-GAAP financial measures to analyze our financial performance because we believe they provide useful information to our investors and creditors in evaluating our financial condition and results of operations. Our non-GAAP financial measures should not be considered a substitute for, or superior to, measures calculated in accordance with U.S. GAAP. Reconciliations of the non-GAAP financial measures to their closest U.S. GAAP measure used in subsequent sections of Item 7 are provided below. Note: Totals may not foot due to rounding. (1) Regulatory environmental disallowance of $3.3 million in 2016 includes $2.8 million recorded in NGD other income (expense), net and $0.5 million recorded in NGD operations and maintenance expense. The tax effect of the adjustment is calculated using the combined federal and state statutory rate in effect at the time of 39.5%. NW Holdings' EPS amounts for the 2016 adjustment are calculated using diluted shares of 27.8 million, as shown on the NW Holdings Consolidated Statements of Comprehensive Income. (2) Non-cash TCJA benefit (expense) associated with continuing operations of $3.4 million was recorded in income tax expense (benefit) in the fourth quarter of 2017 as a result of the federal tax rate changing from 35% to 21% effective December 22, 2017. The majority of this benefit was recorded at NW Natural. NW Holdings EPS amounts are calculated using diluted shares of 28.8 million as shown on the NW Holdings Consolidated Statements of Comprehensive Income. The TCJA impacts in the NGD segment and other may not correlate exactly to the consolidated amount due to rounding. See Note 10 for additional information on the TCJA. EXECUTIVE SUMMARY We manage our business and strategic initiatives with a long-term view of providing service safely and reliably to our customers, working with regulators on key policy initiatives, and remaining focused on growing our businesses. See "2019 Outlook" below for more information. Highlights for the year include: • added over 12,500 natural gas customers in 2018 for an annual growth rate of 1.7% at December 31, 2018; • invested $215 million in NGD distribution systems and facilities for growth and reliability; • completed key components of the North Mist Gas Storage Expansion Project and continue to target an in-service date during the spring of 2019; • NW Natural ranked first in the West in the 2018 J.D. Power Gas Utility Residential Customer Satisfaction Study and Gas Utility Business Customer Satisfaction Study; • completed key aspects of NW Natural's Oregon general rate case and filed for a general rate increase in Washington for the first time in a decade; • completed four water distribution acquisitions with several more pending, the largest of which is a water and wastewater business in Sunriver, Oregon. Once pending transactions close, our water business is expected to serve 18,000 connections; and • delivered increasing dividends for the 63rd consecutive year to shareholders. Key financial highlights for NW Holdings include: Key financial highlights for NW Natural include: (1) See the Non-GAAP Reconciliations table at the beginning of Item 7 for a reconciliation of this non-GAAP financial measure to its closest U.S. GAAP measure. 2018 COMPARED TO 2017. NW Holdings' and NW Natural's net income from continuing operations were $67.3 million and $68.0 million, respectively, in 2018 compared to $72.1 million and $71.7 million, respectively, in 2017. The decrease was primarily due to the benefit associated with the TCJA deferred income tax remeasurement in 2017. Excluding the benefit in 2017 associated with the TCJA remeasurement, NW Holdings adjusted net income from continuing operations decreased $1.4 million. See the Non-GAAP reconciliations at the beginning of Item 7 for additional information. The decrease was primarily due to the following factors, all of which were driven by activity at NW Natural: • an $8.9 million decrease in NGD segment margin primarily due to the deferral of excess revenue associated with the federal income tax rate decrease as a result of the TCJA; • a $4.3 million increase in operations and maintenance expense driven by general payroll and benefits increases as well as increases in professional services and contract labor; • a $4.1 million increase in depreciation and amortization primarily due to additional capital expenditures; and • a $3.3 million decrease in other income (expense), net primarily due to an increase in pension and postretirement benefit expense, partially offset by an increase in the equity portion of AFUDC; partially offset by • a $20.2 million decrease in income tax expense due to the decrease in the federal income tax rate as a result of the TCJA and lower pretax earnings. 2017 COMPARED TO 2016. NW Holdings' and NW Natural's net income from continuing operations were $72.1 million and $71.7 million, respectively, in 2017 compared to $62.4 million and $62.8 million, respectively, in 2016. The increase included a $3.4 million benefit due to the deferred income tax balance remeasurement associated with the TCJA in 2017 and a $3.3 million pre-tax regulatory environmental disallowance in 2016. Excluding the impact of these items, NW Holdings adjusted net income from continuing operations increased $4.3 million. See the Non-GAAP reconciliations at the beginning of Item 7 for additional information. The increase was primarily due to the following factors, all of which were driven by activity at NW Natural: • a $16.0 million increase in NGD segment margin primarily due to customer growth and effects of colder than average weather in 2017 compared to warmer than average weather in 2016; and • a $6.9 million increase in other income (expense), net primarily due an increase in the equity portion of AFUDC; partially offset by • a $15.7 million increase in operations and maintenance expense driven by higher NGD segment payroll and benefits increases, as well as increased NGD segment safety equipment upgrade costs; and • a $1.0 million decrease in revenues from asset management agreements for Mist storage and transportation capacity. 2019 OUTLOOK Our 2019 goals leverage our resources and history of innovation to continue meeting the evolving needs of customers, regulators, and shareholders. Our near-term outlook is centered on the following long-term strategic objectives: SAFETY AND RELIABILITY. Delivering our products safely and reliably to customers is our first priority. During 2019, NW Natural will maintain its vigilant focus on safety and emergency response through hands-on scenario-based training for employees, third-party contractors, and local authorities. To ensure the reliability, resiliency, and safety of NW Natural's infrastructure, we intend to continue to invest in the maintenance and necessary upgrades of our pipeline system, including completing projects to replace end-of-life equipment at our Mist storage facility, renovating several resource centers, and supporting growth and reliability in Oregon and southwest Washington. Safety also includes NW Holdings' and NW Natural's vigilance in maintaining and seeking to strengthen cybersecurity defenses and preparing for large-scale emergency events, such as seismic hazards. SUPERIOR CUSTOMER EXPERIENCE. NW Natural has a legacy of providing excellent customer service and a long-standing dedication to continuous improvement, which has resulted in consistently high rankings in the J.D. Power and Associates customer satisfaction studies. In 2019, we will strive to enhance our customers' experience to meet their evolving expectations by prioritizing improvements to technology and internal processes which supports our customers' frequent interactions and highest value touchpoints. POLICIES AND REGULATION. We remain committed to working constructively with policymakers and regulators to provide the best outcomes for both our customers and stakeholders. At NW Natural, we are working closely with the Oregon commission and other stakeholders on several significant items, including the best way to return benefits from the TCJA to NW Natural customers and complete its Oregon general rate case, which we filed in December 2017. With regard to Washington regulation, NW Natural filed a general rate case with Washington in December 2018 and will seek to work productively with parties in an effort to conclude that case in 2019. NW Natural will continue working with the EPA and other stakeholders on an environmentally protective and cost effective clean-up for the Portland Harbor Superfund Site. Finally, we are engaged in policy discussions both in Oregon and Washington at the state and community level to build support for a constructive role for natural gas in a low-carbon future. NW NATURAL GROWTH. Natural gas is the preferred energy choice in NW Natural's service territory given its efficient, affordable, and reliable qualities. We are focused on leveraging these key attributes to capitalize on our region's strong economic growth. We continue to grow our market share in the single-family residential sector and capture new commercial customers as well as multifamily or mixed-use developments. In addition, one of the largest and most innovative capital projects in the history of NW Natural, the North Mist Gas Storage Expansion, is expected to be completed and begin supporting the integration of renewables into the electric grid in 2019. We will continue to look for opportunities to serve and grow with our communities. LOW-CARBON PATHWAY. We are deeply committed to a clean energy future. It's why NW Natural launched a low-carbon initiative to reduce emissions in the customers and communities NW Natural serves by leveraging modern pipeline systems in new ways, working closely with customers, policymakers and regulators, and embracing cutting-edge technology. NW Natural partnered with the City of Portland to bring renewable natural gas (RNG) onto its system. We expect the entire project to be operational in 2019 with several other RNG projects underway for completion this year or in 2020. To further understand the role of natural gas in a low-carbon future, NW Natural engaged a premier environmental consultant to complete a deep decarbonization study. The study outlines how natural gas can help achieve crucial emission reductions of 80% by 2050. We will continue helping our customers reduce and offset their consumption as we support the development of renewable natural gas supply and explore other cutting edge solutions to lower the carbon intensity of natural gas, such as power to gas. INTEGRATE AND GROW WATER. NW Water began its expansion into the water business more than a year ago with a focus on water sector investments that fit our conservative risk profile and core competencies. In 2019 we plan to close our largest acquisition to date in Sunriver, Oregon that serves approximately 9,400 water and wastewater connections. Once all outstanding transactions are closed, NW Water will serve 18,000 connections and have invested nearly $70 million in the water sector. DIVIDENDS NW Holdings dividend highlights include: In January 2019, the NW Holdings' Board of Directors declared a quarterly dividend on NW Holdings common stock of $0.4750 per share, payable on February 15, 2019, to shareholders of record on January 31, 2019, reflecting an indicated annual dividend rate of $1.90 per share. See "Financial Condition - Liquidity and Capital Resources" for more information regarding the NW Holdings and NW Natural dividend policies and regulatory conditions on NW Natural dividends to its parent, NW Holdings. RESULTS OF OPERATIONS Regulatory Matters Regulation and Rates NATURAL GAS DISTRIBUTION. NW Natural's natural gas distribution business is subject to regulation by the OPUC and WUTC with respect to, among other matters, rates and terms of service, systems of accounts, and issuances of securities by NW Natural. In 2018, approximately 89% of NGD customers were located in Oregon, with the remaining 11% in Washington. Earnings and cash flows from natural gas distribution operations are largely determined by rates set in general rate cases and other proceedings in Oregon and Washington. They are also affected by weather, the local economies in Oregon and Washington, the pace of customer growth in the residential, commercial, and industrial markets, and NW Natural's ability to remain price competitive, control expenses, and obtain reasonable and timely regulatory recovery of its natural gas distribution-related costs, including operating expenses and investment costs in plant and other regulatory assets. See "Most Recent General Rate Cases" below. MIST INTERSTATE GAS STORAGE. NW Natural's interstate storage activity at Mist is subject to regulation by the OPUC, WUTC, and FERC with respect to, among other matters, rates and terms of service. The OPUC also regulates the intrastate storage services at Mist, while FERC regulates the interstate storage services at Mist. The FERC uses a maximum cost of service model which allows for gas storage prices to be set at or below the cost of service as approved by each agency in their last regulatory filing. The OPUC Schedule 80 rates are tied to the FERC rates, and are updated whenever NW Natural modifies FERC maximum rates. OTHER. In June 2018, NWN Gas Storage entered into a Purchase and Sale Agreement for the sale of all of its ownership interests in Gill Ranch, a natural gas storage facility located near Fresno, California, which is subject to approval by the CPUC and other customary closing conditions. See Note 18 for more information. Most Recent General Rate Cases OREGON. Effective November 1, 2012, through October 31, 2018, the OPUC authorized rates to customers based on an ROE of 9.5%, an overall rate of return of 7.78%, and a capital structure of 50% common equity and 50% long-term debt. Effective November 1, 2018, the OPUC authorized rates to customers based on an ROE of 9.4%, an overall rate of return of 7.317%, and a capital structure of 50% common equity and 50% long-term debt. For additional information, see "Regulatory Proceeding Updates" below. WASHINGTON. Effective January 1, 2009, the WUTC authorized rates to customers based on an ROE of 10.1% and an overall rate of return of 8.4% with a capital structure of 51% common equity, 5% short-term debt, and 44% long-term debt. On December 31, 2018, NW Natural filed a general rate case in Washington requesting an ROE of 10.3%, an overall rate of return of 7.63%, and a capital structure of 49.5% common equity, 49.5% long-term debt, and 1% short-term debt. For additional information, see "Regulatory Proceeding Updates" below. FERC. NW Natural is required under its Mist interstate storage certificate authority and rate approval orders to file every five years either a petition for rate approval or a cost and revenue study to change or justify maintaining the existing rates for its interstate storage services. In January 2018, various state parties filed a request with the FERC to adjust the revenue requirements of public utilities to reflect the recent reduction in the federal corporate income tax rate and other impacts resulting from the TCJA. In July 2018, the FERC issued an order finalizing its regulations regarding the effect of the TCJA. The new regulations required NW Natural to file a petition for rate approval or a cost and revenue study to reflect the new federal corporate income tax rate within thirty days of the rate effective date of NW Natural's Oregon rate case. On October 12, 2018, NW Natural filed a rate petition with FERC for revised maximum cost-based rates, which incorporated the new federal corporate income tax rate. The revised rates became effective November 1, 2018. NW Natural continuously evaluates the need for rate cases in its jurisdictions. For additional information, see "Regulatory Proceeding Updates-Rate Case" below. Regulatory Proceeding Updates During 2018, NW Natural was involved in the regulatory activities discussed below. INTERSTATE STORAGE AND OPTIMIZATION SHARING. NW Natural received an Order from the OPUC in March 2015 on their review of the current revenue sharing arrangement that allocates a portion of the net revenues generated from non-NGD Mist storage services and third-party asset management services to NGD business customers. The Order required a third-party cost study to be performed. In 2017, a third-party consultant completed a cost study and their final report was filed with the OPUC in February 2018. The OPUC concluded on this matter in the Oregon general rate case proceeding. For additional information, see "Oregon General Rate Case" below. HOLDING COMPANY REORGANIZATION. In February 2017, NW Natural filed applications with the OPUC, WUTC, and CPUC for approval to reorganize under a holding company structure. In 2017, the OPUC and WUTC approved NW Natural's applications subject to certain restrictions or "ring-fencing" provisions applicable to NW Natural, the company that currently engages, and would continue to engage, in NGD business operations. During the second quarter of 2018, NW Natural received approval to reorganize into a holding company structure from the CPUC. On October 1, 2018, we completed the reorganization to a holding company structure. Effective November 1, 2018 there are a number of conditions under the agreement with the OPUC and the WUTC related to the formation of a holding company structure. One of the conditions is that, for three years, NW Natural will be required to provide an annual $500,000 credit to Oregon customers and a $55,000 credit to Washington customers. The first-year credit to both Oregon and Washington customers was given in conjunction with the PGA filings, with the rate adjustments commencing on November 1, 2018. TAX REFORM DEFERRAL. In December 2017, NW Natural filed applications with the OPUC and WUTC to defer the overall net benefit associated with the TCJA that was enacted on December 22, 2017. Through the Oregon general rate case, in October 2018 the OPUC issued an order directing NW Natural and the other parties to the rate case to engage in further regulatory proceedings to resolve open issues with respect to the treatment of the 10-month deferral period of benefits associated with the TCJA. On February 4, 2019, NW Natural and the other parties to the rate case agreed upon terms by which the deferred benefits would be returned to customers via a joint stipulation filed with the OPUC. For it to be effective, the OPUC must issue an Order. See "Regulatory Proceeding Updates-Oregon General Rate Case" below for more information. NW Natural expects to work with the WUTC regarding the Washington deferral for the TCJA as part of the general rate case filed in Washington on December 31, 2018, and is currently deferring all amounts for the benefit of Washington customers. WATER BUSINESS. Since we initiated our water strategy in December 2017, we have entered into the following agreements which require or required regulator approval: • Salmon Valley Water Company - We received regulatory approval for this Welches, Oregon acquisition in September 2018, and the transaction closed in November 2018. • Falls Water Company - We received regulatory approval for this Idaho Falls, Idaho acquisition in July 2018 from the IPUC and closed the transaction in September 2018. • Lehman Enterprises, Inc. and Sea View Water LLC - We received regulatory approval from the WUTC for these Whidbey Island, Washington acquisitions in October 2018 and closed the transaction in November 2018. • Sunriver Water, LLC and Sunriver Environmental, LLC - We filed an application for regulatory approval from the OPUC for the Sunriver Water, LLC acquisition in October 2018 and anticipate receiving regulatory approval in 2019. Sunriver Environmental, LLC is not under the OPUC's jurisdiction. The transaction is expected to close in the first half of 2019. • Spirit Lake East Water Company and Lynnwood Water - We filed an application for regulatory approval from the IPUC for these Coeur d'Alene, Idaho acquisitions in February 2019. • Estates Water Systems Inc. and Monterra Inc - We filed an application for regulatory approval from the WUTC for these Sequim, Washington acquisitions in February 2019. The acquisitions described above are expected to, upon the closing of the Sunriver transaction, represent approximately $70 million of aggregate investment. OREGON GENERAL RATE CASE. On October 26, 2018, the OPUC issued an order regarding NW Natural's general rate case originally filed in December 2017 and approved the following items: • Annual revenue requirement increase of $23.4 million or 3.72% over NW Natural's revenue from existing rates, which includes approximately $12.1 million that would otherwise be recovered under the conservation tariff deferral; • Capital structure of 50% debt and 50% equity; • Return on equity of 9.4%; • Cost of capital of 7.317%; • Rate base of $1.186 billion, or an increase of $300 million since the last rate case in 2012; • Commencing November 1, 2018, ASC 715 pension expenses for the qualified pension plan will be recovered through rates with an increase of $8.1 million to revenue requirement for a total of $11.9 million; and • The sharing of asset management revenues related to NGD business pipeline and storage assets will be 90%/10% with 90% being credited to customers. Previously customers received 67% of these revenues. The rate changes listed above went into effect on November 1, 2018. In addition to the items above, the OPUC issued an order on October 26, 2018, to freeze NW Natural's pension balancing account as of October 31, 2018. The order directed NW Natural and the other parties to the rate case to engage in further regulatory proceedings extending the general rate case docket to resolve open issues with respect to the recovery of the pension balancing account, and treatment of the 10-month deferral period benefits associated with the TCJA. On February 4, 2019, NW Natural, OPUC Staff, Oregon Citizen’s Utility Board (CUB), and the Alliance of Western Energy Customers (AWEC), which comprise all of the parties to the 2018 Oregon rate case, filed with the OPUC a joint stipulation addressing remaining items related to NW Natural's pension balancing account and the return of deferred TCJA benefits to customers (Settlement). The Settlement is subject to the review and approval of the OPUC. For it to be effective, the OPUC must issue an Order, which may approve or deny the terms of the Settlement or be issued under the OPUC's own terms. Under the Settlement, the stipulating parties agree that NW Natural properly recorded the remeasurement of regulated NGD excess deferred income taxes pursuant to the effects of the TCJA, and agree that all of NW Natural’s TCJA-related dockets will be resolved in accordance with the terms of the Settlement. Under the Settlement, NW Natural would return excess deferred income taxes pursuant to the TCJA as follows: (i) an annual credit to base rates of $3.4 million; (ii) a credit of $3.0 million per year for five years to sale customers; (iii) a credit to customers' benefit of $5.44 million of deferred income taxes, and $7.07 million of TCJA benefits deferred between January 1, 2018 and October 31, 2018, reflected as a reduction to NW Natural’s pension balancing account, described below. As a result of these returns and credits, NW Natural’s rate base is expected to increase by approximately $15.38 million, and the revenue requirement is expected to increase approximately $1.43 million. If NW Natural files a general rate case within five years of the date of the Order implementing the Settlement, this revenue requirement may be adjusted as part of that general rate case. As to the future operation and timing of rate recovery of amounts reflected in NW Natural’s pension balancing account, under the Settlement, the stipulating parties agree that, effective October 31, 2018, NW Natural would: (i) reduce the amount of the frozen pension balancing account by $10.5 million, and apply $12.51 million of the Company’s deferred TCJA benefits, for a total reduction of the pension balancing account of approximately $23.01 million; and (ii) reduce the interest rate on the pension balancing account from NW Natural’s authorized rate of return of 7.317 percent to 4.3 percent. NW Natural would then collect the remainder of the pension balancing account balance over ten years in a customer tariff of $7.3 million per year beginning on the rate effective date. If the Settlement is approved, NW Natural expects to recognize an after-tax charge to earnings of approximately $6.7 million in the quarter in which an order is issued. The Settlement is subject to the review and approval of the OPUC with a decision and order expected in March 2019, and new rates expected to be effective April 1, 2019. WASHINGTON GENERAL RATE CASE. On December 31, 2018, NW Natural filed for a general rate case in the state of Washington. The requested increase, the first in approximately 10 years, is intended to recover operating costs and investments made in the Washington distribution system and is based upon the following assumptions or requests: • Capital structure of 49.5% long-term debt, 1.0% short-term debt, and 49.5% common equity; • Return on equity of 10.3%; • Cost of capital of 7.63%; and • Rate base of $186.5 million, an increase of $58.7 million since the last rate case. The filing also includes a proposal to return federal tax reform benefits to customers related to the TCJA. NW Natural estimates the total liability for tax reform benefits allocated to Washington customers to be approximately $20.2 million, which is comprised of a historical deferred liability of $18.1 million primarily related to property, plant, and equipment and an expected $2.1 million associated with interim tax benefits accumulated from January 1, 2018 to November 30, 2019. NW Natural is requesting that the $18.1 million historical deferral be credited to rates in compliance with the TCJA guidance, which is currently at a rate of approximately $0.5 million annually for the first five years, and which would be reviewed and adjusted in year five for the next five years. NW Natural is requesting that the interim $2.1 million tax benefit be returned to customers over two years. In addition, NW Natural is requesting a decoupling tariff for Washington customers, which is intended to allow the NGD business to continue encouraging customers to conserve energy without adversely affecting earnings due to reductions in sales volumes. The proposed decoupling tariff would also adjust for any deviation from normal usage, including weather. Finally, NW Natural is requesting that the WUTC review costs allocable to Washington related to environmental remediation expenses and consider a mechanism for recovery of these costs. The requested costs are estimated to be approximately 3.32% of total costs associated with those sites related to serving Washington customers. NW Natural's filing will be reviewed by the WUTC and other stakeholders. The process is anticipated to take up to 11 months. NW Natural has requested that the new rates take effect December 1, 2019. INTEGRATED RESOURCE PLAN (IRP). NW Natural files a full IRP biennially for Oregon and Washington with the OPUC and WUTC, respectively. NW Natural filed its 2018 Oregon and Washington IRPs in August 2018, and received both a letter of compliance from the WUTC and acknowledgment by the OPUC in February 2019. The IRPs included analysis of different growth scenarios and corresponding resource acquisition strategies. This analysis is needed to develop supply and demand resource requirements, consider uncertainties in the planning process, and to establish a plan for providing reliable and low cost natural gas service. DEPRECIATION STUDY. Under OPUC regulations, NW Natural is required to file a depreciation study every five years to update or justify maintaining the existing depreciation rates. In December 2016, NW Natural filed the required depreciation study with the OPUC. In September 2017, the parties to the docket filed a settlement with the Commission requesting approval of updated depreciation rates. In January 2018, OPUC issued an order adopting the stipulation. A corresponding docket was filed and approved in Washington for the same depreciation rates. FERC also adopted the new depreciation rates which were included in the rate petition described in Regulation and Rates - FERC above. The new depreciation rates were effective and implemented as of November 1, 2018 for Oregon, Washington, and FERC regulated customers. The new depreciation rates did not materially change NW Natural's depreciation rates and did not have a material impact to financial results. Rate Mechanisms During 2018, NW Natural's approved rates and recovery mechanisms for each service area included: PURCHASED GAS ADJUSTMENT. Rate changes are established for NW Natural each year under PGA mechanisms in Oregon and Washington to reflect changes in the expected cost of natural gas commodity purchases. The PGA filings and filings coincident with the PGA include gas costs under spot purchases as well as contract supplies, gas costs hedged with financial derivatives, gas costs from the withdrawal of storage inventories, the production of gas reserves, interstate pipeline demand costs, temporary rate adjustments, which amortize balances of deferred regulatory accounts, and the removal of temporary rate adjustments effective for the previous year. Each year, NW Natural typically hedges gas prices on a portion of NW Natural's annual sales requirement based on normal weather, including both physical and financial hedges. NW Natural entered the 2018-19 gas year with its forecasted sales volumes hedged at 49% in financial swap and option contracts and 26% in physical gas supplies for Oregon and Washington. As of December 31, 2018, NW Natural is also hedged in future gas years at approximately 17% for the 2019-20 gas year and between 1% and 8% for annual requirements over the subsequent five gas years. Hedge levels are subject to change based on actual load volumes, which depend to a certain extent on weather, economic conditions, and estimated gas reserve production. Also, gas storage inventory levels may increase or decrease with storage expansion, changes in storage contracts with third parties, variations in the heat content of the gas, and/or storage recall by NW Natural. In September 2018, NW Natural filed its annual PGA and received OPUC and WUTC approval in October 2018. PGA rate changes were effective November 1, 2018. Rates between states can vary due to different rate structures and mechanisms. Oregon residential customers' rates declined 2.1% from the combined effect of the PGA and Oregon rate case and Washington residential customers' rates declined by 7.2%. In addition, as required with the Washington PGA filing, NW Natural provided the WUTC with a full strategy implementation plan to incorporate risk-responsive hedging strategies in its natural gas procurement process. The plan calls for a flexible hedging approach that reacts to changes in market conditions as those changes occur. NW Natural expects to begin implementing risk-responsive hedging strategies for the 2019-20 PGA for its Washington gas supplies. Under the current PGA mechanism in Oregon, there is an incentive sharing provision whereby NW Natural is required to select each year an 80% deferral or a 90% deferral of higher or lower actual gas costs compared to estimated PGA prices, such that the impact on NW Natural's current earnings from the incentive sharing is either 20% or 10% of the difference between actual and estimated gas costs, respectively. For the 2017-18 and 2018-19 gas years, NW Natural selected the 90% deferral option. Under the Washington PGA mechanism, NW Natural defers 100% of the higher or lower actual gas costs, and those gas cost differences are passed on to customers through the annual PGA rate adjustment. EARNINGS TEST REVIEW. NW Natural is subject to an annual earnings review in Oregon to determine if the NGD business is earning above its authorized ROE threshold. If NGD business earnings exceed a specific ROE level, then 33% of the amount above that level is required to be deferred or refunded to customers. Under this provision, if NW Natural selects the 80% deferral gas cost option, then NW Natural retains all earnings up to 150 basis points above the currently authorized ROE. If NW Natural selects the 90% deferral option, then it retains all earnings up to 100 basis points above the currently authorized ROE. For the 2017-18 and 2018-19 gas years, it selected the 90% deferral option. The ROE threshold is subject to adjustment annually based on movements in long-term interest rates. For calendar years 2016, 2017, and 2018, the ROE threshold was 11.06%, 10.66%, and 10.48%, respectively. There were no refunds required for 2016 and 2017. NW Natural does not expect a refund for 2018 based on results, and NW Natural anticipates filing its 2018 earnings test in May 2019. GAS RESERVES. In 2011, the OPUC approved the Encana gas reserves transaction to provide long-term gas price protection for NGD business customers and determined costs under the agreement would be recovered on an ongoing basis through the annual PGA mechanism. Gas produced from NW Natural's interests is sold at then prevailing market prices, and revenues from such sales, net of associated operating and production costs and amortization, are included in cost of gas. The cost of gas, including a carrying cost for the rate base investment made under the original agreement, is included in NW Natural's annual Oregon PGA filing, which allows NW Natural to recover these costs through customer rates. The net investment under the original agreement earns a rate of return. In 2014, NW Natural amended the original gas reserves agreement in response to Encana's sale of its interest in the Jonah field located in Wyoming to Jonah Energy. Under the amended agreement with Jonah Energy, NW Natural has the option to invest in additional wells on a well-by-well basis with drilling costs and resulting gas volumes shared at the amended proportionate working interest for each well in which NW Natural invests. Volumes produced from the additional wells drilled after the amended agreement are included in NW Natural's Oregon PGA at a fixed rate of $0.4725 per therm. NW Natural did not have the opportunity to participate in additional wells in 2016, 2017, or 2018. DECOUPLING. In Oregon, NW Natural has a decoupling mechanism. Decoupling is intended to break the link between earnings and the quantity of gas consumed by customers, removing any financial incentive to discourage customers’ efforts to conserve energy. The Oregon decoupling mechanism was reauthorized and the baseline expected usage per customer was reset in the 2018 Oregon general rate case. This mechanism employs a use-per-customer decoupling calculation, which adjusts margin revenues to account for the difference between actual and expected customer volumes. The margin adjustment resulting from differences between actual and expected volumes under the decoupling component is recorded to a deferral account, which is included in the annual PGA filing. In Washington, customer use is not covered by such a tariff. However, NW Natural's general rate case filed in Washington on December 31, 2018, requests that such a tariff be implemented. See "Regulatory Proceeding Updates-Washington General Rate Case" above. WARM. In Oregon, NW Natural has an approved weather normalization mechanism, which is applied to residential and commercial customer bills. This mechanism is designed to help stabilize the collection of fixed costs by adjusting residential and commercial customer billings based on temperature variances from average weather, with rate decreases when the weather is colder than average and rate increases when the weather is warmer than average. The mechanism is applied to bills from December through mid-May of each heating season. The mechanism adjusts the margin component of customers’ rates to reflect average weather, which uses the 25-year average temperature for each day of the billing period. Daily average temperatures and 25-year average temperatures are based on a set point temperature of 59 degrees Fahrenheit for residential customers and 58 degrees Fahrenheit for commercial customers. The collections of any unbilled WARM amounts due to tariff caps and floors are deferred and earn a carrying charge until collected, or returned, in the PGA the following year. This weather normalization mechanism was reauthorized in the 2012 Oregon general rate case without an expiration date. Residential and commercial customers in Oregon are allowed to opt out of the weather normalization mechanism, and as of December 31, 2018, 8% of eligible customers had opted out. NW Natural does not have a weather normalization mechanism approved for residential and commercial customers in Washington, which account for about 11% of total customers. See "Business Segments-Natural Gas Distribution" below. INDUSTRIAL TARIFFS. The OPUC and WUTC have approved tariffs covering NGD service to major industrial customers, which are intended to give NW Natural certainty in the level of gas supplies needed to serve this customer group. The approved terms include, among other things, an annual election period, special pricing provisions for out-of-cycle changes, and a requirement that industrial customers complete the term of their service election under NW Natural's annual PGA tariff. ENVIRONMENTAL COST DEFERRAL AND SRRM. NW Natural has a SRRM through which it tracks and has the ability to recover past deferred and future prudently incurred environmental remediation costs allocable to Oregon, subject to an earnings test. Under the SRRM collection process, there are three types of deferred environmental remediation expense: • Pre-review - This class of costs represents remediation spend that has not yet been deemed prudent by the OPUC. Carrying costs on these remediation expenses are recorded at NW Natural's authorized cost of capital. NW Natural anticipates the prudence review for annual costs and approval of the earnings test prescribed by the OPUC to occur by the third quarter of the following year. • Post-review - This class of costs represents remediation spend that has been deemed prudent and allowed after applying the earnings test, but is not yet included in amortization. NW Natural earns a carrying cost on these amounts at a rate equal to the five-year treasury rate plus 100 basis points. • Amortization - This class of costs represents amounts included in current customer rates for collection and is generally calculated as one-fifth of the post-review deferred balance. NW Natural earns a carrying cost equal to the amortization rate determined annually by the OPUC, which approximates a short-term borrowing rate. NW Natural included $6.1 million and $7.4 million of deferred remediation expense approved by the OPUC for collection during the 2018-19 and 2017-18 PGA years, respectively. In addition, the SRRM also provides for the annual collection of $5.0 million from Oregon customers through a tariff rider. As it collects amounts from customers, NW Natural recognizes these collections as revenue and separately amortizes an equal and offsetting amount of the deferred regulatory asset balance through the environmental remediation operating expense line shown separately in the operating expenses section of the Consolidated Statements of Comprehensive Income (Loss). See Note 17 for more information on our environmental matters. The SRRM earnings test is an annual review of adjusted NGD ROE compared to authorized NGD ROE. For 2018, the first ten months will be weighted at 9.5% and the last two months at 9.4%, reflecting the ROE change from NW Natural's most recent rate case effective November 1, 2018. To apply the earnings test NW Natural must first determine what if any costs are subject to the test through the following calculation: Annual spend Less: $5.0 million base rate rider Prior year carry-over(1) $5.0 million insurance + interest on insurance Total deferred annual spend subject to earnings test Less: over-earnings adjustment, if any Add: deferred interest on annual spend(2) Total amount transferred to post-review (1) Prior year carry-over results when the prior year amount transferred to post-review is negative. The negative amount is carried over to offset annual spend in the following year. (2) Deferred interest is added to annual spend to the extent the spend is recoverable. To the extent the NGD business earns at or below its authorized ROE, the total amount transferred to post-review is recoverable through the SRRM. To the extent more than authorized ROE is earned in a year, the amount transferred to post-review would be reduced by those earnings that exceed its authorized ROE. For 2018, NW Natural has performed this test, which is anticipated to be submitted to the OPUC in May 2019, and no earnings test adjustment is expected for 2018. The WUTC has also previously authorized the deferral of environmental costs, if any, that are appropriately allocated to Washington customers. This Order was effective in January 2011 with cost recovery and carrying charges on amounts deferred for costs associated with services provided to Washington customers to be determined in a future proceeding. Annually, or more often if circumstances warrant, NW Natural reviews all regulatory assets for recoverability. If NW Natural should determine all or a portion of these regulatory assets no longer meet the criteria for continued application of regulatory accounting, then NW Natural would be required to write-off the net unrecoverable balances against earnings in the period such a determination was made. PENSION COST DEFERRAL AND PENSION BALANCING ACCOUNT. From 2011 through October 2018, the OPUC authorized a regulatory mechanism in which NW Natural deferred annual pension expenses above the amount set in rates, with recovery of these deferred amounts through the implementation of a balancing account, which included the expectation of higher and lower pension expenses in future years. During this period the mechanism permitted for NW Natural to accrue interest on the account balance at the NGD business' authorized rate of return. On October 26, 2018, the OPUC issued an order to freeze NW Natural's pension balancing account as of October 31, 2018. The order directed NW Natural and the other parties to the 2018 Oregon rate case to engage in further regulatory proceedings extending the general rate case docket to resolve open issues with respect to the recovery of the pension balancing account. On February 4, 2019, NW Natural and the other parties to the rate case filed a joint stipulation with the OPUC outlining a resolution to the issue. See "Regulatory Proceeding Updates-Oregon General Rate Case" above. Pension expense deferrals, excluding interest, were $10.3 million, $6.5 million, and $6.3 million in 2018, 2017 and 2016, respectively. INTERSTATE STORAGE AND OPTIMIZATION SHARING. On an annual basis, NW Natural credits amounts to Oregon and Washington customers as part of a regulatory incentive sharing mechanism related to net revenues earned from Mist gas storage and asset management activities. Generally, amounts are credited to Oregon customers in June, while credits are given to customers in Washington as reductions in rates through the annual PGA filing in November. The following table presents the credits to NGD customers: Business Segment - Natural Gas Distribution (NGD) NGD margin results are primarily affected by customer growth, revenues from rate-base additions, and, to a certain extent, by changes in delivered volumes due to weather and customers’ gas usage patterns because a significant portion of NGD margin is derived from natural gas sales to residential and commercial customers. In Oregon, NW Natural has a conservation tariff (also called the decoupling mechanism), which adjusts margin up or down each month through a deferred regulatory accounting adjustment designed to offset changes resulting from increases or decreases in average use by residential and commercial customers. NW Natural also has a weather normalization tariff in Oregon, WARM, which adjusts customer bills up or down to offset changes in margin resulting from above- or below-average temperatures during the winter heating season. Both mechanisms are designed to reduce, but not eliminate, the volatility of customer bills and natural gas distribution earnings. See "Regulatory Matters-Rate Mechanisms" above. The NGD business is seasonal in nature due to higher gas usage by residential and commercial customers during the cold winter heating months. Other categories of customers experience seasonality in their usage but to a lesser extent. Seasonality affects the comparability of the results of operations of the NGD business across quarters but not across years. NGD segment highlights include: (1) See the Non-GAAP Reconciliations table at the beginning of Item 7 for a reconciliation of this non-GAAP financial measure to its closest U.S. GAAP measure. (2) See Natural Gas Distribution Margin Table below for additional detail. 2018 COMPARED TO 2017. NGD net income was $57.5 million in 2018 compared to $60.5 million in 2017. NGD net income in 2017 includes a $1.0 million loss from the remeasurement of deferred income tax balances due to the enactment of the TCJA. Excluding this item, adjusted NGD net income decreased $4.0 million, or $0.14 per share. See the NW Holdings non-GAAP reconciliations at the beginning of Item 7 for additional information. The primary factors contributing to the decrease in adjusted NGD net income were as follows: • a $8.9 million decrease in natural gas distribution margin primarily due to: ▪ a $7.9 million decrease due to revenues collected and deferred in association with the TCJA; partially offset by ▪ a $4.8 million increase from customer growth; and ▪ the majority of the remaining decrease was due to the effects of warmer than average weather in 2018 compared to colder than average weather in 2017, partially offset by higher rates from the 2018 Oregon general rate case effective November 1, 2018. • a $6.0 million increase in operations and maintenance expense driven largely from payroll and benefits due to increased headcount, general salary increases, and increased professional services and contract labor expense; • a $4.2 million decrease in other income (expense), net, primarily due to increases in pension non-service component costs, partially offset by increases in the equity portion of AFUDC in 2018; and • a $4.0 million increase in depreciation expense primarily due to additional capital expenditures; partially offset by • a $20.0 million decrease in income tax expense primarily due to the reduction in the federal statutory tax rate from the TCJA and lower pretax income. Total natural gas sold and delivered in 2018 decreased 9% over 2017 primarily due to the impact of weather that was 26% warmer than the prior period and 15% warmer than average. 2017 COMPARED TO 2016. NGD net income was $60.5 million in 2017 compared to $54.6 million in 2016, which includes the $1.0 million loss from the remeasurement of deferred income tax balances associated with the TCJA in 2017 and the after-tax $2.0 million regulatory disallowance in 2016. Excluding these items, adjusted NGD net income increased $4.9 million, or $0.10 per share. See the Non-GAAP reconciliations at the beginning of Item 7 for additional information. The primary factors contributing to this increase in adjusted NGD net income were as follows: • a $16.0 million increase in NGD margin primarily due to: • a $6.8 million increase from customer growth; partially offset by; • a $2.7 million decrease from gains in gas cost incentive sharing due to actual gas prices being lower than those estimated in the 2016-2017 PGA, but not by the same magnitude as in the prior period; • a portion of the remaining increase was due to the effects of colder than average weather in 2017 compared to warmer than average weather in 2016. • a $2.2 million increase in other income (expense), net, primarily due to an increase in the equity portion of AFUDC in 2017; partially offset by • a $10.4 million increase in operations and maintenance expense driven largely from payroll and benefits due to increased headcount, general salary increases, and increased safety equipment update costs; and • a $3.4 million increase in depreciation expense primarily due to additional capital expenditures. Total natural gas sold and delivered in 2017 increased 14% over 2016 primarily due to the impact of weather that was 48% colder than the prior period and 15% colder than average. NATURAL GAS DISTRIBUTION MARGIN TABLE. The following table summarizes the composition of NGD gas volumes, revenues, and cost of sales: (1) The change in presentation of revenue taxes was a result of the adoption of ASU 2014-09 "Revenue From Contracts with Customers" and all related amendments on January 1, 2018. This change had no impact on NGD margin results. For additional information, see Note 2. (2) Amounts reported as margin for each category of meters are operating revenues, which are net of revenue taxes, less cost of gas and environmental remediation expense. (3) Other margin adjustments include revenue deferrals of $7.9 million for the year ended December 31, 2018 associated with the decline of the U.S. federal corporate income tax rate. (4) Heating degree days are units of measure reflecting temperature-sensitive consumption of natural gas, calculated by subtracting the average of a day's high and low temperatures from 59 degrees Fahrenheit. (5) Average weather represents the 25-year average of heating degree days. Through October 31, 2018, average weather is calculated over the period 1986 - 2010, as determined in NW Natural's 2012 Oregon general rate case, and beginning November 1, 2018, average weather is calculated over the period May 31, 1992 through May 30, 2017, as determined in NW Natural's 2018 Oregon general rate case. Residential and Commercial Sales The primary factors that impact results of operations in the residential and commercial markets are customer growth, seasonal weather patterns, energy prices, competition from other energy sources, and economic conditions in our service areas. The impact of weather on margin is significantly reduced through NW Natural's weather normalization mechanism in Oregon; approximately 81% of NW Natural's total customers are covered under this mechanism. The remaining customers either opt out of the mechanism or are located in Washington, which does not have a similar mechanism in place. For more information on the weather mechanism, see "Regulatory Matters-Rate Mechanisms-Weather Normalization Mechanism" above. NGD residential and commercial sales highlights include: 2018 COMPARED TO 2017. The primary factors contributing to changes in the residential and commercial markets were decreases of $62.5 million in operating revenue and $3.1 million in NGD margin as a result of sales volume decreases of 79.2 million therms, or 11%, due to warmer than average weather in 2018 compared to colder than average weather in the prior period, partially offset by customer growth. 2017 COMPARED TO 2016. The primary factors contributing to changes in the residential and commercial markets were increases of $79.8 million in operating revenue and $17.7 million in natural gas distribution margin as a result of sales volume increases of 131.2 million therms, or 22%, due to customer growth and the effects of colder than average weather in 2017 compared to warmer than average weather in the prior period. Industrial Sales and Transportation Industrial customers have the option of purchasing sales or transportation services. Under the sales service, the customer buys the gas commodity. Under the transportation service, the customer buys the gas commodity directly from a third-party gas marketer or supplier. The NGD gas commodity cost is primarily a pass-through cost to customers; therefore, NGD profit margins are not materially affected by an industrial customer's decision to purchase gas from third parties. Industrial and large commercial customers may also select between firm and interruptible service options, with firm services generally providing higher profit margins compared to interruptible services. To help manage gas supplies, industrial tariffs are designed to provide some certainty regarding industrial customers' volumes by requiring an annual service election which becomes effective November 1, special charges for changes between elections, and in some cases, a minimum or maximum volume requirement before changing options. NGD industrial sales and transportation highlights include: 2018 COMPARED TO 2017. Industrial sales and transportation volumes decreased by 32.9 million therms and NGD margin decreased $1.0 million due to lower usage from warmer than average weather in 2018 compared to colder than average weather in 2017. 2017 COMPARED TO 2016. Industrial sales and transportation volumes increased by 24.1 million therms and NGD margin increased $0.8 million due to higher usage from colder than average weather in 2017 compared to warmer than average weather in 2016, and increased usage from higher production load. Other NGD Revenues Other NGD revenues include miscellaneous fee income as well as regulatory revenue adjustments, which reflect current period deferrals to and prior year amortizations from regulatory asset and liability accounts, except for gas cost deferrals which flow through cost of gas. Decoupling and other regulatory amortizations from prior year deferrals are included in revenues from residential, commercial, and industrial firm customers. Other NGD revenue highlights include: Other NGD revenue increased $1.6 million in 2018 compared to 2017 due to increases in entitlement and curtailment revenue due to system restrictions for certain industrial and commercial customers as a result of a Canadian pipeline event in October 2018 that disrupted gas supply. Other NGD revenues remained flat between 2017 and 2016. Cost of Gas Cost of gas as reported by the NGD segment includes gas purchases, gas withdrawn from storage inventory, gains and losses from commodity hedges, pipeline demand costs, seasonal demand cost balancing adjustments, regulatory gas cost deferrals, gas reserves costs, and company gas use. The OPUC and WUTC generally require natural gas commodity costs to be billed to customers at the actual cost incurred, or expected to be incurred. Customer rates are set each year so that if cost estimates were met the NGD business would not earn a profit or incur a loss on gas commodity purchases; however, in Oregon we have the incentive sharing mechanism described under "Regulatory Matters-Rate Mechanisms-Purchased Gas Adjustment" above. In addition to the PGA incentive sharing mechanism, gains and losses from hedge contracts entered into after annual PGA rates are effective for Oregon customers are also required to be shared and therefore may impact net income. Further, NW Natural also has a regulatory agreement whereby it earns a rate of return on its investment in the gas reserves acquired under the original agreement with Encana and includes gas from the amended gas reserves agreement at a fixed rate of $0.4725 per therm, which are also reflected in NGD margin. See "Application of Critical Accounting Policies and Estimates-Accounting for Derivative Instruments and Hedging Activities" below. Cost of gas highlights include: 2018 COMPARED TO 2017. Cost of gas decreased $69.3 million, or 21%, primarily due to the 10% decrease in volumes sold due to warmer than average weather in 2018 compared to colder than average weather in 2017, and lower average cost of gas collected from customers, partially offset by customer growth. 2017 COMPARED TO 2016. Cost of gas increased $64.4 million, or 25%, primarily due to the 20% increase in volumes sold due to colder than average weather in 2017 compared to warmer than average weather in 2016, and customer growth. The effect on net income from NW Natural's gas cost incentive sharing mechanism resulted in a slight margin loss in 2018 and margin gains of $1.2 million and $4.0 million for 2017 and 2016, respectively. In 2018, actual prices closely aligned with estimated prices included in customer rates. In 2017 and 2016, actual prices were lower than the estimated prices included in customer rates due to warmer than average weather nationally, which resulted in lower national natural gas commodity prices. For a discussion of the gas cost incentive sharing mechanism, see "Regulatory Matters-Rate Mechanisms-Purchased Gas Adjustment" above. Other Other activities aggregated and reported as other at NW Natural include the non-NGD storage activity at Mist as well as asset management services and the appliance retail center operations. Other activities aggregated and reported as other at NW Holdings include NWN Energy's equity investment in Trail West Holding, LLC (TWH), which is pursuing the development of a proposed natural gas pipeline through its wholly-owned subsidiary, Trail West Pipeline, LLC (TWP); NNG Financial's investment in Kelso-Beaver Pipeline (KB Pipeline); and NWN Water, which owns and continues to pursue investments in the water sector. See Note 4 for further discussion of our business segment and other, as well as our direct and indirect wholly-owned subsidiaries, and Note 13 for further details on our investment in TWH. At Mist, NW Natural provides gas storage services to customers in the interstate and intrastate markets using storage capacity that has been developed in advance of NGD customers’ requirements. Pre-tax income from gas storage at Mist and asset management services is subject to revenue sharing with NGD customers. Under this regulatory incentive sharing mechanism, NW Natural retains 80% of pre-tax income from Mist gas storage services and asset management services when the underlying costs of the capacity being used are not included in NGD business rates. The remaining 20% is credited to a deferred regulatory account for credit to NGD customers. Through October 2018, when the capacity used was included in NGD rates, NW Natural retained 33% of pre-tax income with the remaining 67% credited to a deferred regulatory account for credit to NGD customers. In conjunction with the Oregon rate case, effective November 2018 NW Natural retains 10% of pre-tax income from such storage and asset management services and 90% is credited to NGD business customers. See "Regulatory Matters-Regulatory Proceeding Updates" above for information regarding an open docket related to this incentive sharing mechanism. The following table presents the results of activities aggregated and reported as other for both NW Holdings and NW Natural: The significant drivers of changes in other net income discussed below apply to both NW Holdings and NW Natural. 2018 COMPARED TO 2017. Other net income decreased compared to the prior period primarily due to $4.2 million in higher income tax expense driven by $4.4 million in income tax benefits recognized in 2017 from the enactment of the TCJA, partially offset by a $2.8 million increase in revenues from asset management agreements for Mist storage and transportation capacity. 2017 COMPARED TO 2016. Other net income increased primarily due to a gain associated with the TCJA deferred taxes remeasurement, partially offset by a decrease in revenues from asset management agreements for Mist storage and transportation capacity. Consolidated Operations Operations and Maintenance Operations and maintenance highlights include: The significant drivers of changes in operations and maintenance expenses discussed below apply to both NW Holdings and NW Natural. 2018 COMPARED TO 2017. Operations and maintenance expense increased $4.3 million and $3.0 million for NW Holdings and NW Natural, respectively, primarily due to the following factors: • a $3.4 million increase in NGD payroll and benefits due to increased headcount and general salary increases; and • a $3.2 million increase in NGD non-payroll costs primarily due to increases in general professional services and contract labor. 2017 COMPARED TO 2016. Operations and maintenance expense increased $15.7 million and $16.2 million for NW Holdings and NW Natural, respectively, primarily due to the following factors: • a $7.3 million increase in NGD payroll and benefits due to increased headcount and general salary increases; and • a $1.0 million increase in safety equipment upgrade costs. Delinquent customer receivable balances continue to remain at historically low levels. Bad debt expense as a percent of revenues was 0.1% for 2018, 2017, and 2016. Depreciation and Amortization Depreciation and amortization highlights include: The significant drivers of changes in depreciation and amortization discussed below apply to both NW Holdings and NW Natural. 2018 COMPARED TO 2017. Depreciation and amortization expense increased by $4.1 million and $4.0 million for NW Holdings and NW Natural, respectively, primarily due to NGD plant additions that included investments in natural gas transmission and distribution systems supporting customer growth, safety, reliability, facility upgrades, and enhanced technology. 2017 COMPARED TO 2016. Depreciation and amortization expense increased by $3.5 million and $3.4 million for NW Holdings and NW Natural, respectively, primarily due to NGD plant additions that included investments in natural gas transmission and distribution systems, storage facilities, and technology. Other Income (Expense), Net Other income (expense), net highlights include: The significant drivers of changes in Other income (expense) discussed below apply to both NW Holdings and NW Natural. 2018 COMPARED TO 2017. Other income (expense), net, decreased $3.3 million and $3.4 million at NW Holdings and NW Natural, respectively, primarily due to a $3.0 million increase in pension and other postretirement non-service costs and $0.8 million lower gains from company-owned life insurance, partially offset by a $1.4 million increase in the equity portion of AFUDC. 2017 COMPARED TO 2016. Other income (expense), net, increased $6.9 million and $6.8 million at NW Holdings and NW Natural, respectively, primarily due to the January 2016 Order from the OPUC, which resulted in a pre-tax $2.8 million interest disallowance in 2016, an increase of $2.7 million in the equity portion of AFUDC, and $0.8 million in higher gains from company-owned life insurance. In addition to fluctuations in other income (expense), net reported above, from 2011 through October 31, 2018, NW Natural had OPUC approval to defer certain pension costs in excess of what was recovered in customer rates, with the majority of such costs being non-service component costs reflected within other income (expense), net. This pension cost deferral was recorded to a regulatory balancing account, which stabilized the amount of other income (expense), net each year. Total pension cost deferrals, excluding interest, were $10.3 million, $6.5 million, and $6.3 million for the years ended December 31, 2018, 2017 and 2016, respectively. As a result, increased pension costs had a minimal effect on other income (expense), net in 2018, 2017, and 2016, with the increase principally related to the costs allocated to NW Natural's Washington operations, which were not covered by the pension balancing account. On October 26, 2018, the OPUC issued an order to freeze NW Natural's pension balancing account as of October 31, 2018. The order directed NW Natural and the other parties to the rate case to engage in further regulatory proceedings extending the general rate case docket to resolve open issues with respect to the recovery of the pension balancing account. On February 4, 2019, NW Natural and the other parties to the rate case filed a joint stipulation with the OPUC outlining a resolution to the issue. See Note 9 and "Regulatory Matters-Regulatory Proceeding Updates- Oregon General Rate Case". Interest Expense, Net Interest expense, net highlights include: The significant drivers of changes in interest expense, net discussed below apply to both NW Holdings and NW Natural. 2018 COMPARED TO 2017. Interest expense, net of amounts capitalized decreased $0.4 million and $0.5 million at NW Holdings and NW Natural, respectively, primarily due to a $2.3 million increase in the interest-related portion of AFUDC, partially offset by increased commercial paper interest expenses of $1.6 million. 2017 COMPARED TO 2016. Interest expense, net of amounts capitalized, decreased $0.6 million at both NW Holdings and NW Natural primarily due to a $2.1 million increase in the interest-related portion of AFUDC, partially offset by increased interest expense of $1.5 million due to the issuance of long-term debt in December 2016 and August 2017. Income Tax Expense NW Holdings income tax expense highlights include: (1) See the Non-GAAP Reconciliations table at the beginning of Item 7 for a reconciliation of this non-GAAP financial measure to its closest U.S.GAAP measure. NW Natural income tax expense highlights include: (1) See the Non-GAAP Reconciliations table at the beginning of Item 7 for a reconciliation of this non-GAAP financial measure to its closest U.S.GAAP measure. The significant drivers of changes in Income tax expense discussed below apply to both NW Holdings and NW Natural. 2018 COMPARED TO 2017. The effective tax rate decreased by 9.9% and 10.2% at NW Holdings and NW Natural, respectively, primarily due to a decline in the statutory income tax rate from 39.5% to 26.5% as a result of the TCJA enactment in 2017. Income tax expense decreased due to the TCJA and lower pre-tax income, partially offset by a benefit of $3.4 million recognized in 2017 at NW Holdings and a benefit of $3.0 million recognized in 2017 at NW Natural from the remeasurement of deferred tax balances upon the TCJA enactment date. Excluding the impact of the 2017 remeasurement benefits of $3.4 million and $3.0 million at NW Holdings and NW Natural, respectively, the adjusted effective tax rate decreased 12.9% at both NW Holdings and NW Natural due to the statutory tax rate declining from the TCJA. See the Non-GAAP reconciliations at the beginning of Item 7 for additional information. 2017 COMPARED TO 2016. The effective tax rate decreased by 4.5% and 4.2% at NW Holdings and NW Natural, respectively. Excluding the tax benefits associated with the TCJA enactment in 2017 of $3.4 million and $3.0 million at NW Holdings and NW Natural, respectively, and the $1.3 million tax effects of non-GAAP adjustments in 2016 at both NW Holdings and NW Natural, the adjusted effective tax rate decreased 1.5% at both NW Holdings and NW Natural. See the Non-GAAP reconciliations at the beginning of Item 7 for additional information. The adjusted effective tax rate decreased primarily as a result of AFUDC equity income and increased stock-based compensation deductions in 2017. Pending Sale of Gill Ranch Storage On June 20, 2018, NWN Gas Storage, a wholly owned subsidiary of NW Holdings, entered into a Purchase and Sale Agreement (the Sale Agreement) that provides for the sale by NWN Gas Storage of all of its membership interests in Gill Ranch. Gill Ranch owns a 75% interest in the natural gas storage facility located near Fresno, California known as the Gill Ranch Gas Storage Facility. PG&E owns the remaining 25% interest in the Gill Ranch Facility. In the Sale Agreement, NWN Gas Storage makes representations and warranties concerning, among other things, Gill Ranch, the Gill Ranch Facility and Gill Ranch’s business and contractual relationships, and agrees to cause Gill Ranch to conduct its business and maintain its properties in the ordinary course, consistent with material agreements and past practice. The Sale Agreement provides for an initial cash purchase price of $25.0 million (subject to a working capital adjustment), plus potential additional payments to NWN Gas Storage of up to $26.5 million in the aggregate if Gill Ranch achieves certain economic performance levels for the first three full gas storage years (April 1 of one year through March 31 of the following year) occurring after the closing and the remaining portion of the gas storage year during which the closing occurs. The closing of the transaction is subject to approval by the CPUC, other customary closing conditions and covenants, including the requirement that all of the representations and warranties be true and correct as of the closing date except, as would not, in the case of certain representations and warranties, be reasonably expected to have a material adverse effect on Gill Ranch. The agreement is subject to termination by either party if the transaction has not closed by June 20, 2019, subject to automatic extension for six months if the CPUC has not issued an order approving the transaction by that date. In July 2018, Gill Ranch filed an application with the CPUC for approval of this transaction. On February 14, 2019, the active parties to the CPUC proceeding filed a settlement agreement with the CPUC. The CPUC is expected to rule on the settlement agreement within 90 days of its filing, but may grant further time for public comment. We expect an order on this matter by the end of June. On January 29, 2019, PG&E filed voluntary petitions for relief under chapter 11 bankruptcy. Although we do not currently anticipate that the PG&E filing will affect the sale of Gill Ranch, we cannot fully predict the course of the bankruptcy proceedings or the impact on the sale and will continue to monitor the situation closely. We will continue to seek to close the transaction in the first half of 2019. The results of Gill Ranch Storage have been determined to be discontinued operations and are presented separately, net of tax, from the results of continuing operations of NW Holdings for all periods presented. See Note 18 for more information on the Sale Agreement and the results of our discontinued operations. The CPUC regulates Gill Ranch under a market-based rate model which allows for the price of storage services to be set by the marketplace. The CPUC also regulates the issuance of securities, system of accounts, and regulates intrastate storage services. The California Department of Oil Gas and Geothermal Resources (DOGGR) regulations for gas storage wells were finalized in June 2018, and the U.S. Department of Transportation's Pipeline and Hazardous Materials Safety Administration (PHMSA) proposed new federal regulations for underground natural gas storage facilities, which are expected to be finalized during 2019 and increase costs for all storage providers. NW Holdings will continue to monitor and assess the new regulations until the sale is complete, which is expected in 2019. Short-term liquidity for Gill Ranch is supported by cash balances, internal cash flow from operations, equity contributions from its parent company, and, if necessary, additional external financing. FINANCIAL CONDITION Capital Structure One of our long-term goals is to maintain a strong and balanced consolidated capital structure, while maintaining a long-term target capital structure at NW Natural of 50% common stock and 50% long-term debt to align to allocations prescribed by NW Natural's regulators. When additional capital is required, debt or equity securities are issued depending on both the target capital structure and market conditions. These sources of capital are also used to fund long-term debt retirements and short-term commercial paper maturities. See "Liquidity and Capital Resources" below and Note 8. Achieving our target capital structure and maintaining sufficient liquidity to meet operating requirements are necessary to maintain attractive credit ratings and provide access to capital markets at reasonable costs. NW Holdings' consolidated capital structure was as follows: NW Natural's consolidated capital structure was as follows: During 2018, changes to NW Holdings' and NW Natural's capital structures were primarily due to increases in short term debt at NW Natural partially offset by lower net proceeds from long-term debt activity at NW Natural. See further discussion below in "Cash Flows - Financing Activities". Liquidity and Capital Resources At December 31, 2018 and December 31, 2017, NW Holdings had approximately $12.6 million and $3.5 million, and NW Natural had approximately $7.9 million and $3.1 million of cash and cash equivalents, respectively. In order to maintain sufficient liquidity during periods when capital markets are volatile, NW Holdings and NW Natural may elect to maintain higher cash balances and add short term borrowing capacity. NW Holdings and NW Natural may also pre-fund their respective capital expenditures when long-term fixed rate environments are attractive. NW Holdings For NW Holdings, short-term liquidity is primarily provided by cash balances, dividends from its operating subsidiaries, in particular NW Natural, available cash from a multi-year credit facility, and short-term credit facilities. NW Holdings also has a universal shelf registration statement filed with the SEC for the issuance of debt and equity securities. NW Holdings long-term debt, if any, and equity issuances are primarily used to provide equity contributions to NW Holdings’ operating subsidiaries for operating and capital expenditures and other corporate purposes. NW Holdings' issuance of securities is not subject to regulation by state public utility commissions, but the dividends from NW Natural to NW Holdings are subject to regulatory ring-fencing provisions. As part of the ring-fencing conditions agreed upon with the OPUC and WUTC in connection with the holding company reorganization, NW Natural may not pay dividends or make distributions to NW Holdings if NW Natural’s credit ratings and common equity ratio fall below specified levels. If NW Natural’s long term secured credit ratings are below A- for S&P and A3 for Moody’s, dividends may be issued so long as NW Natural’s common equity ratio is 45% or more. If NW Natural’s long term secured credit ratings are below BBB for S&P and Baa2 for Moody’s, dividends may be issued so long as NW Natural’s common equity ratio is 46% or more. Dividends may not be issued if NW Natural’s long-term secured credit ratings are BB+ or below for S&P or Ba1 or below for Moody’s, or if NW Natural’s common equity ratio is below 44%. In each case, common equity ratios are determined based on a preceding or projected 13-month average. In addition, there are certain OPUC notice requirements for dividends in excess of 5% of NW Natural’s retained earnings. Additionally, if NW Natural’s common equity (excluding goodwill and equity associated with non-regulated assets), on a preceding or projected 13-month average basis, is less than 46% of NW Natural’s capital structure (common equity and long-term debt excluding imputed debt or debt-like lease obligations), NW Natural is required to notify the OPUC, and if the common equity ratio falls below 44%, file a plan with the OPUC to restore its equity ratio to 44%. This condition is designed to ensure NW Natural continues to be adequately capitalized under the holding company structure. Under the WUTC order, the average common equity ratio must not exceed 56%. At December 31, 2018, NW Natural satisfied the ring-fencing provisions described above. NW HOLDINGS DIVIDEND POLICY. Quarterly dividends have been paid on common stock each year since NW Holdings’ predecessor’s stock was first issued to the public in 1951. Annual common stock dividend payments per share, adjusted for stock splits, have increased each year since 1956. The declarations and amount of future dividends to shareholders will depend upon earnings, cash flows, financial condition, NW Natural’s ability to pay dividends to NW Holdings and other factors. The amount and timing of dividends payable on common stock is at the sole discretion of the NW Holdings Board of Directors. Based on several factors, including current cash reserves, committed credit facilities, its ability to receive dividends from its operating subsidiaries, in particular NW Natural, and an expected ability to issue long-term debt and equity securities in the capital markets, NW Holdings believes its liquidity is sufficient to meet anticipated near-term cash requirements, including all contractual obligations, investing, and financing activities as discussed in "Contractual Obligations and Cash Flows" below. Natural Gas Distribution Segment For the NGD business segment, short-term borrowing requirements typically peak during colder winter months when the NGD business borrows money to cover the lag between natural gas purchases and bill collections from customers. Short-term liquidity for the NGD business is primarily provided by cash balances, internal cash flow from operations, proceeds from the sale of commercial paper notes, as well as available cash from multi-year credit facilities, short-term credit facilities, company-owned life insurance policies, the sale of long-term debt, and equity contributions from NW Holdings. NW Natural's long-term debt and contributions from NW Holdings are primarily used to finance NGD capital expenditures, refinance maturing debt, and provide temporary funding for other general corporate purposes of the NGD business. Based on NW Natural's current debt ratings (see "Credit Ratings" below), it has been able to issue commercial paper and long-term debt at attractive rates and has not needed to borrow or issue letters of credit from its back-up credit facility. In the event NW Natural is not able to issue new debt due to adverse market conditions or other reasons, NW Natural expects that near-term liquidity needs can be met using internal cash flows, issuing commercial paper, receiving equity contributions from NW Holdings, or, for the NGD segment, drawing upon a committed credit facility. NW Natural also has a universal shelf registration statement filed with the SEC for the issuance of secured and unsecured debt securities. As of December 31, 2018, NW Natural has Board authorization to issue up to $325 million of additional FMBs and OPUC approval to issue up to $25 million of additional long-term debt for approved purposes. In the event senior unsecured long-term debt ratings are downgraded, or outstanding derivative positions exceed a certain credit threshold, counterparties under derivative contracts could require NW Natural to post cash, a letter of credit, or other forms of collateral, which could expose NW Natural to additional cash requirements and may trigger increases in short-term borrowings while in a net loss position. NW Natural was not required to post collateral at December 31, 2018. However, if the credit risk-related contingent features underlying these contracts were triggered on December 31, 2018, assuming long-term debt ratings dropped to non-investment grade levels, NW Natural could have been required to post $4.5 million in collateral with our counterparties. See "Credit Ratings" below and Note 15. Other items that may have a significant impact on NW Natural's liquidity and capital resources include NW Natural's pension contribution requirements and environmental expenditures. PENSION CONTRIBUTION. NW Natural expects to make contributions to its company-sponsored defined benefit plan, which is closed to new employees, over the next several years until the plan is fully funded under the Pension Protection Act rules, including the rules issued under the Moving Ahead for Progress in the 21st Century Act (MAP-21) and the Highway and Transportation Funding Act of 2014 (HATFA). See "Application of Critical Accounting Policies-Accounting for Pensions and Postretirement Benefits" below. BONUS DEPRECIATION. Fifty percent bonus depreciation was available for a large portion of our capital expenditures in 2016 and 2017 for both federal and Oregon taxes. This reduced taxable income and provided cash flow benefits. However, due to the enactment of the TCJA on December 22, 2017, bonus depreciation is eliminated for regulated NGD-business property acquired after December 31, 2017. Accordingly, we do not anticipate similar cash flow benefits related to bonus depreciation in the future. ENVIRONMENTAL EXPENDITURES. NW Natural expects to continue using cash resources to fund environmental liabilities. In 2015, NW Natural received an Order from the OPUC regarding the SRRM mechanism and began recovering amounts through NGD business rates in November 2015. In addition, the OPUC issued a subsequent Order regarding SRRM implementation in January 2016. See Note 17, and "Results of Operations-Regulatory Matters-Environmental Costs" above. Based on several factors, including current credit ratings, NW Natural's commercial paper program, current cash reserves, committed credit facilities, and an expected ability to issue long-term debt and receive equity contributions from NW Holdings, NW Natural believes its liquidity is sufficient to meet anticipated near-term cash requirements, including all contractual obligations, investing, and financing activities as discussed in "Contractual Obligations" and "Cash Flows" below. NW NATURAL DIVIDEND POLICY. The declarations and amount of future dividends to NW Holdings will depend upon earnings, cash flows, financial condition, the satisfaction of OPUC and WUTC regulatory ring-fencing restrictions, and other factors. The amount and timing of dividends payable on common stock is subject to approval of the NW Natural Board of Directors. OFF-BALANCE SHEET ARRANGEMENTS. Except for certain lease and purchase commitments, NW Holdings and NW Natural have no material off-balance sheet financing arrangements. See "Contractual Obligations" below. In October 2017, NW Natural entered into a 20-year operating lease agreement for a new headquarters location in Portland, Oregon. The existing headquarters lease expires in 2020 and after an extensive search and evaluation process with a focus on seismic preparedness, safety, reliability, least cost to customers and a continued commitment to NW Natural's employees and the communities NW Natural serves, NW Natural executed a new lease for suitable commercial office space in Portland, Oregon. Payments under the lease are expected to commence in 2020 and total estimated base rent payments over the life of the lease are approximately $160 million. NW Natural has the option to extend the term of the lease for two additional seven-year periods. Additionally, the lease was analyzed in consideration of build-to-suit lease accounting guidance with the conclusion that NW Natural is the accounting owner of the asset during construction. As a result, NW Natural recognized $25.5 million and $0.5 million during 2018 and 2017, respectively, in property, plant and equipment and an obligation in other non-current liabilities for the same amount on its consolidated balance sheet. These accounting transactions are non-cash in nature, and as such, are not included in the cash flow analysis and capital expenditures forecasts below, and have no impact on short-term liquidity. When the new lease accounting standard became effective for NW Holdings and NW Natural in 2019, the associated build-to-suit asset and liability were de-recognized in accordance with the new standard. See Note 2 for more information on the impacts of the new lease standard. Contractual Obligations The following table shows contractual obligations from continuing operations at December 31, 2018 by maturity and type of obligation: (1) Postretirement benefit payments primarily consists of two NW Natural items: (1) estimated pension and other postretirement plan payments, which are funded by plan assets and future cash contributions, and (2) required payments to the Western States multiemployer pension plan due to our withdrawal from the plan in December 2013. See Note 9. (2) Gas purchases include contracts which use price formulas tied to monthly index prices. The commitment amounts presented incorporate the December 2018 first of month index price for each supply basin from which gas is purchased. For a summary of gas purchase and gas pipeline capacity commitments, see Note 16. (3) Other purchase commitments primarily consist of remaining balances under existing purchase orders. (4) Other long-term liabilities includes accrued vacation liabilities for management employees and deferred compensation plan liabilities for executives and directors. The timing of these payments are uncertain; however, these payments are unlikely to all occur in the next 12 months. (5) Short- and long-term obligations include short- and long-term debt obligations and other immaterial liabilities. In addition to known contractual obligations listed in the above table, NW Natural has also recognized liabilities for future environmental remediation or action. The exact timing of payments beyond 12 months with respect to those liabilities cannot be reasonably estimated due to numerous uncertainties surrounding the course of environmental remediation and the preliminary nature of site investigations. See Note 17 for a further discussion of environmental remediation cost liabilities. At December 31, 2018, 635 of NW Natural's natural gas distribution employees were members of the Office and Professional Employees International Union (OPEIU) Local No. 11. In May 2014, our union employees ratified a new labor agreement (Joint Accord) that expires on November 30, 2019, and thereafter from year to year unless either party serves notice of its intent to negotiate modifications to the collective bargaining agreement. The remaining terms of Joint Accord include the following items: a scheduled 3% wage increase effective December 1 each year with the potential for up to an additional 3% per year based on wage inflation at or above 4%. The Joint Accord also maintains competitive health benefits, including a 15% to 20% premium cost sharing by employees, a 401(k) contribution of 4% for employees hired after our pension plan was closed on December 31, 2009, and a 401(k) match of 50% of the first 6% of savings, and other flexibility provisions benefiting the Company. Short-Term Debt The primary source of short-term liquidity for NW Holdings is cash balances, dividends from its operating subsidiaries, in particular NW Natural, available cash from a multi-year credit facility, and short-term credit facilities it may enter into from time to time. The primary source of short-term liquidity for NW Natural is from the sale of commercial paper and bank loans. NW Holdings and NW Natural have separate commercial paper programs and separate bank facilities. In addition to issuing commercial paper or bank loans to meet working capital requirements, including seasonal requirements to finance gas purchases and accounts receivable, short-term debt may also be used to temporarily fund capital requirements. For NW Natural, commercial paper and bank loans are periodically refinanced through the sale of long-term debt or equity contributions from NW Holdings. Commercial paper, when outstanding, is sold through two commercial banks under an issuing and paying agency agreement and is supported by one or more unsecured revolving credit facilities. See “Credit Agreements” below. At December 31, 2018 and 2017, NW Holdings had short-term debt outstanding of $217.6 million and $54.2 million, respectively, and NW Natural had short-term debt outstanding of $217.5 million and $54.2 million, respectively. The weighted average interest rate on commercial paper outstanding at December 31, 2018 and 2017 was 3.0% and 1.9%, respectively. Credit Agreements NW Holdings In October 2018, NW Holdings entered into a $100 million credit agreement, with a feature that allows it to request increases in the total commitment amount, up to a maximum of $150 million. The maturity date of the agreement is October 2, 2023, with available extension of commitments for two additional one-year periods, subject to lender approval. All lenders under the NW Holdings credit agreement are major financial institutions with committed balances and investment grade credit ratings as of December 31, 2018 as follows: Based on credit market conditions, it is possible one or more lending commitments could be unavailable to NW Holdings if the lender defaulted due to lack of funds or insolvency; however, NW Holdings does not believe this risk to be imminent due to the lenders' strong investment-grade credit ratings. The NW Holdings credit agreement permits the issuance of letters of credit in an aggregate amount of up to $40 million. The principal amount of borrowings under the credit agreement is due and payable on the maturity date. The credit agreement requires NW Holdings to maintain a consolidated indebtedness to total capitalization ratio of 70% or less. Failure to comply with this covenant would entitle the lenders to terminate their lending commitments and accelerate the maturity of all amounts outstanding. NW Holdings was in compliance with this covenant at December 31, 2018, with a consolidated indebtedness to total capitalization ratio of 55.6%. The agreement also requires NW Holdings to maintain debt ratings (which are defined by a formula using NW Natural's credit ratings in the event NW Holdings does not have a credit rating) with Standard & Poor's (S&P) and Moody's Investors Service, Inc. (Moody’s) and notify the lenders of any change in its senior unsecured debt ratings or senior secured debt ratings, as applicable, by such rating agencies. A change in NW Holdings' debt ratings by S&P or Moody’s is not an event of default, nor is the maintenance of a specific minimum level of debt rating a condition of drawing upon the credit agreement. Rather, interest rates on any loans outstanding under the credit agreements are tied to debt ratings and therefore, a change in the debt rating would increase or decrease the cost of any loans under the credit agreements when ratings are changed. NW Holdings does not currently maintain ratings with S&P or Moody's. NW Holdings had $2.8 million of letters of credit issued and outstanding, separate from the aforementioned credit agreement, at December 31, 2018. NW Natural In October 2018, NW Natural entered into a new multi-year credit agreement for unsecured revolving loans totaling $300 million, with a feature that allows NW Natural to request increases in the total commitment amount, up to a maximum of $450 million. The maturity date of the agreement is October 2, 2023 with an available extension of commitments for two additional one-year periods, subject to lender approval. NW Natural concurrently terminated its prior credit agreement upon the closing of the new agreement. All lenders under the NW Natural credit agreement are major financial institutions with committed balances and investment grade credit ratings as of December 31, 2018 as follows: Based on credit market conditions, it is possible one or more lending commitments could be unavailable to NW Natural if the lender defaulted due to lack of funds or insolvency; however, NW Natural does not believe this risk to be imminent due to the lenders' strong investment-grade credit ratings. The NW Natural credit agreement permits the issuance of letters of credit in an aggregate amount of up to $60 million. The principal amount of borrowings under the credit agreement is due and payable on the maturity date. There were no outstanding balances under this credit agreement or the prior credit agreement at December 31, 2018 or 2017. The credit agreement requires NW Natural to maintain a consolidated indebtedness to total capitalization ratio of 70% or less. Failure to comply with this covenant would entitle the lenders to terminate their lending commitments and accelerate the maturity of all amounts outstanding. NW Natural was in compliance with this covenant at December 31, 2018 and 2017, with consolidated indebtedness to total capitalization ratios of 57.1% and 52.9%, respectively. The agreement also requires NW Natural to maintain credit ratings with S&P and Moody’s and notify the lenders of any change in NW Natural's senior unsecured debt ratings or senior secured debt ratings, as applicable, by such rating agencies. A change in NW Natural's debt ratings by S&P or Moody’s is not an event of default, nor is the maintenance of a specific minimum level of debt rating a condition of drawing upon the credit agreement. Rather, interest rates on any loans outstanding under the agreement are tied to debt ratings and therefore, a change in the debt rating would increase or decrease the cost of any loans under the credit agreement when ratings are changed. See "Credit Ratings" below. Credit Ratings NW Holdings does not currently maintain ratings with S&P or Moody's. NW Natural's credit ratings are a factor of liquidity, potentially affecting access to the capital markets including the commercial paper market. NW Natural's credit ratings also have an impact on the cost of funds and the need to post collateral under derivative contracts. The following table summarizes NW Natural's current credit ratings: The above credit ratings and ratings outlook are dependent upon a number of factors, both qualitative and quantitative, and are subject to change at any time. The disclosure of or reference to these credit ratings is not a recommendation to buy, sell or hold NW Holdings or NW Natural securities. Each rating should be evaluated independently of any other rating. As part of the ring-fencing conditions agreed upon with the OPUC and WUTC in connection with the holding company reorganization, NW Holdings and NW Natural are required to maintain separate credit ratings, long-term debt ratings, and preferred stock ratings, if any. Long-Term Debt The following NW Natural debentures were retired in the periods indicated: Bankruptcy Ring-fencing Restrictions As part of the ring-fencing conditions agreed upon with the OPUC and WUTC in connection with the holding company reorganization, NW Natural is required to have one director who is independent from NW Natural management and from NW Holdings and to issue one share of NW Natural preferred stock to an independent third party. NW Natural was in compliance with both of these ring-fencing provisions as of December 31, 2018. NW Natural may file a voluntary petition for bankruptcy only if approved unanimously by the Board of Directors of NW Natural, including the independent director, and by the holder of the preferred share. Cash Flows Operating Activities Changes in our operating cash flows are primarily affected by net income or loss, changes in working capital requirements, and other cash and non-cash adjustments to operating results. Operating activity highlights include: The significant drivers of changes in cash provided by operating activities discussed below apply to both NW Holdings and NW Natural. 2018 COMPARED TO 2017. The significant factors contributing to the $37.9 million and $33.0 million decreases in NW Holdings and NW Natural cash flow provided by operating activities, respectively, were as follows: • a decrease of $31.5 million in cash flow benefits from changes in deferred gas cost balances primarily due to higher gas prices in the fourth quarter of 2018 and lower current year PGA rates reflecting over-collections of certain fixed costs from customers in the prior year when weather was colder than average; • a decrease of $12.6 million due to $27.4 million income taxes paid in 2018 due to the elimination of bonus depreciation as a result of the TCJA, compared to income taxes paid of $14.8 million in 2017; partially offset by • a net increase of $10.2 million from changes in working capital related to receivables, inventories, and accounts payable reflecting warmer than average weather in 2018 compared to the prior period; and • an increase of $3.9 million due to a decrease in contributions paid to qualified defined benefit pension plans 2017 COMPARED TO 2016. The significant factors contributing to the $15.4 million and $15.7 million decreases in NW Holdings and NW Natural cash flows provided by operating activities, respectively, were as follows: • a decrease of $21.9 million due to $14.8 million income taxes paid in 2017 compared to a refund of $7.2 million in 2016 as a result of the enactment of bonus depreciation in December 2015; • a decrease of $5.0 million due to an increase in contributions paid to qualified defined benefit pension plans; and • a net decrease of $12.2 million from changes in working capital related to receivables, inventories, and accounts payable reflecting colder than average weather in 2017 compared to the prior period; partially offset by • an increase of $27.3 million in cash flow benefits from changes in deferred gas cost balances primarily due to the $19.4 million gas cost savings credited to customers in 2016 that did not occur in 2017. During the year ended December 31, 2018, NW Natural contributed $15.5 million to its qualified defined benefit pension plan, compared to $19.4 million for 2017 and $14.5 million for 2016. The amount and timing of future contributions will depend on market interest rates and investment returns on the plans’ assets. See Note 9. Bonus depreciation of 50% was available for a large portion of capital expenditures for federal and Oregon purposes in 2016 and 2017. This reduced our taxable income and provided cash flow benefits. Bonus depreciation for 2015 was not enacted until December 18, 2015, and was extended retroactively back to January 1, 2015 of the respective year. As a result, estimated income tax payments were made throughout 2015 without the benefit of bonus depreciation for the year. This delayed the cash flow benefit of bonus depreciation until refunds could be requested and received. We received refunds of federal income tax overpayments of $7.9 million during 2016. As a result of the enactment of the TCJA on December 22, 2017, bonus depreciation was eliminated for NGD business property acquired after December 31, 2017. Accordingly, we do not anticipate similar cash flow benefits related to bonus depreciation in the future. We have lease and purchase commitments relating to our operating activities that are financed with cash flows from operations. For information on cash flow requirements related to leases and other purchase commitments, see “Financial Condition-Contractual Obligations” above and Note 16. Investing Activities Investing activity highlights include: NW HOLDINGS 2018 COMPARED TO 2017. The $3.3 million increase in cash used in investing activities was primarily due to continued capital expenditures primarily related to NW Natural's North Mist Gas Storage Expansion Project as well as customer growth, system reinforcement, technology, and facilities. 2017 COMPARED TO 2016. The $77.6 million increase in cash used in investing activities was primarily due to higher capital expenditures primarily related to NW Natural's North Mist Gas Storage Expansion Project as well as customer growth, system reinforcement, technology, and facilities. NW NATURAL 2018 COMPARED TO 2017. The $24.3 million increase in cash used in investing activities was primarily due to NW Natural's initial cash contribution of $20 million to its then subsidiary, and now parent, NW Holdings, in addition to continued capital expenditures primarily related to NW Natural's North Mist Gas Storage Expansion Project as well as customer growth, system reinforcement, technology, and facilities. 2017 COMPARED TO 2016. The $77.6 million increase in cash used in investing activities was primarily due to higher capital expenditures primarily related to NW Natural's North Mist Gas Storage Expansion Project as well as customer growth, system reinforcement, technology, and facilities. The operating subsidiaries of NW Holdings invest in capital expenditures to maintain and enhance the safety and integrity of their distribution systems, to expand the reach or capacity of those assets, and improve the efficiency of operations. CAPITAL EXPENDITURES. NW Holdings' largest subsidiary, NW Natural, expects to make a significant level of investments in its NGD segment in 2019 and through 2023. Over the five-year period from 2019 to 2023, the NGD segment is expected to invest $820 to $910 million in capital expenditures to support system reliability, customer growth, and operate effective technology for the business. In 2019, NW Natural anticipates several significant projects for the NGD segment, including completing the replacement of end of life equipment at the Mist gas storage facility, and renovating several resource facilities across NW Natural's service territory. Projects in 2019 also include leasehold improvements and technology for the new headquarters in Portland, Oregon and the completion of the North Mist gas storage expansion project. NW Holdings' wholly-owned water subsidiaries expect to invest in their facilities to support growth and upgrade their systems with $30 to $40 million expected to be invested from 2019 to 2023. NW Holdings expects an immaterial amount of non-NGD capital investments for Gill Ranch and other activities in 2019 and through 2023. Investments in our infrastructure during and after 2019 beyond the amounts provided below will depend largely on additional regulations, growth, and expansion opportunities. For 2019, capital expenditures are estimated, on an accrual basis, to be as follows: Required funds for the investments are expected to be internally generated and/or financed with long-term debt or equity, as appropriate. Financing Activities Financing activity highlights include: NW HOLDINGS 2018 COMPARED TO 2017. The $50.4 million increase in cash provided by financing activities was primarily due to $162.4 million higher short-term debt issuances, partially offset by $107.0 million lower net proceeds from long-term debt activity in 2018. 2017 COMPARED TO 2016. The $93.6 million increase in cash provided by financing activities was primarily due to $217.6 million lower repayments of short-term debt compared to the prior period, partially offset by $65.0 million lower net proceeds from long-term debt activity in 2017 and $52.8 million of common stock proceeds in 2016. NW NATURAL 2018 COMPARED TO 2017. The $62.4 million increase in cash provided by financing activities was primarily due to increases in short term debt issuances of $162.4 million, partially offset by $107.0 million lower net proceeds from long-term debt activity in 2018. NW Natural cash provided by financing activities was $12.0 million higher in comparison to NW Holdings primarily due to the payment of the November 15, 2018 dividend to NW Holdings shareholders using NW Holdings funds. 2017 COMPARED TO 2016.The $93.6 million increase in cash provided by financing activities was primarily due to $217.6 million lower repayments of short-term debt compared to the prior period, partially offset by $65 million lower net proceeds from long-term debt activity in 2017 and $52.8 million of common stock proceeds in 2016. Pension Cost and Funding Status of Qualified Retirement Plans NW Natural's pension costs are determined in accordance with accounting standards for compensation and retirement benefits. See “Application of Critical Accounting Policies and Estimates - Accounting for Pensions and Postretirement Benefits” below. Pension expense for NW Natural's qualified defined benefit plan, which is allocated between operations and maintenance expenses, capital expenditures, and through October 31, 2018, the deferred regulatory balancing account, totaled $20.7 million in 2018, an increase of $2.6 million from 2017. The fair market value of pension assets in this plan decreased to $257.8 million at December 31, 2018 from $287.9 million at December 31, 2017. The decrease was due to a loss on plan assets of $25.9 million and benefit payments of $19.7 million, offset by $15.5 million in employer contributions. Contributions made to NW Natural's company-sponsored qualified defined benefit pension plan are based on actuarial assumptions and estimates, tax regulations, and funding requirements under federal law. The qualified defined benefit pension plan was underfunded by $162.4 million at December 31, 2018. NW Natural plans to make contributions during 2019 of $11.0 million. See Note 9 for further pension disclosures. Contingent Liabilities Loss contingencies are recorded as liabilities when it is probable that a liability has been incurred and the amount of the loss is reasonably estimable in accordance with accounting standards for contingencies. See “Application of Critical Accounting Policies and Estimates” below. At December 31, 2018, NW Natural's total estimated liability related to environmental sites was $128.7 million. See Note 17 and "Results of Operations-Regulatory Matters-Rate Mechanisms-Environmental Costs" above. NW Holdings is not currently party to any direct claims or litigation, though in the future it may be subject to claims and litigation arising in the ordinary course of business. New Accounting Pronouncements For a description of recent accounting pronouncements that may have an impact on our financial condition, results of operations, or cash flows, see Note 2. APPLICATION OF CRITICAL ACCOUNTING POLICIES AND ESTIMATES In preparing financial statements in accordance with U.S. GAAP, management exercises judgment in the selection and application of accounting principles, including making estimates and assumptions that affect reported amounts of assets, liabilities, revenues, expenses, and related disclosures in the financial statements. Management considers critical accounting policies to be those which are most important to the representation of financial condition and results of operations and which require management’s most difficult and subjective or complex judgments, including accounting estimates that could result in materially different amounts if reported under different conditions or used different assumptions. Our most critical estimates and judgments for both NW Holdings and NW Natural include accounting for: • regulatory accounting; • revenue recognition; • derivative instruments and hedging activities; • pensions and postretirement benefits; • income taxes; • environmental contingencies; and • impairment of long-lived assets and goodwill. Management has discussed its current estimates and judgments used in the application of critical accounting policies with the Audit Committees of the Boards of NW Holdings and NW Natural. Within the context of critical accounting policies and estimates, management is not aware of any reasonably likely events or circumstances that would result in materially different amounts being reported. Regulatory Accounting The NGD segment is regulated by the OPUC and WUTC, which establish the rates and rules governing services provided to customers, and, to a certain extent, set forth special accounting treatment for certain regulatory transactions. In general, the same accounting principles as non-regulated companies reporting under U.S. GAAP are used. However, authoritative guidance for regulated operations (regulatory accounting) requires different accounting treatment for regulated companies to show the effects of such regulation. For example, NW Natural accounts for the cost of gas using a PGA deferral and cost recovery mechanism, which is submitted for approval annually to the OPUC and WUTC. See "Results of Operations-Regulatory Matters-Rate Mechanisms-Purchased Gas Adjustment" above. There are other expenses and revenues that the OPUC or WUTC may require NW Natural to defer for recovery or refund in future periods. Regulatory accounting requires NW Natural to account for these types of deferred expenses (or deferred revenues) as regulatory assets (or regulatory liabilities) on the balance sheet. When the recovery of these regulatory assets from, or refund of regulatory liabilities to, customers is approved, NW Natural recognizes the expense or revenue on the income statement at the same time the adjustment to amounts included in rates charged to customers. The conditions that must be satisfied to adopt the accounting policies and practices of regulatory accounting include: • an independent regulator sets rates; • the regulator sets the rates to cover specific costs of delivering service; and • the service territory lacks competitive pressures to reduce rates below the rates set by the regulator. Because NW Natural's NGD operations satisfy all three conditions, NW Natural continues to apply regulatory accounting to NGD operations. Future accounting changes, regulatory changes, or changes in the competitive environment could require NW Natural to discontinue the application of regulatory accounting for some or all of our regulated businesses. This would require the write-off of those regulatory assets and liabilities that would no longer be probable of recovery from or refund to customers. Based on current accounting and regulatory competitive conditions, NW Natural believes it is reasonable to expect continued application of regulatory accounting for NGD activities. Further, it is reasonable to expect the recovery or refund of NW Natural's regulatory assets and liabilities at December 31, 2018 through future customer rates. If it is determined that all or a portion of these regulatory assets or liabilities no longer meet the criteria for continued application of regulatory accounting, then NW Natural would be required to write-off the net unrecoverable balances against earnings in the period such determination is made. The net balance in regulatory asset and liability accounts was a net liability of $245.3 million and a net liability of $217.7 million as of December 31, 2018 and 2017, respectively. See Note 2 for more detail on regulatory balances. Revenue Recognition Revenues, which are derived primarily from the sale, transportation, and storage of natural gas, are recognized upon the delivery of gas commodity or services rendered to customers. Accrued Unbilled Revenue For a description of the policy regarding accrued unbilled revenue, most of which relates to the NGD business at NW Natural, see Note 2. The following table presents changes in key metrics if the estimated percentage of unbilled volume at December 31 was adjusted up or down by 1%: (1) Includes impact of regulatory mechanisms including decoupling mechanism and excludes the impact of unbilled revenue from water services. Derivative Instruments and Hedging Activities NW Natural's gas acquisition and hedging policies set forth guidelines for using financial derivative instruments to support prudent risk management strategies. These policies specifically prohibit the use of derivatives for trading or speculative purposes. Financial derivative contracts are utilized to hedge a portion of natural gas sale requirements. These contracts include swaps, options, and combinations of option contracts. NW Natural primarily uses these derivative financial instruments to manage commodity price variability. A small portion of NW Natural's derivative hedging strategy involves foreign currency exchange contracts. Derivative instruments are recorded on the balance sheet at fair value. If certain regulatory conditions are met, then the derivative instrument fair value is recorded together with an offsetting entry to a regulatory asset or liability account pursuant to regulatory accounting, and no unrealized gain or loss is recognized in current income or loss. See "Regulatory Accounting" above for additional information. The gain or loss from the fair value of a derivative instrument subject to regulatory deferral is included in the recovery from, or refund to, NGD business customers in future periods. If a derivative contract is not subject to regulatory deferral, then the accounting treatment for unrealized gains and losses is recorded in accordance with accounting standards for derivatives and hedging which is either in current income or loss or in accumulated other comprehensive income or loss (AOCI or AOCL). Derivative contracts outstanding at December 31, 2018, 2017 and 2016 were measured at fair value using models or other market accepted valuation methodologies derived from observable market data. Estimates of fair value may change significantly from period-to-period depending on market conditions and prices. These changes may have an impact on results of operations, but the impact would largely be mitigated due to the majority of derivative activities being subject to regulatory deferral treatment. For more information on derivative activity and associated regulatory treatment, see Note 2 and Note 15. The following table summarizes the amount of losses realized from commodity price transactions for the last three years: Realized losses from commodity hedges shown above were recorded as increases to cost of gas and were, or will be, included in annual PGA rates. Pensions and Postretirement Benefits NW Natural maintains a qualified non-contributory defined benefit pension plan, non-qualified supplemental pension plans for eligible executive officers and certain key employees, and other postretirement employee benefit plans covering certain non-union employees. NW Natural also has a qualified defined contribution plan (Retirement K Savings Plan) for all eligible employees. Only the qualified defined benefit pension plan and Retirement K Savings Plan have plan assets, which are held in qualified trusts to fund the respective retirement benefits. The qualified defined benefit retirement plan for union and non-union employees was closed to new participants several years ago. Non- union and union employees hired or re-hired after December 31, 2006 and 2009, respectively, and employees of certain NW Holdings subsidiaries are provided an enhanced Retirement K Savings Plan benefit. The postretirement Welfare Benefit Plan for non-union employees was also closed to new participants several years ago. Net periodic pension and postretirement benefit costs (retirement benefit costs) and projected benefit obligations (benefit obligations) are determined using a number of key assumptions including discount rates, rate of compensation increases, retirement ages, mortality rates and an expected long-term return on plan assets. See Note 9. Accounting standards also require balance sheet recognition of unamortized actuarial gains and losses and prior service costs in AOCI or AOCL, net of tax. However, the retirement benefit costs related to qualified defined benefit pension and postretirement benefit plans are generally recovered in rates charged to NGD customers, which are set based on accounting standards for pensions and postretirement benefit expenses. As such, NW Natural received approval from the OPUC to recognize the unamortized actuarial gains and losses and prior service costs as a regulatory asset or regulatory liability based on expected rate recovery, rather than including it as AOCI or AOCL under common equity. See "Regulatory Accounting" above and Note 2, "Industry Regulation". In 2011, NW Natural received regulatory approval from the OPUC and began deferring a portion of pension expense above or below the amount set in rates to a regulatory balancing account on the balance sheet. On October 26, 2018, the OPUC issued an order to freeze NW Natural's pension balancing account as of October 31, 2018. The order directed NW Natural and the other parties to the rate case to engage in further regulatory proceedings extending the general rate case docket to resolve open issues with respect to the recovery of the pension balancing account. On February 4, 2019, NW Natural and the other parties to the rate case filed a joint stipulation with the OPUC outlining a resolution to the issue. See "Regulatory Matters-Regulatory Proceeding Updates-Oregon General Rate Case" for more information. At December 31, 2018, the cumulative amount deferred for future pension cost recovery was $74.2 million, including accrued interest. The regulatory balancing account includes the recognition of accrued interest on the account balance at NW Natural's authorized rate of return, with the equity portion of this interest deferred until amounts are collected in rates. A number of factors, as discussed above, are considered in developing pension and postretirement benefit assumptions. For the December 31, 2018 measurement date, NW Natural reviewed and updated: • the weighted-average discount rate assumptions for pensions increased from 3.52% for 2017 to 4.20% for 2018, and our weighted-average discount rate assumptions for other postretirement benefits increased from 3.44% for 2017 to 4.13% for 2018. The new rate assumptions were determined for each plan based on a matching of benchmark interest rates to the estimated cash flows, which reflect the timing and amount of future benefit payments. Benchmark interest rates are drawn from the FTSE Above Median Curve, which consists of high quality bonds rated AA- or higher by S&P or Aa3 or higher by Moody’s; • the expected annual rate of future compensation increases, which was updated to a range of 3.25% to 3.5% at December 31, 2018; • the expected long-term return on qualified defined benefit plan assets, which remained unchanged at a rate of 7.50%; • the mortality rate assumptions were updated from RP-2006 mortality tables for employees and healthy annuitants with a fully generational projection using scale MP-2017 to RP-2014 mortality tables using scale MP-2018, which contributed to the decrease of our projected benefit obligation; and • other key assumptions, which were based on actual plan experience and actuarial recommendations. At December 31, 2018, the net pension liability (benefit obligations less market value of plan assets) for NW Natural's qualified defined benefit plan increased $0.7 million compared to 2017. The increase in the net pension liability is primarily due to the $30.1 million decrease in plan assets, partially offset by a $29.5 million decrease in the pension benefit obligation. The liability for non-qualified plans decreased $1.3 million, and the liability for other postretirement benefits decreased $0.8 million in 2018. The expected long-term rate of return on plan assets is determined by averaging the expected earnings for the target asset portfolio. In developing expected return, historical actual performance and long-term return projections are analyzed, which gives consideration to the current asset mix and target asset allocation. NW Natural believes its pension assumptions are appropriate based on plan design and an assessment of market conditions. The following shows the sensitivity of retirement benefit costs and benefit obligations to changes in certain actuarial assumptions: In July 2012, President Obama signed MAP-21 into law. This legislation changed several provisions affecting pension plans, including temporary funding relief and Pension Benefit Guaranty Corporation (PBGC) premium increases, which reduces the level of minimum required contributions in the near-term but generally increases contributions in the long-run as well as increasing the operational costs of running a pension plan. Prior to MAP-21, interest rates based on a 24-month average yield of investment grade corporate bonds (also referred to as "segment rate") were used to calculate minimum contribution requirements. MAP-21 established a new minimum and maximum corridor for segment rates based on a 25-year average of bond yields, which resulted in lower minimum contributions requirements than those under previous regulations. In August 2014, HATFA was signed and extended funding relief for an additional five years. Income Taxes Valuation Allowances Deferred tax assets are recognized to the extent that these assets are believed to be more likely than not to be realized. In making such a determination, available positive and negative evidence is considered, including future reversals of existing taxable temporary differences, projected future taxable income, tax-planning strategies, and results of recent operations. NW Holdings and NW Natural have determined that all recorded deferred tax assets are more likely than not to be realized as of December 31, 2018. See Note 10. Uncertain Tax Benefits The calculation of tax liabilities involves dealing with uncertainties in the application of complex tax laws and regulations in the jurisdictions in which we operate. A tax benefit from a material uncertain tax position will only be recognized when it is more likely than not that the position, or some portion thereof, will be sustained upon examination, including resolution of any related appeals or litigation processes, on the basis of the technical merits. NW Holdings and NW Natural participate in the Compliance Assurance Process (CAP) with the Internal Revenue Service (IRS). Under the CAP program companies work with the IRS to identify and resolve material tax matters before the federal income tax return is filed each year. No reserves for uncertain tax benefits were recorded during 2018, 2017, or 2016. See Note 10. Tax Legislation When significant proposed or enacted changes in income tax rules occur we consider whether there may be a material impact to our financial position, results of operations, cash flows, or whether the changes could materially affect existing assumptions used in making estimates of tax related balances. On December 22, 2017, 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, also known as the Tax Cuts and Jobs Act (TCJA), was enacted. The TCJA lowers the U.S. federal corporate income tax rate to 21% from the existing maximum rate of 35%, effective for our tax year beginning January 1, 2018. The TCJA includes specific provisions related to regulated public utilities that generally provide for the continued deductibility of interest expense and the elimination of bonus depreciation. Certain rate normalization requirements for accelerated cost recovery benefits related to regulated plant balances also continue. See Note 10 for more information on how we are impacted by the TCJA. The reduced U.S. corporate income tax rate had a material impact on our financial statements in 2017. As a result of the reduction of the U.S. corporate income tax rate to 21%, U.S. GAAP requires deferred tax assets and liabilities be revalued as of the date of enactment, with resulting tax effects accounted for in the reporting period of enactment. We recorded a net revaluation of deferred tax asset and liability balances of $196.4 million as of December 31, 2017, utilizing the reduced federal rate of 21% expected to apply when these temporary differences are realized or settled, based upon balances in existence at the date of enactment. This revaluation had no impact on our 2017 cash flows. With respect to other tax legislation, the final tangible property regulations applicable to all taxpayers were issued on September 13, 2013 and were generally effective for taxable years beginning on or after January 1, 2014. In addition, procedural guidance related to the regulations was issued under which taxpayers may make accounting method changes to comply with the regulations. We have evaluated the regulations and do not anticipate any material impact. However, unit-of-property guidance applicable to natural gas distribution networks has not yet been issued and is expected in the near future. We will further evaluate the effect of these regulations after this guidance is issued, but believe the current method is materially consistent with the new regulations and do not expect this additional guidance to have a material effect on our financial statements. Regulatory Matters Regulatory tax assets and liabilities are recorded to the extent it is probable they will be recoverable from, or refunded to, customers in the future. At December 31, 2018 and 2017, NW Natural had net regulatory income tax assets of $21.4 million and $22.2 million, respectively, representing future rate recovery of deferred tax liabilities resulting from differences in NGD plant financial statement and tax bases and NGD plant removal costs. These regulatory assets are currently being recovered through customer rates. In 2017, the regulatory asset balance, and its associated deferred tax liability, were both reduced by $17.4 million as a result of the TCJA revaluation to reflect the lower corporate income tax rate. At December 31, 2018 and 2017, regulatory income tax assets of $2.3 million and $0.9 million, respectively, were recorded by NW Natural, representing probable future rate recovery of deferred tax liabilities resulting from the equity portion of AFUDC. In 2017, the regulatory asset balance, and its associated deferred tax liability, were both reduced by $0.8 million as a result of the TCJA revaluation to reflect the lower corporate income tax rate. On December 29, 2017, NW Natural filed applications with the OPUC and WUTC seeking authorization to defer the overall net benefits of NGD resulting from the TCJA. On the same day, Staff of the OPUC filed an application seeking deferral of changes in NW Natural’s federal tax obligations resulting from the TCJA. On January 8, 2018, the WUTC issued a statement acknowledging receipt of NW Natural’s application and indicating their intention to incorporate the impact into future rate case proceedings. At December 31, 2018 and 2017, regulatory liability balances, representing the estimated net benefit to NGD customers resulting from the change in deferred taxes as a result of the TCJA, of $217.1 million and $213.3 million, respectively, were recorded by NW Natural. These balances include a gross up for income taxes of $57.5 and $56.5 million, respectively. The TCJA includes specific guidance for determining the shortest time period over which the portion of this regulatory liability resulting from accelerated cost recovery of NGD plant may accrue to the benefit of customers to avoid incurring federal normalization penalties. However, it is anticipated that until such time that customers receive the direct benefit of this regulatory liability, the balance, net of the additional gross up for income taxes, will continue to provide an indirect benefit to customers by reducing the NGD rate base which determines customer rates for service. It is not possible at this time to determine when the final resolution of these regulatory proceedings will occur, and as result, this regulatory liability is classified as non-current. On February 4, 2019, NW Natural and the parties to the 2018 Oregon rate case filed a joint stipulation addressing the return of net tax benefits to customers. See "Regulatory Matters-Regulatory Proceeding Updates-Oregon General Rate Case" for more information. NGD rates in effect for Oregon through October 31, 2018 and for Washington through December 31, 2018 included an allowance to provide for the recovery of the anticipated provision for income taxes incurred as a result of providing regulated services. The provision for income taxes during these periods included an allowance for federal income taxes determined by utilizing the pre-TCJA federal corporate income tax rate of 35 percent. NW Natural recorded an additional regulatory liability representing the deferral of NGD’s net benefit from a lower provision for income taxes due to the newly enacted 21 percent federal corporate income tax rate, including a gross up for income taxes. As of December 31, 2018, a regulatory liability of $8.2 million, including accrued interest, was recorded to reflect this revenue deferral. Environmental Contingencies Environmental liabilities are accounted for in accordance with accounting standards under the loss contingency guidance when it is probable that a liability has been incurred and the amount of the loss is reasonably estimable. Amounts recorded for environmental contingencies take numerous factors into consideration, including, among other variables, changes in enacted laws, regulatory orders, estimated remediation costs, interest rates, insurance proceeds, participation by other parties, timing of payments, and the input of legal counsel and third-party experts. Accordingly, changes in any of these variables or other factual circumstances could have a material impact on the amounts recorded for our environmental liabilities. For a complete discussion of environmental accounting policies refer to Note 2. For a discussion of current environmental sites and liabilities refer to Note 17. In addition, for information regarding the regulatory treatment of these costs and NW Natural's regulatory recovery mechanism, see "Results of Operations-Regulatory Matters-Rate Mechanisms-Environmental Costs" above. Impairment of Long-Lived Assets and Goodwill Long-lived assets We review the carrying value of long-lived assets whenever events or changes in circumstances indicate the carrying amount of the assets might not be recoverable. Factors that would necessitate an impairment assessment of long-lived assets include a significant adverse change in the extent or manner in which the asset is used, a significant adverse change in legal factors or business climate that could affect the value of the asset, or a significant decline in the observable market value or expected future cash flows of the asset, among others. When such factors are present, we assess the recoverability by determining whether the carrying value of the asset will be recovered through expected future cash flows. An asset is determined to be impaired when the carrying value of the asset exceeds the expected undiscounted future cash flows from the use and eventual disposition of the asset. If an impairment is indicated, we record an impairment loss for the difference between the carrying value and the fair value of the long-lived assets. Fair value is estimated using appropriate valuation methodologies, which may include an estimate of discounted cash flows. In the fourth quarter of 2017, we recognized a non-cash pre-tax impairment of long-lived assets at the Gill Ranch Facility of $192.5 million. We determined circumstances existed that indicated the carrying value of the assets may not be recoverable. Those circumstances included the completion of a comprehensive strategic review process that evaluated various alternatives including a potential sale, as well as contracting for available storage at lower than anticipated values for the coming storage year. Given these considerations, management was required to re-evaluate the estimated cash flows from our interests in the Gill Ranch Facility, and determined that those estimated cash flows were no longer sufficient to cover the carrying value of the assets. We used the income approach to estimate fair value, using the estimated future net cash flows. We also compared the results of the income approach to our own recent sale experience and recent market comparable transactions in order to estimate fair value. Many factors and assumptions impact the net cash flows used. The most significant and uncertain estimates included our forecast of gas storage pricing, our ability to successfully identify and contract with higher-value customers in and/or near the northern California market that Gill Ranch serves, and exploring the possibility of providing energy storage services such as compressed gas energy storage (CGES). After completing the strategic evaluation, which included a potential sale in the fourth quarter of 2017, we lowered our views of a near-term market recovery and decreased the likelihood associated with contracting with higher-value customers. These changes were the most significant estimates that caused our cash flow projections to decrease to a point where they were no longer sufficient to cover the carrying value of the asset. On June 20, 2018, NWN Gas Storage, NW Holdings' wholly-owned subsidiary, entered into a Purchase and Sale Agreement that provides for the sale by NWN Gas Storage of all of the membership interests in Gill Ranch. As a result of our strategic shift away from California gas storage operations and the significance of Gill Ranch's financial results in 2017, we concluded that the pending sale of Gill Ranch qualifies as assets and liabilities held for sale and discontinued operations. As such, the assets and liabilities associated with Gill Ranch have been classified as discontinued operations assets and discontinued operations liabilities, respectively, and, the results of Gill Ranch are presented separately from the results of continuing operations, net of tax, as discontinued operations for the consolidated results of NW Holdings in all periods presented. The expenses included in the results of discontinued operations within the consolidated results of NW Holdings are the direct operating expenses incurred by Gill Ranch that may be reasonably segregated from the costs of our continuing operations. See "Results of Operations - Pending Sale of Gill Ranch Storage" above, Note 4, and Note 18 for additional information. Goodwill In a business combination, goodwill is initially measured as any excess of the acquisition-date fair value of the consideration transferred over the acquisition-date fair value of the net identifiable assets acquired. The carrying value of goodwill is reviewed annually during the fourth quarter using balances as of October 1, or whenever events or changes in circumstance indicate that such carrying values may not be recoverable. NW Holdings and NW Natural early-adopted ASU 2017-04, "Simplifying the Test for Goodwill Impairment" in the third quarter of 2018. The ASU removes Step 2 from the goodwill impairment test and under the amended guidance an entity should perform its annual goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount and recognize an impairment charge for the amount in which the carrying amounts exceed the fair value of the reporting unit. In accordance with the updated guidance per ASU 2017-04, NW Holdings' and NW Natural's policy for goodwill assessments begins with a qualitative analysis in which events and circumstances are evaluated, including macroeconomic conditions, industry and market conditions, regulatory environments, and the overall financial performance of the reporting unit. If the qualitative assessment indicates that the carrying value may be at risk of recoverability, a quantitative evaluation is performed to measure the carrying value against the fair value of the reporting unit. This evaluation may involve the assessment of future cash flows and other subjective factors for which uncertainty exists and could impact the estimation of future cash flows. These factors include, but are not limited to, the amount and timing of future cash flows, future growth rates, and the discount rate. Unforeseen events and changes in circumstances or market conditions could adversely affect these estimates, which could result in an impairment charge. A qualitative assessment was performed during the fourth quarter of 2018 which indicated a quantitative assessment was not required; thus, no goodwill impairment was recorded. See Note 2 and Note 14 for additional information.
0.018457
0.018595
0
<s>[INST] NW Holdings is a holding company headquartered in Portland, Oregon and owns NW Natural, NWN Water, and other businesses and activities. NW Natural is NW Holdings’ largest subsidiary. NW Natural's natural gas distribution activities are reported in the natural gas distribution (NGD) segment, formerly titled and reported as the utility segment. All other business activities, including certain gas storage activities, water businesses, and other investments and activities are aggregated and reported as other at their respective registrant. References in this discussion to "Notes" are to the Notes to the Consolidated Financial Statements in Item 8 of this report. In addition, NW Holdings has reported discontinued operations results related to the pending sale of Gill Ranch Storage, LLC (Gill Ranch). NW Natural Gas Storage, LLC (NWN Gas Storage), currently an indirect whollyowned subsidiary of NW Holdings, entered into a Purchase and Sale Agreement during the second quarter of 2018 that provides for the sale of all membership interests in Gill Ranch. Gill Ranch owns a 75% interest in the natural gas storage facility located near Fresno, California known as the Gill Ranch Gas Storage Facility. Pacific Gas and Electric Company (PG&E) owns the remaining 25% interest in the Gill Ranch Gas Storage Facility. For more information, see "Results of Operations Pending Sale of Gill Ranch Storage" below. The following is management’s assessment of NW Holdings' and NW Natural's financial condition, including the principal factors that affect results of operations. The discussion covers the years ended December 31, 2018, 2017, and 2016 and refers to the consolidated results of NW Holdings, the substantial majority of which consist of the operating results of NW Natural. When significant activity exists at NW Holdings that does not exist at NW Natural, additional disclosure has been provided. NW Holdings' direct and indirect whollyowned subsidiaries include: Northwest Natural Gas Company (NW Natural); ◦ Northwest Energy Corporation (Energy Corp); ▪ NWN Gas Reserves LLC (NWN Gas Reserves); NW Natural Energy, LLC (NWN Energy); ◦ NW Natural Gas Storage, LLC (NWN Gas Storage); ▪ Gill Ranch Storage, LLC (Gill Ranch), which is presented as a discontinued operation; NNG Financial Corporation (NNG Financial); ◦ KB Pipeline Company (KB); NW Natural Water Company, LLC (NWN Water); ◦ Falls Water Co., Inc. (Falls Water); ◦ Salmon Valley Water Company; ◦ Cascadia Water, LLC (Cascadia); ◦ NW Natural Water of Oregon, LLC (NWN Water of Oregon); ◦ NW Natural Water of Washington, LLC (NWN Water of Washington); ◦ NW Natural Water of Idaho, LLC (NWN Water of Idaho); and ▪ Gem State Water Company, LLC (Gem State) The NGD segment includes our NW Natural local gas distribution business, NWN Gas Reserves, which is a whollyowned subsidiary of Energy Corp, and the NGDportion of NW Natural's Mist storage facility in Oregon. Other activities aggregated and reported as other at NW Natural include the nonNGD storage activity at Mist as well as asset management services and the appliance retail center operations. Other activities aggregated and reported as other at NW Holdings include NWN Energy's equity investment in Trail West Holding, LLC (TWH), which is pursuing the development of a proposed natural gas pipeline through its whollyowned subsidiary, Trail West Pipeline, LLC (TWP); NNG Financial's investment in KelsoBeaver Pipeline (KB Pipeline); and NWN Water, which owns and continues to pursue investments in the water sector. See Note 4 for further discussion of our business segment and other, as well as our direct and indirect whollyowned subsidiaries. NONGAAP FINANCIAL MEASURES. In addition to presenting the results of operations and earnings amounts in total, certain financial measures are expressed in cents per share or exclude the effects of certain items, [/INST] Positive. </s>
2,019
21,910
1,733,998
Northwest Natural Holding Co
2020-03-02
2019-12-31
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following is management’s assessment of NW Holdings' and NW Natural's financial condition, including the principal factors that affect results of operations. The discussion covers the years ended December 31, 2019, 2018, and 2017 and refers to the consolidated results of NW Holdings, the substantial majority of which consist of the operating results of NW Natural. When significant activity exists at NW Holdings that does not exist at NW Natural, additional disclosure has been provided. References in this discussion to "Notes" are to the Notes to the Consolidated Financial Statements in Item 8 of this report. NW Holdings' direct and indirect wholly-owned subsidiaries include: • Northwest Natural Gas Company (NW Natural); ◦ Northwest Energy Corporation (Energy Corp); ▪ NWN Gas Reserves LLC (NWN Gas Reserves); • NW Natural Energy, LLC (NWN Energy); ◦ NW Natural Gas Storage, LLC (NWN Gas Storage); ▪ Gill Ranch Storage, LLC (Gill Ranch), which is presented as a discontinued operation; • NNG Financial Corporation (NNG Financial); ◦ KB Pipeline Company (KB); • NW Natural Water Company, LLC (NWN Water); ◦ Falls Water Co., Inc. (Falls Water); ◦ Salmon Valley Water Company; ◦ NW Natural Water of Oregon, LLC (NWN Water of Oregon); ▪ Sunstone Water, LLC; ▪ Sunstone Infrastructure, LLC; ▪ Sunriver Water, LLC (Sunriver Water); ▪ Sunriver Environmental, LLC (Sunriver Environmental) ◦ NW Natural Water of Washington, LLC (NWN Water of Washington); ▪ Cascadia Water, LLC (Cascadia Water); ▪ Cascadia Infrastructure, LLC; ▪ Suncadia Water Company, LLC (Suncadia Water); ▪ Suncadia Environmental Company, LLC (Suncadia Environmental); ◦ NW Natural Water of Idaho, LLC (NWN Water of Idaho); ▪ Gem State Water Company, LLC (Gem State Water); ▪ Gem State Infrastructure, LLC; and ◦ NW Natural Water of Texas, LLC (NWN Water of Texas); ▪ Blue Topaz Water, LLC; and ▪ Blue Topaz Infrastructure, LLC. On October 1, 2018, we completed a reorganization into a holding company structure. We believe that our holding company structure is an agile and efficient platform from which to pursue, finance, and oversee new opportunities, such as in the water sector, while also providing legal separation between regulated natural gas distribution operations and other businesses. In this reorganization, shareholders of NW Natural (the predecessor publicly held parent company) became shareholders of NW Holdings, on a one-for-one basis, with the same number of shares and same ownership percentage as they held in NW Natural immediately prior to the reorganization. NW Natural became a wholly-owned subsidiary of NW Holdings. Additionally, certain subsidiaries of NW Natural were transferred to NW Holdings. As required under accounting guidance, these subsidiaries are presented as discontinued operations in the 2018 and 2017 consolidated results of NW Natural within this report. NW Natural's natural gas distribution activities are reported in the natural gas distribution (NGD) segment. The NGD segment also includes NWN Gas Reserves, which is a wholly-owned subsidiary of Energy Corp, and the NGD-portion of NW Natural's Mist storage facility in Oregon. Other activities aggregated and reported as other at NW Natural include the non-NGD storage activity at Mist as well as asset management services and the appliance retail center operations. Other activities aggregated and reported as other at NW Holdings include NWN Energy's equity investment in Trail West Holding, LLC (TWH), which is pursuing the development of a proposed natural gas pipeline through its wholly-owned subsidiary, Trail West Pipeline, LLC (TWP); NNG Financial's investment in Kelso-Beaver Pipeline (KB Pipeline); and NWN Water, which owns and continues to pursue investments in the water sector. See Note 4 for further discussion of our business segment and other, as well as our direct and indirect wholly-owned subsidiaries. In addition, NW Holdings has reported discontinued operations results related to the pending sale of Gill Ranch Storage, LLC (Gill Ranch). NW Natural Gas Storage, LLC (NWN Gas Storage), currently an indirect wholly-owned subsidiary of NW Holdings, entered into a Purchase and Sale Agreement during the second quarter of 2018 that provides for the sale of all membership interests in Gill Ranch. Gill Ranch owns a 75% interest in the natural gas storage facility located near Fresno, California known as the Gill Ranch Gas Storage Facility. Pacific Gas and Electric Company (PG&E) owns the remaining 25% interest in the Gill Ranch Gas Storage Facility. For more information, see "Results of Operations - Pending Sale of Gill Ranch Storage" below. NON-GAAP FINANCIAL MEASURES. In addition to presenting the results of operations and earnings amounts in total, certain financial measures are expressed in cents per share or exclude the effects of certain items, which are non-GAAP financial measures. We present net income or loss and earnings or loss per share adjusted for certain items along with the U.S. GAAP financial measures to illustrate their magnitude on ongoing business and operational results. Although the excluded amounts are properly included in the determination of net income or loss and earnings or loss per share under U.S. GAAP, we believe the amount and nature of these items make period to period comparisons of operations difficult or potentially confusing. We use such non-GAAP financial measures to analyze our financial performance because we believe they provide useful information to our investors and creditors in evaluating our financial condition and results of operations. Our non-GAAP financial measures should not be considered a substitute for, or superior to, measures calculated in accordance with U.S. GAAP. Reconciliations of the non-GAAP financial measures to their closest U.S. GAAP financial measure used in subsequent sections of Item 7 are provided below. Note: Totals may not foot due to rounding. (1) Non-cash TCJA benefit (expense) associated with continuing operations of $3.4 million was recorded in income tax expense (benefit) in the fourth quarter of 2017 as a result of the federal tax rate changing from 35% to 21% effective December 22, 2017. The majority of this benefit was recorded at NW Natural. NW Holdings EPS amounts are calculated using diluted shares of 28.8 million as shown on the NW Holdings Consolidated Statements of Comprehensive Income. The TCJA impacts in the NGD segment and other may not correlate exactly to the consolidated amount due to rounding. See Note 11 for additional information on the TCJA. EXECUTIVE SUMMARY We manage our business and strategic initiatives with a long-term view of providing service safely and reliably to our customers, working with regulators on key policy initiatives, and remaining focused on growing our businesses. See "2020 Outlook" below for more information. Highlights for the year include: • added nearly 12,500 natural gas customers in 2019 for an annual growth rate of 1.7% at December 31, 2019; • invested $219.9 million in NGD's infrastructure and facilities for growth, reliability, and technology upgrades; • completed construction of the North Mist gas storage facility and commenced storage services in May 2019; • scored first in the nation among large gas utilities in the 2019 J.D. Power Gas Utility Residential Customer Satisfaction Study; • concluded the Washington general rate case with a $5.1 million increase in revenue requirement; • filed a general rate case in Oregon requesting a $71.4 million revenue requirement increase; • continued acquiring water utilities, closing the largest transaction to date with the purchase of the water and wastewater utilities in Sunriver, Oregon in May 2019; and • delivered increasing dividends for the 64th consecutive year to shareholders. Key financial highlights for NW Holdings include: Key financial highlights for NW Natural include: (1) See the Non-GAAP Reconciliations table at the beginning of Item 7 for a reconciliation of this non-GAAP financial measure to its closest U.S. GAAP financial measure. 2019 COMPARED TO 2018. NW Holdings' net income from continuing operations decreased $2.0 million and NW Natural's net income from continuing operations increased $1.0 million. In March 2019, the OPUC issued an order resolving the remaining open items from NW Natural's 2018 Oregon general rate case regarding recovery of the pension balancing account and treatment of the benefits associated with the TCJA. As a result of the order, in the first quarter of 2019, NW Natural recorded a disallowance and several benefits and expenses through the consolidated statements of comprehensive income as follows: Pension balancing account. Approximately $12.5 million in previously deferred pension expenses were recognized of which approximately $4.6 million was recorded in operations and maintenance expense and $7.9 million was recorded in other income (expense), net. These charges were offset with a corresponding increase in revenue of $7.1 million and in income tax benefits of $2.7 million as the order required the offset of certain deferred TCJA benefits against the pension balancing account. Additional TCJA income tax benefits were realized throughout 2019 to offset the remainder of the $12.5 million charge. NW Natural also recognized a regulatory pension disallowance of $10.5 million with approximately $3.9 million recognized in operations and maintenance expense and $6.6 million recognized in other income (expense), net, partially offset by related discrete income tax benefits of $1.1 million. Lastly, NW Natural realized $3.8 million of deferred regulatory interest accrued on the pension balancing account. Deferred TCJA benefits and timing variance. In addition, the OPUC ordered the return of approximately $6.3 million of excess deferred income taxes associated with plant and gas reserves annually beginning April 1, 2019. As a result, NW Natural recognized approximately $2.0 million in income tax benefits in the first quarter of 2019. Reductions to customer billings commenced April 1, 2019 and offset these income tax benefits in total by the end of 2019. NW Natural will continue reductions to customer billings and recognition of deferred income tax benefits in subsequent years until all benefits have been returned. The increase of $1.0 million at NW Natural was primarily due to the following factors: • a $39.0 million increase in NGD segment margin driven by new customer rates from the 2018 Oregon rate case and 2019 Washington rate case, customer growth, and lease revenue from the North Mist storage facility; the remaining increase primarily relates to $7.1 million in revenues which were offset by pension expenses due to the OPUC order as discussed above; • a $9.4 million decrease in NGD segment income tax expense primarily due to the income tax implications of the March 2019 OPUC order, of which $5.4 million was offset by pension expenses as discussed above, with the remainder driven by the return of deferred TCJA benefit credits to customers and lower pretax income in the current period compared to the prior period; and • a $5.8 million increase in deferred regulatory interest income in other income (expense), net, of which $5.1 million relates to interest recognized in association with the OPUC order discussed above; offset by • a $34.4 million increase in pension costs within operations and maintenance expense and other income (expense), net, of which $12.5 million relates to costs which were entirely offset by revenues and income tax benefits as discussed above, and $10.5 million relates to the regulatory pension disallowance discussed above. In addition, there was an $11.4 million increase in pension expenses as NW Natural began collecting ongoing pension costs through customer rates on November 1, 2018 and began collecting deferred pension costs through customer rates on April 1, 2019 rather than deferring a portion to the balancing account; • a $5.4 million increase in depreciation and amortization primarily due to additional capital expenditures; • a $5.4 million decrease in non-NGD segment operating revenues due to lower asset management revenues and increased asset management revenue sharing with Oregon customers as a result of the 2018 Oregon rate case; • a $4.6 million increase in NGD segment interest expense due to higher interest on long- and short-term debt balances; and • a $2.9 million increase in NGD segment operations and maintenance expenses primarily attributable to annual employee cost increases. The decrease of $2.0 million at NW Holdings was primarily driven by increases in professional service costs and expenses associated with developing the water business, partially offset by the increase of $1.0 million at NW Natural. 2018 COMPARED TO 2017. NW Holdings' and NW Natural's net income from continuing operations were $67.3 million and $68.0 million, respectively, in 2018 compared to $72.1 million and $71.7 million, respectively, in 2017. The decrease was primarily due to the benefit associated with the TCJA deferred income tax remeasurement in 2017. Excluding the benefit in 2017 associated with the TCJA remeasurement, NW Holdings adjusted net income from continuing operations decreased $1.4 million. See the Non-GAAP reconciliations at the beginning of Item 7 for additional information. The decrease was primarily due to the following factors, all of which were driven by activity at NW Natural: • an $8.9 million decrease in NGD segment margin primarily due to the deferral of excess revenue associated with the federal income tax rate decrease as a result of the TCJA; • a $4.3 million increase in operations and maintenance expense driven by general payroll and benefits increases as well as increases in professional services and contract labor; • a $4.1 million increase in depreciation and amortization primarily due to additional capital expenditures; and • a $3.3 million decrease in other income (expense), net, primarily due to an increase in pension and postretirement benefit expense, partially offset by an increase in the equity portion of AFUDC; partially offset by • a $20.2 million decrease in income tax expense due to the decrease in the federal income tax rate as a result of the TCJA and lower pretax earnings. 2020 OUTLOOK We expect to make significant progress on our long-term objectives in the coming year. Our natural gas distribution business is focused on providing safe, reliable, and affordable energy in an environmentally responsible way to better the lives of the public we serve. Our water and wastewater utility business is committed to reliably providing clean water and safe wastewater services to the public, while also continuing to grow organically and through acquisitions. In 2020, we remain focused on the strategic pillars of our business: • Ensuring safe & reliable service; • Providing superior customer service; • Advancing constructive legislative policies and regulation; • Enabling customer growth; and • Leading in a low-carbon future. ENSURING SAFE AND RELIABLE SERVICE. Delivering our products safely and reliably to customers is our first priority. At NW Natural, we remain focused on safety and emergency response through hands-on, scenario-based training for employees, third-party contractors, and first responders. The reliability, resiliency and safety of our gas system is critical and to this end, we remain focused on investing in necessary upgrades and replacing key system components. Safety for our gas infrastructure also includes maintaining and strengthening our cybersecurity defenses, upgrading key technology systems over the next several years, and preparing for large-scale emergency events, such as seismic hazards. Our water and wastewater utilities are focused on enhancing their capital expenditure plans to ensure continued safe and reliable service to customers and allow us to readily prioritize capital investments. PROVIDING SUPERIOR CUSTOMER EXPERIENCE. We have a legacy of providing excellent customer service and a long-standing dedication to continuous improvement, which has resulted in NW Natural consistently receiving high rankings in the J.D. Power and Associates customer satisfaction studies. In 2020, we intend to strive to enhance our natural gas customers’ experience to meet their evolving expectations by prioritizing improvements to technology and internal processes, to support our customers’ most frequent interactions and highest value touchpoints. ADVANCING CONSTRUCTIVE LEGISLATIVE POLICIES AND REGULATION. NW Natural recently worked with lawmakers and the governor to pass a landmark bill for the State of Oregon Senate Bill 98 is groundbreaking legislation that allows utilities to procure renewable natural gas for homes and businesses. While currently in regulatory rulemaking, NW Natural has been pursuing potential renewable natural gas supplies and expects to begin procuring it for customers in 2020. This year, NW Natural plans to submit an integrated resource plan to both the Oregon and Washington Commissions outlining our key long-term capital projects and resource plans for conventional and renewable natural gas. NW Natural will also continue working with the EPA and other stakeholders on an environmentally protective and cost-effective clean-up for the Portland Harbor Superfund Site. For our water utilities, we are focused on building relationships with our current and prospective regulators, pursuing efficient approval processes for acquisitions, and engaging in constructive regulatory proceedings. ENABLING CUSTOMER GROWTH. Natural gas is the preferred energy choice in our service territory given its efficient, affordable, and reliable qualities. We are focused on leveraging these key attributes to capitalize on our region's strong economic growth. We continue to grow our market share in the residential sector and capture new commercial customers as well as multifamily developments. At NW Natural Water, we continue to be focused on supporting the fast-growing communities we currently serve and continuing our disciplined acquisition strategy. LEADING IN A LOW-CARBON FUTURE. We are deeply committed to a clean energy future and environmental stewardship. It's why NW Natural launched a low-carbon initiative to reduce emissions in the communities we serve by leveraging our modern natural gas pipeline system in new ways, working closely with customers, policymakers and regulators, and embracing cutting-edge technology. In 2020, we will continue to execute on our RNG strategy with plans to procure RNG for our customers as prescribed under Oregon Senate Bill 98, execute on our RNG interconnection projects, and develop voluntary renewable product offerings for our customers. A study commissioned with a premier environmental consultant has concluded that natural gas can help achieve crucial emission reductions of 80% by 2050. NW Natural intends to strive to help its customers reduce and offset their consumption, support the development of RNG, and explore other innovative solutions to lower the carbon intensity of natural gas, such as power to gas. We also intend to leverage technology and relationships to examine ways to reduce emissions across the entire value chain from suppliers to end-use heating appliances. DIVIDENDS NW Holdings dividend highlights include: In January 2020, the NW Holdings' Board of Directors declared a quarterly dividend on NW Holdings common stock of $0.4775 per share, payable on February 14, 2020, to shareholders of record on January 31, 2020, reflecting an indicated annual dividend rate of $1.91 per share. See "Financial Condition - Liquidity and Capital Resources" for more information regarding the NW Holdings and NW Natural dividend policies and regulatory conditions on NW Natural dividends to its parent, NW Holdings. RESULTS OF OPERATIONS Regulatory Matters Regulation and Rates NATURAL GAS DISTRIBUTION. NW Natural's natural gas distribution business is subject to regulation by the OPUC and WUTC with respect to, among other matters, rates and terms of service, systems of accounts, and issuances of securities by NW Natural. In 2019, approximately 89% of NGD customers were located in Oregon, with the remaining 11% in Washington. Earnings and cash flows from natural gas distribution operations are largely determined by rates set in general rate cases and other proceedings in Oregon and Washington. They are also affected by weather, the local economies in Oregon and Washington, the pace of customer growth in the residential, commercial, and industrial markets, and NW Natural's ability to remain price competitive, control expenses, and obtain reasonable and timely regulatory recovery of its natural gas distribution-related costs, including operating expenses and investment costs in plant and other regulatory assets. See "Most Recent Completed Rate Cases" below. MIST INTERSTATE GAS STORAGE. NW Natural's interstate storage activity at Mist is subject to regulation by the OPUC, WUTC, and the Federal Energy Regulatory Commission (FERC) with respect to, among other matters, rates and terms of service. The OPUC also regulates the intrastate storage services at Mist, while FERC regulates the interstate storage services at Mist. The FERC uses a maximum cost of service model which allows for gas storage prices to be set at or below the cost of service as approved by the agency in NW Natural's last regulatory filing. The OPUC Schedule 80 rates are tied to the FERC rates, and are updated whenever NW Natural modifies FERC maximum rates. OTHER. In June 2018, NWN Gas Storage, a wholly-owned subsidiary of NW Holdings, entered into a Purchase and Sale Agreement for the sale of all of its ownership interests in Gill Ranch, a natural gas storage facility located near Fresno, California. The sale was approved by the CPUC in December 2019. The wholly owned rate regulated water businesses of NWN Water, a wholly owned subsidiary of NW Holdings, are subject to regulation by the utility commissions in the states in which they are located, which currently include Oregon, Washington, and Idaho, and is expected to include Texas. Most Recent Completed Rate Cases OREGON. Effective November 1, 2018, the OPUC authorized rates to customers based on an ROE of 9.4%, an overall return of 7.317%, and a capital structure of 50% common equity and 50% long-term debt. In March 2019, the OPUC issued an order resolving the remaining matters of the rate case regarding recovery of NW Natural's pension balancing account and the return of tax reform benefits to customers. For additional information, see "Rate Mechanisms - Pension Cost Deferral and Pension Balancing Account" and "Rate Mechanisms - Tax Reform Deferral" below. On December 30, 2019, NW Natural filed a general rate case in Oregon. For more information, see "Regulatory Proceeding Updates - 2020 Oregon Rate Case" below. WASHINGTON. Effective January 1, 2009, through October 31, 2019, the WUTC authorized rates to customers based on an ROE of 10.1% and an overall rate of return of 8.4% with a capital structure of 51% common equity, 5% short-term debt, and 44% long-term debt. Effective November 1, 2019, the WUTC authorized rates to customers based on an ROE of 9.4% and an overall rate of return of 7.161% with a capital structure of 50.0% long-term debt, 1.0% short-term debt, and 49.0% common equity. The WUTC also authorized the recovery of environmental remediation expenses allocable to Washington customers through an Environmental Cost Recovery Mechanism (ECRM) and directed NW Natural to provide federal tax reform benefits to customers. See "Rate Mechanisms - Environmental Cost Deferral and Recovery - Washington ECRM" and "Rate Mechanisms -Tax Reform Deferral" below. FERC. NW Natural is required under its Mist interstate storage certificate authority and rate approval orders to file every five years either a petition for rate approval or a cost and revenue study to change or justify maintaining the existing rates for its interstate storage services. On October 12, 2018, NW Natural filed a rate petition with FERC for revised maximum cost-based rates, which incorporated the new federal corporate income tax rate. The revised rates were effective beginning November 1, 2018. NW Natural continuously evaluates the need for rate cases in its jurisdictions. See "Regulatory Proceeding Updates-Oregon Rate Case" below. Rate Mechanisms During 2019, NW Natural's key approved rates and recovery mechanisms for each service area included: Annually, or more often if circumstances warrant, NW Natural reviews all regulatory assets for recoverability. If NW Natural should determine all or a portion of these regulatory assets no longer meet the criteria for continued application of regulatory accounting, then NW Natural would be required to write-off the net unrecoverable balances against earnings in the period such a determination was made. PURCHASED GAS ADJUSTMENT. Rate changes are established for NW Natural each year under PGA mechanisms in Oregon and Washington to reflect changes in the expected cost of natural gas commodity purchases. The PGA filings include gas costs under spot purchases as well as contract supplies, gas costs hedged with financial derivatives, gas costs from the withdrawal of storage inventories, the production of gas reserves, interstate pipeline demand costs, temporary rate adjustments, which amortize balances of deferred regulatory accounts, and the removal of temporary rate adjustments effective for the previous year. Typically, each year NW Natural hedges gas prices on a portion of NW Natural's annual sales requirement based on normal weather, including both physical and financial hedges. NW Natural entered the 2019-20 gas year with its forecasted sales volumes hedged at 52% in financial swap and option contracts, including hedging of 56% in Oregon and 24% in Washington, and 19% in physical gas supplies, including hedging of 20% in Oregon and 14% in Washington. As of December 31, 2019, NW Natural was hedged at approximately 71% for the 2019-20 gas year, and was hedged in Oregon at approximately 75% and Washington at approximately 38%. NW Natural is also hedged between 1% and 29% for annual requirements over the subsequent five gas years, which consists of between 2% and 31% in Oregon and between 0% and 15% in Washington. Hedge levels are subject to change based on actual load volumes, which depend to a certain extent on weather, economic conditions, and estimated gas reserve production. Also, gas storage inventory levels may increase or decrease with storage expansion, changes in storage contracts with third parties, variations in the heat content of the gas, and/or storage recall by NW Natural. In September 2019, NW Natural filed its annual PGA and received OPUC and WUTC approval in October 2019. PGA rate changes were effective November 1, 2019. Rates and hedging approaches may vary between states due to different rate structures and mechanisms. In addition, as required with the Washington PGA filing, NW Natural incorporated and began implementing risk-responsive hedging strategies for the 2019-20 PGA for its Washington gas supplies. Under the current PGA mechanism in Oregon, there is an incentive sharing provision whereby NW Natural is required to select each year an 80% deferral or a 90% deferral of higher or lower actual gas costs compared to estimated PGA prices, such that the impact on NW Natural's current earnings from the incentive sharing is either 20% or 10% of the difference between actual and estimated gas costs, respectively. For the 2018-19 and 2019-20 gas years, NW Natural selected the 90% deferral option. Under the Washington PGA mechanism, NW Natural defers 100% of the higher or lower actual gas costs, and those gas cost differences are passed on to customers through the annual PGA rate adjustment. EARNINGS TEST REVIEW. NW Natural is subject to an annual earnings review in Oregon to determine if the NGD business is earning above its authorized ROE threshold. If NGD business earnings exceed a specific ROE level, then 33% of the amount above that level is required to be deferred or refunded to customers. Under this provision, if NW Natural selects the 80% deferral gas cost option, then NW Natural retains all earnings up to 150 basis points above the currently authorized ROE. If NW Natural selects the 90% deferral option, then it retains all earnings up to 100 basis points above the currently authorized ROE. For the 2018-19 and 2019-20 gas years, it selected the 90% deferral option. The ROE threshold is subject to adjustment annually based on movements in short-term interest rates. For calendar years 2017, 2018, and 2019, the ROE threshold was 10.66%, 10.48%, and 10.24%, respectively. There were no refunds required for 2017 and 2018. NW Natural does not expect a refund for 2019 based on results, and anticipates filing its 2019 earnings test in May 2020. GAS RESERVES. In 2011, the OPUC approved the Encana gas reserves transaction to provide long-term gas price protection for NGD business customers and determined costs under the agreement would be recovered on an ongoing basis through the annual PGA mechanism. Gas produced from NW Natural's interests is sold at then prevailing market prices, and revenues from such sales, net of associated operating and production costs and amortization, are included in cost of gas. The cost of gas, including a carrying cost for the rate base investment made under the original agreement, is included in NW Natural's annual Oregon PGA filing, which allows NW Natural to recover these costs through customer rates. The net investment under the original agreement earns a rate of return. In 2014, NW Natural amended the original gas reserves agreement in response to Encana's sale of its interest in the Jonah field located in Wyoming to Jonah Energy. Under the amended agreement with Jonah Energy, NW Natural has the option to invest in additional wells on a well-by-well basis with drilling costs and resulting gas volumes shared at the amended proportionate working interest for each well in which NW Natural invests. Volumes produced from the additional wells drilled after the amended agreement are included in NW Natural's Oregon PGA at a fixed rate of $0.4725 per therm. NW Natural has not participated in additional wells since 2014. DECOUPLING. In Oregon, NW Natural has a decoupling mechanism. Decoupling is intended to break the link between earnings and the quantity of gas consumed by customers, removing any financial incentive to discourage customers’ efforts to conserve energy. The Oregon decoupling mechanism was reauthorized and the baseline expected usage per customer was reset in the 2018 Oregon general rate case. This mechanism employs a use-per-customer decoupling calculation, which adjusts margin revenues to account for the difference between actual and expected customer volumes. The margin adjustment resulting from differences between actual and expected volumes under the decoupling component is recorded to a deferral account, which is included in the annual PGA filing. WARM. In Oregon, NW Natural has an approved weather normalization mechanism, which is applied to residential and commercial customer bills. This mechanism is designed to help stabilize the collection of fixed costs by adjusting residential and commercial customer billings based on temperature variances from average weather, with rate decreases when the weather is colder than average and rate increases when the weather is warmer than average. The mechanism is applied to bills from December through mid-May of each heating season. The mechanism adjusts the margin component of customers’ rates to reflect average weather, which uses the 25-year average temperature for each day of the billing period. Daily average temperatures and 25-year average temperatures are based on a set point temperature of 59 degrees Fahrenheit for residential customers and 58 degrees Fahrenheit for commercial customers. The collections of any unbilled WARM amounts due to tariff caps and floors are deferred and earn a carrying charge until collected, or returned, in the PGA the following year. Residential and commercial customers in Oregon are allowed to opt out of the weather normalization mechanism, and as of December 31, 2019, 8% of total eligible customers had opted out. NW Natural does not have a weather normalization mechanism approved for residential and commercial Washington customers, which account for about 11% of total customers. See "Business Segment-Natural Gas Distribution" below. INDUSTRIAL TARIFFS. The OPUC and WUTC have approved tariffs covering NGD service to major industrial customers, which are intended to give NW Natural certainty in the level of gas supplies needed to serve this customer group. The approved terms include, among other things, an annual election period, special pricing provisions for out-of-cycle changes, and a requirement that industrial customers complete the term of their service election under NW Natural's annual PGA tariff. ENVIRONMENTAL COST DEFERRAL AND RECOVERY. NW Natural has authorizations in Oregon and Washington to defer costs related to remediation of properties that are owned or were previously owned by NW Natural. In Oregon, a Site Remediation and Recovery Mechanism (SRRM) is currently in place to recover prudently incurred costs allocable to Oregon customers, subject to an earnings test. On October 21, 2019 the WUTC authorized an Environmental Cost Recovery Mechanism (ECRM) for recovery of prudently incurred costs allocable to Washington customers beginning November 1, 2019. Oregon SRRM Under the Oregon SRRM collection process, there are three types of deferred environmental remediation expense: • Pre-review - This class of costs represents remediation spend that has not yet been deemed prudent by the OPUC. Carrying costs on these remediation expenses are recorded at NW Natural's authorized cost of capital. NW Natural anticipates the prudence review for annual costs and approval of the earnings test prescribed by the OPUC to occur by the third quarter of the following year. • Post-review - This class of costs represents remediation spend that has been deemed prudent and allowed after applying the earnings test, but is not yet included in amortization. NW Natural earns a carrying cost on these amounts at a rate equal to the five-year treasury rate plus 100 basis points. • Amortization - This class of costs represents amounts included in current customer rates for collection and is generally calculated as one-fifth of the post-review deferred balance. NW Natural earns a carrying cost equal to the amortization rate determined annually by the OPUC, which approximates a short-term borrowing rate. NW Natural included $5.1 million and $6.1 million of deferred remediation expense approved by the OPUC for collection during the 2019-20 and 2018-19 PGA years, respectively. In addition, the SRRM also provides for the annual collection of $5.0 million from Oregon customers through a tariff rider. As it collects amounts from customers, NW Natural recognizes these collections as revenue net of any earnings test adjustments and separately amortizes an equal and offsetting amount of the deferred regulatory asset balance through the environmental remediation operating expense line shown separately in the operating expenses section of the Consolidated Statements of Comprehensive Income (Loss). See Note 18 for more information on our environmental matters. The SRRM earnings test is an annual review of adjusted NGD ROE compared to authorized NGD ROE. For 2018, the first ten months were weighted at 9.5% and the last two months at 9.4%, reflecting the ROE change from NW Natural's most recent rate case effective November 1, 2018. To apply the earnings test NW Natural must first determine what if any costs are subject to the test through the following calculation: (1) Prior year carry-over results when the prior year amount transferred to post-review is negative. The negative amount is carried over to offset annual spend in the following year. (2) Deferred interest is added to annual spend to the extent the spend is recoverable. To the extent the NGD business earns at or below its authorized ROE as defined in the SRRM, the total amount transferred to post-review is recoverable through the SRRM. To the extent more than authorized ROE is earned in a year, the amount transferred to post-review would be reduced by those earnings that exceed its authorized ROE. For 2019, NW Natural has performed this test, which is anticipated to be submitted to the OPUC in May 2020. No earnings test adjustment is expected for 2019. Washington ECRM The ECRM established by the WUTC order on October 21, 2019 permits NW Natural’s recovery of environmental remediation expenses allocable to Washington customers. These expenses represent 3.32 percent of costs associated with remediation of sites that historically served both Oregon and Washington customers. The order allows for recovery of past deferred and future prudently incurred remediation costs allocable to Washington through application of insurance proceeds and collections from customers. Prudently incurred costs that were deferred from the initial deferral authorization in February 2011 through June 2019 are to be fully offset with insurance proceeds, with any remaining insurance proceeds to be amortized over a 10.5 year period. On an annual basis NW Natural will file for a prudence determination and a request to recover remediation expenditures in excess of insurance amortizations in the following year's customer rates. After insurance proceeds are fully amortized, if in a particular year the request to collect deferred amounts exceeds one percent of Washington normalized revenues, then the excess will be collected over three years with interest. The WUTC order also disallowed approximately $1.5 million of deferred environmental remediation expenses. NW Natural recognized an after-tax charge of approximately $1.1 million in the fourth quarter of 2019 as a result of this order. PENSION COST DEFERRAL AND PENSION BALANCING ACCOUNT. From 2011 through October 2018, the OPUC authorized a regulatory mechanism in which NW Natural deferred annual pension expenses above the amount set in rates, with recovery of these deferred amounts through the implementation of a balancing account, which included the expectation of higher and lower pension expenses in future years. During this period the mechanism permitted NW Natural to accrue interest on the account balance at the NGD business' authorized rate of return. The OPUC ordered the freezing of the account in October 2018 with pension expenses to be recovered through rates beginning November 1, 2018. In March 2019 the OPUC issued an order (Pension Order) directing the means by which the account would be recovered. As a result, the following items were recorded in the first quarter of 2019: • Applied $7.1 million of TCJA benefits deferred from January 1, 2018 to October 31, 2018, as a reduction against the pension balancing account; • Credited to customers' benefit $5.4 million of deferred income taxes as a reduction against the pension balancing account; • Reduced the amount of the frozen balancing account by an additional $10.5 million; and • Reduced the interest rate on the pension balancing account from NW Natural's authorized rate of return of 7.317% to 4.3%. The items above resulted in the recovery of $12.5 million of deferred pension expenses by applying deferred tax benefits against the pension balancing account. Recognition of these items resulted in higher operations and maintenance expense and other income (expense), net with offsetting benefits recognized in operating revenues and income tax expense. Additional pension expenses of $10.5 million from the regulatory disallowance were also recognized in operations and maintenance expense and other income (expense), net. Deferred regulatory interest income of $3.8 million was also realized in other income (expense), net. Commencing April 1, 2019, the OPUC also authorized the collection of the remainder of the pension balancing account over ten years in a customer tariff of $7.3 million per year. Pension expense deferrals, excluding interest, were $10.3 million and $6.5 million in 2018 and 2017, respectively. Deferred pension expense recoveries, inclusive of the applications of deferred TCJA benefits described above, were $16.8 million in 2019. TAX REFORM DEFERRAL. In December 2017, NW Natural filed applications with the OPUC and WUTC to defer the overall net benefit associated with the TCJA that was enacted on December 22, 2017. In February 2019, NW Natural and the other parties to the 2018 Oregon rate case agreed upon terms by which the deferred benefits would be returned to customers via a joint stipulation filed with the OPUC. In March 2019, the OPUC approved the terms in their entirety as follows: • Applied $7.1 million of TCJA benefits deferred from January 1, 2018 to October 31, 2018, as a reduction against the pension balancing account; • Credited to customers' benefit $5.4 million of deferred income taxes as a reduction against the pension balancing account; Commencing April 1, 2019, the OPUC also ordered the following: • Provide an annual credit to base rates of $3.4 million for excess deferred income taxes to all customers, subject to the average rate assumption method; • Provide an additional annual credit of $3.0 million to sales service customers for five years; • An increase in rate base of $15.4 million, and corresponding increase to revenue requirement of $1.4 million. If NW Natural files a general rate case within five years of the date of the Pension Order, this revenue requirement may be adjusted as part of that general rate case. On October 21, 2019 the WUTC issued an order dictating the means by which deferred tax reform benefits would be returned to customers beginning November 1, 2019. The order directs NW Natural to provide customers with a rate reduction of $2.1 million over one year to reflect the benefit of the lower federal corporate income tax rate accumulating from January 1, 2018 through October 31, 2019, and provides an additional annual rate reduction initially set at approximately $0.5 million to reflect a benefit from the remeasurement of deferred tax liabilities of approximately $15.0 million. INTERSTATE STORAGE AND ASSET MANAGEMENT SHARING. On an annual basis, NW Natural credits amounts to Oregon and Washington customers as part of a regulatory incentive sharing mechanism related to net revenues earned from Mist gas storage and asset management activities. Generally, amounts are credited to Oregon customers in June, while credits are given to customers in Washington as reductions in rates through the annual PGA filing in November. In November 2018, the percentage of net revenues shared with Oregon customers increased from 67% to 90% as a result of the 2018 Oregon general rate case. The following table presents the credits to NGD customers: HOLDING COMPANY REORGANIZATION. On October 1, 2018, we completed the reorganization to a holding company structure. There are a number of conditions under the agreement with the OPUC and the WUTC related to the formation of a holding company structure. One of the conditions is that, for three years following formation of the holding company, NW Natural will be required to provide an annual $500,000 credit to Oregon customers and a $55,000 credit to Washington customers. The first and second year credits to both Oregon and Washington customers were given in conjunction with the 2018-19 and 2019-20 PGA filings with the rate adjustments commencing on November 1, 2018 and 2019, respectively. Regulatory Proceeding Updates During 2019, NW Natural was involved in the regulatory activities discussed below. WATER UTILITIES. In 2019, NW Holdings, through its water subsidiaries, continued implementation of its growth strategy and entered into the following agreements which required regulatory approval: • Sunriver Water, LLC and Sunriver Environmental, LLC - NWN Water of Oregon received regulatory approval from the OPUC for the Sunriver Water acquisition in April 2019. Sunriver Environmental is not under the OPUC's jurisdiction. The transaction closed in May 2019. • Estates Water Systems Inc. and Monterra Inc. - Cascadia Water received regulatory approval from the WUTC for these Sequim, Washington acquisitions in April 2019. The transaction closed in May 2019. • Spirit Lake East Water Company and Lynnwood Water - Gem State Water received regulatory approval from the IPUC for these Coeur d'Alene, Idaho acquisitions in July 2019. The transaction closed in July 2019. • Suncadia Water Company, LLC and Suncadia Environmental, LLC - NWN Water of Washington received regulatory approval for the purchase of Suncadia Water in January 2020. Suncadia Environmental is not subject to the WUTC's jurisdiction. The transaction closed in January 2020. See Note 20 for additional information. • T&W Water Service Company - NWN Water of Texas received regulatory approval from the Public Utility Commission of Texas for the T&W Water Service Company acquisition in February 2020. We expect the transaction to close in 2020. INTEGRATED RESOURCE PLAN (IRP). NW Natural files a full IRP biennially for Oregon and Washington with the OPUC and WUTC, respectively. NW Natural filed its 2018 Oregon and Washington IRPs in August 2018, and received both a letter of compliance from the WUTC and acknowledgment by the OPUC in February 2019. The IRP included analysis of different growth scenarios and corresponding resource acquisition strategies. This analysis is needed to develop supply and demand resource requirements, consider uncertainties in the planning process, and to establish a plan for providing reliable and low cost natural gas service. RENEWABLE NATURAL GAS. On June 19, 2019, the Oregon legislature passed Senate Bill 98 (SB98), which enables natural gas utilities to procure or develop renewable natural gas (RNG) on behalf of their Oregon customers. RNG is produced from organic materials like food, agricultural and forestry waste, wastewater, or landfills. Methane is captured from these organic materials as they decompose and is conditioned to pipeline quality, so it can be added into the existing natural gas system, reducing net greenhouse gas emissions. SB98 outlines the following parameters for the RNG program including: setting out broad targets for gas utilities that allow for the purchase of RNG from third parties such that 30% of the gas distributed to retail customers is RNG by 2050; allowing gas utilities to invest in RNG infrastructure for the production, processing, pipeline interconnection and distribution of RNG to their customers; and creating a limit of 5% of a utility's revenue requirement that can be used to cover the incremental cost of RNG to protect utilities and ratepayers from increased costs as the RNG market develops. The bill was signed into law by the governor in July 2019. The OPUC opened a docket in August to begin the rulemaking process for the bill, which is expected to conclude with the OPUC adopting rules by July 31, 2020. CORPORATE ACTIVITY TAX. In 2019, the State of Oregon enacted a Corporate Activity Tax (CAT) that is applicable to all businesses with annual Oregon gross revenue in excess of $1 million. The CAT is in addition to the state's corporate income tax and imposes a 0.57% tax on certain Oregon gross receipts less a reduction for a portion of cost of goods sold or labor. The CAT legislation became effective September 29, 2019 and applies to calendar years beginning January 1, 2020. On December 23, 2019, NW Natural filed an application with the OPUC to allow us to defer this additional expense, with recovery of these deferred amounts to be determined through future rate case proceedings. 2020 OREGON RATE CASE. On December 30, 2019, NW Natural filed a request for a general rate increase with the OPUC. The filing includes a requested $71.4 million annual revenue requirement increase based upon the following assumptions or requests: • Capital structure of 50% debt and 50% equity; • Return on equity of 10.0%; • Cost of capital of 7.298%; • Average rate base of $1.47 billion. The filing includes an increase in average rate base of $269.9 million compared to the last rate case due to the following items: • Investments supporting customer growth and reliability for the distribution system as well as for operating resiliency; • Replacing key components of our Mist storage facility, which provides service during the peak winter months; and • Upgrading technology including cybersecurity and critical customer interfacing systems. NW Natural’s filing will be reviewed by the OPUC and other stakeholders. The process is anticipated to take up to 10 months with new rates expected to take effect November 1, 2020. Business Segment - Natural Gas Distribution (NGD) NGD results are primarily affected by customer growth, revenues from rate-base additions, and, to a certain extent, by changes in delivered volumes due to weather and customers’ gas usage patterns. In Oregon, NW Natural has a conservation tariff (also called the decoupling mechanism), which adjusts margin up or down each month through a deferred regulatory accounting adjustment designed to offset changes resulting from increases or decreases in average use by residential and commercial customers. NW Natural also has a weather normalization tariff in Oregon, WARM, which adjusts customer bills up or down to offset changes in margin resulting from above- or below-average temperatures during the winter heating season. Residential and commercial customers in Oregon are allowed to opt out of the weather normalization mechanism, and as of December 31, 2019, 8% of total eligible customers had opted out. NW Natural does not have a weather normalization mechanism approved for residential and commercial Washington customers, which account for about 11% of total customers. The decoupling and WARM mechanisms are designed to reduce, but not eliminate, the volatility of customer bills and natural gas distribution earnings. See "Regulatory Matters-Rate Mechanisms" above. The NGD business is seasonal in nature due to higher gas usage by residential and commercial customers during the cold winter heating months. Other categories of customers experience seasonality in their usage but to a lesser extent. Seasonality affects the comparability of the results of operations of the NGD business across quarters but not across years. NGD segment highlights include: (1) See the Non-GAAP Reconciliations table at the beginning of Item 7 for a reconciliation of this non-GAAP financial measure to its closest U.S. GAAP financial measure. (2) See Natural Gas Distribution Margin Table below for additional detail. 2019 COMPARED TO 2018. NGD net income was $60.8 million in 2019 compared to $57.5 million in 2018. The primary factors contributing to the increase in NGD net income were as follows: • a $39.0 million increase in NGD margin primarily due to: ▪ a $16.2 million increase due to new customer rates from the 2018 Oregon rate case and 2019 Washington rate case; ▪ a $6.1 million increase from customer growth; ▪ an $11.8 million increase from revenue generated from NW Natural's North Mist storage contract which commenced service in May 2019 and is included within other regulated services within NGD margin; ▪ a $7.1 million increase due to revenues recognized in association with recoveries of NW Natural's pension balancing account, which are entirely offset by pension expenses within operations and maintenance and other income (expense), net; and ▪ a $3.7 million increase driven by colder than average weather in the first quarter of 2019 coupled with higher fee revenues from interruptible customers as a result of system restrictions; partially offset by ▪ a $3.2 million decrease due to an adjustment to the tax reform deferral estimate in 2018; and ▪ a $1.5 million decrease due to a regulatory disallowance of deferred environmental expenditures as a result of the 2019 Washington rate case. • a $9.4 million decrease in income tax expense primarily due to the income tax implications of the March 2019 OPUC order, of which $5.4 million was offset by pension expenses as discussed above, with the remainder driven by the return of deferred TCJA benefit credits to customers and lower pretax income in the current period compared to the prior period; and • a $5.8 million increase in deferred regulatory interest income in other income (expense), net, of which $5.1 million relates to interest recognized in association with the OPUC order discussed above. The increases were partially offset by: • a $34.4 million increase in pension costs within operations and maintenance expense and other income (expense), net, of which $12.5 million relates to costs which were entirely offset by revenues and income tax benefits in the March 2019 OPUC order, and $10.5 million relates to the regulatory pension disallowance included in the March 2019 OPUC order. In addition, there was a $11.4 million increase in pension expenses as NW Natural began collecting ongoing pension costs through customer rates on November 1, 2018 and began collecting deferred pension costs through customer rates on April 1, 2019 rather than deferring a portion to the balancing account; • a $5.7 million increase in depreciation expense due to NGD plant additions; • a $4.6 million increase in interest expense driven by $2.3 million higher interest on long term debt, $1.2 million lower AFUDC debt interest income, and $0.9 million higher commercial paper and line of credit interest; • a $3.3 million decrease in AFUDC equity interest; and • a $2.9 million increase in NGD segment operations and maintenance expenses primarily attributable to annual employee cost increases. Total natural gas sold and delivered in 2019 increased 8% over 2018 primarily due to the impact of weather that was average in the current period compared to weather that was 15% warmer than average in the prior period. 2018 COMPARED TO 2017. NGD net income was $57.5 million in 2018 compared to $60.5 million in 2017. NGD net income in 2017 includes a $1.0 million loss from the remeasurement of deferred income tax balances due to the enactment of the TCJA. Excluding this item, adjusted NGD net income decreased $4.0 million, or $0.14 per share. See the NW Holdings Non-GAAP Reconciliations at the beginning of Item 7 for additional information. The primary factors contributing to the decrease in adjusted NGD net income were as follows: • a $8.9 million decrease in NGD margin primarily due to: ▪ a $7.9 million decrease due to revenues collected and deferred in association with the TCJA; partially offset by ▪ a $4.8 million increase from customer growth; and ▪ the majority of the remaining decrease was due to the effects of warmer than average weather in 2018 compared to colder than average weather in 2017, partially offset by higher rates from the 2018 Oregon general rate case effective November 1, 2018. • a $6.0 million increase in operations and maintenance expense driven largely from payroll and benefits due to increased headcount, general salary increases, and increased professional services and contract labor expense; • a $4.2 million decrease in other income (expense), net, primarily due to increases in pension non-service component costs, partially offset by increases in the equity portion of AFUDC in 2018; and • a $4.0 million increase in depreciation expense primarily due to additional capital expenditures; partially offset by • a $20.0 million decrease in income tax expense primarily due to the reduction in the federal statutory tax rate from the TCJA and lower pretax income. Total natural gas sold and delivered in 2018 decreased 9% over 2017 primarily due to the impact of weather that was 26% warmer than the prior period and 15% warmer than average. NATURAL GAS DISTRIBUTION MARGIN TABLE. The following table summarizes the composition of NGD gas volumes, revenues, and cost of sales: (1) The change in presentation of revenue taxes was a result of the adoption of ASU 2014-09 "Revenue From Contracts with Customers" and all related amendments on January 1, 2018. This change had no impact on NGD margin results. For additional information, see Note 2. (2) Amounts reported as margin for each category of meters are operating revenues, which are net of revenue taxes, less cost of gas and environmental remediation expense. (3) Other margin adjustments include net revenue recoveries of $6.2 million and revenue deferrals of $7.9 million for the years ended December 31, 2019 and 2018, respectively, associated with the decline of the U.S. federal corporate income tax rate. (4) Heating degree days are units of measure reflecting temperature-sensitive consumption of natural gas, calculated by subtracting the average of a day's high and low temperatures from 59 degrees Fahrenheit. (5) Average weather represents the 25-year average of heating degree days. Through October 31, 2018, average weather is calculated over the period 1986 - 2010, as determined in NW Natural's 2012 Oregon general rate case, and beginning November 1, 2018, average weather is calculated over the period May 31, 1992 through May 30, 2017, as determined in NW Natural's 2018 Oregon general rate case. Residential and Commercial Sales The primary factors that impact results of operations in the residential and commercial markets are customer growth, seasonal weather patterns, energy prices, competition from other energy sources, and economic conditions in our service areas. The impact of weather on margin is significantly reduced through NW Natural's weather normalization mechanism in Oregon; approximately 82% of NW Natural's total customers are covered under this mechanism. The remaining customers either opt out of the mechanism or are located in Washington, which does not have a similar mechanism in place. For more information on the weather mechanism, see "Regulatory Matters-Rate Mechanisms-Weather Normalization Mechanism" above. NGD residential and commercial sales highlights include: 2019 COMPARED TO 2018. The increases of $17.2 million in operating revenue and $14.3 million in total residential and commercial NGD margin were primarily driven by new customer rates from the 2018 Oregon rate case and 2019 Washington rate case as well as sales volume increases of 73.1 million therms, or 11%, due to customer growth and average weather in 2019 compared to warmer than average weather in 2018. 2018 COMPARED TO 2017. The decreases of $62.5 million in operating revenue and $3.1 million in total residential and commercial NGD margin were primarily driven by sales volume decreases of 79.2 million therms, or 11%, due to warmer than average weather in 2018 compared to colder than average weather in the prior period, partially offset by customer growth. Industrial Sales and Transportation Industrial customers have the option of purchasing sales or transportation services. Under the sales service, the customer buys the gas commodity from NW Natural. Under the transportation service, the customer buys the gas commodity directly from a third-party gas marketer or supplier. The NGD gas commodity cost is primarily a pass-through cost to customers; therefore, NGD profit margins are not materially affected by an industrial customer's decision to purchase gas from third parties. Industrial and large commercial customers may also select between firm and interruptible service options, with firm services generally providing higher profit margins compared to interruptible services. To help manage gas supplies, industrial tariffs are designed to provide some certainty regarding industrial customers' volumes by requiring an annual service election which becomes effective November 1, special charges for changes between elections, and in some cases, a minimum or maximum volume requirement before changing options. NGD industrial sales and transportation highlights include: 2019 COMPARED TO 2018. Industrial sales and transportation volumes increased by 13.8 million therms and NGD margin increased $1.2 million due to an increase in manufacturing activity in NW Natural's service territory. The increase was partially offset by a reduction in customer count, which was driven by customer elections to switch from industrial to commercial rate schedules. 2018 COMPARED TO 2017. Industrial sales and transportation volumes decreased by 32.9 million therms and NGD margin decreased $1.0 million due to lower usage from warmer than average weather in 2018 compared to colder than average weather in 2017. Miscellaneous Revenues Margin from miscellaneous revenues includes fee income as well as regulatory revenue adjustments, which reflect current period deferrals to and prior year amortizations from regulatory asset and liability accounts, except for gas cost deferrals which flow through cost of gas. Decoupling and other regulatory amortizations from prior year deferrals are included in revenues from residential, commercial, and industrial firm customers. Margin from NGD miscellaneous revenues highlights include: 2019 COMPARED TO 2018. Margin from miscellaneous revenues remained flat due to continued entitlement and curtailment revenue in first quarter of 2019 related to the October 2018 Canadian pipeline event. 2018 COMPARED TO 2017. Margin from miscellaneous revenues increased $1.6 million due to increases in entitlement and curtailment revenue due to system restrictions for certain industrial and commercial customers as a result of a Canadian pipeline event in October 2018 that disrupted gas supply. Other Regulated Services Other Regulated Services primarily consist of lease revenues from NW Natural's North Mist storage facility as well as other lease revenues for compressed natural gas assets. Other regulated services revenue highlights include: 2019 COMPARED TO 2018. Other regulated services margin increased $11.8 million in 2019 compared to 2018 due to the commencement of storage services at the North Mist expansion facility in May 2019. See Note 7 for more information regarding North Mist expansion lease accounting. Cost of Gas Cost of gas as reported by the NGD segment includes gas purchases, gas withdrawn from storage inventory, gains and losses from commodity hedges, pipeline demand costs, seasonal demand cost balancing adjustments, regulatory gas cost deferrals, gas reserves costs, and company gas use. The OPUC and WUTC generally require natural gas commodity costs to be billed to customers at the actual cost incurred, or expected to be incurred. Customer rates are set each year so that if cost estimates were met the NGD business would not earn a profit or incur a loss on gas commodity purchases; however, in Oregon we have the incentive sharing mechanism described under "Regulatory Matters-Rate Mechanisms-Purchased Gas Adjustment" above. In addition to the PGA incentive sharing mechanism, gains and losses from hedge contracts entered into after annual PGA rates are effective for Oregon customers are also required to be shared and therefore may impact net income. Further, NW Natural also has a regulatory agreement whereby it earns a rate of return on its investment in the gas reserves acquired under the original agreement with Encana and includes gas from the amended gas reserves agreement at a fixed rate of $0.4725 per therm, which are also reflected in NGD margin. See "Application of Critical Accounting Policies and Estimates-Accounting for Derivative Instruments and Hedging Activities" below. Cost of gas highlights include: 2019 COMPARED TO 2018. Cost of gas was flat compared to the prior year, primarily due to the 10% increase in volumes sold driven by average weather in 2019 compared to warmer than average weather in 2018 and customer growth, primarily offset by a three cent decrease in the average cost of gas. 2018 COMPARED TO 2017. Cost of gas decreased 69.3 million, or 21%, primarily due to the 10% decrease in volumes sold due to warmer than average weather in 2018 compared to colder than average weather in 2017, and lower average cost of gas collected from customers, partially offset by customer growth. The effect on net income from NW Natural's Oregon gas cost incentive sharing mechanism resulted in a margin loss of $1.3 million in 2019 compared to a slight margin loss in 2018 and a margin gain of $1.2 million in 2017. In 2019, actual gas prices were higher than those included in rates during the period. In 2018, actual prices closely aligned with estimated prices included in customer rates. In 2017, actual prices were lower than the estimated prices included in customer rates due to warmer than average weather nationally, which resulted in lower national natural gas commodity prices. For a discussion of the gas cost incentive sharing mechanism, see "Regulatory Matters-Rate Mechanisms-Purchased Gas Adjustment" above. Other Other activities aggregated and reported as other at NW Holdings include NWN Energy's equity investment in Trail West Holding, LLC (TWH), which is pursuing the development of a proposed natural gas pipeline through its wholly-owned subsidiary, Trail West Pipeline, LLC (TWP); NNG Financial's investment in Kelso-Beaver Pipeline (KB Pipeline); and NWN Water, which owns and continues to pursue investments in the water sector. Other activities aggregated and reported as other at NW Natural include the non-NGD storage activity at Mist as well as asset management services and the appliance retail center operations. See Note 4 for further discussion of our business segment and other, as well as our direct and indirect wholly-owned subsidiaries, and Note 14 for further details on our investment in TWH. At Mist, NW Natural provides gas storage services to customers in the interstate and intrastate markets using storage capacity that has been developed in advance of NGD customers’ requirements. Pre-tax income from gas storage at Mist and asset management services is subject to revenue sharing with NGD customers. Under this regulatory incentive sharing mechanism, NW Natural retains 80% of pre-tax income from Mist gas storage services and asset management services when the underlying costs of the capacity being used are not included in NGD business rates. The remaining 20% is credited to a deferred regulatory account for credit to NGD customers. Through October 2018, when the capacity used was included in NGD rates, NW Natural retained 33% of pre-tax income with the remaining 67% credited to a deferred regulatory account for credit to NGD customers. In conjunction with the Oregon rate case, effective November 2018 NW Natural retains 10% of pre-tax income from such storage and asset management services and 90% is credited to NGD business customers. The following table presents the results of activities aggregated and reported as other for both NW Holdings and NW Natural: The significant drivers of changes in other net income discussed below apply to both NW Holdings and NW Natural. 2019 COMPARED TO 2018. Other net income decreased $5.3 million and $2.5 million at NW Holdings and NW Natural, respectively. The decrease at NW Natural was primarily driven by lower asset management revenues and increased asset management revenue sharing with Oregon customers as a result of the 2018 Oregon rate case. The decrease from other NW Holdings activity was driven by increases in professional service costs and expenses associated with developing the water business. 2018 COMPARED TO 2017. Other net income decreased compared to the prior period primarily due to $4.2 million in higher income tax expense driven by $4.4 million in income tax benefits recognized in 2017 from the enactment of the TCJA, partially offset by a $2.8 million increase in revenues from asset management agreements for Mist storage and transportation capacity. Consolidated Operations Operations and Maintenance Operations and maintenance highlights include: 2019 COMPARED TO 2018. Operations and maintenance expense increased $21.5 million and $13.9 million for NW Holdings and NW Natural, respectively. The increase at NW Natural was primarily due to the following: • a $12.5 million increase in pension expenses, consisting of: • a $4.6 million increase from recovery of amounts in NW Natural's pension balancing account upon receipt of an OPUC accounting order in March 2019, which was offset within NGD margin and income tax benefits; • a $4.0 million increase from higher pension costs as NW Natural began collecting ongoing pension costs through customer rates on November 1, 2018 and began collecting deferred pension costs through customer rates on April 1, 2019 rather than deferring a portion to the balancing account; and • a $3.9 million increase from a regulatory pension disallowance as a result of the March 2019 OPUC order in the Oregon general rate case. The remaining change was primarily attributable to annual employee cost increases. The $7.6 million increase in other NW Holdings operations and maintenance expense was primarily due to expenses associated with developing the water business. 2018 COMPARED TO 2017. Operations and maintenance expense increased $4.3 million and $3.0 million for NW Holdings and NW Natural, respectively, primarily due to the following factors: • a $3.4 million increase in NGD payroll and benefits due to increased headcount and general salary increases; and • a $3.2 million increase in NGD non-payroll costs primarily due to increases in general professional services and contract labor. Delinquent customer receivable balances continue to remain at historically low levels. Bad debt expense as a percent of revenues was 0.1% for 2019, 2018, and 2017. Depreciation and Amortization Depreciation and amortization highlights include: The significant drivers of changes in depreciation and amortization discussed below apply to both NW Holdings and NW Natural. 2019 COMPARED TO 2018. Depreciation and amortization expense increased by $6.3 million and $5.4 million for NW Holdings and NW Natural, respectively, primarily due to NGD plant additions that included investments in natural gas transmission and distribution systems supporting customer growth, safety, reliability, facility upgrades, and enhanced technology. In addition, the North Mist gas storage facility began operations and began depreciating in May 2019. The increase in other NW Holdings depreciation and amortization was primarily due to depreciation expense at acquired water and wastewater entities. 2018 COMPARED TO 2017. Depreciation and amortization expense increased by $4.1 million and $4.0 million for NW Holdings and NW Natural, respectively, primarily due to NGD plant additions that included investments in natural gas transmission and distribution systems supporting customer growth, safety, reliability, facility upgrades, and enhanced technology. Other Income (Expense), Net Other income (expense), net highlights include: The significant drivers of changes in Other income (expense) discussed below apply to both NW Holdings and NW Natural. 2019 COMPARED TO 2018. Other income (expense), net, decreased $19.2 million and $19.4 million at NW Holdings and NW Natural, respectively. The decrease was primarily driven by activity in NW Natural's pension balancing account as described below. In addition, net interest income on deferred regulatory accounts increased $5.5 million primarily due to $5.1 million of deferred equity interest income recognized in 2019 in conjunction with amortization of the pension balancing account. Interest income from the equity portion of AFUDC decreased $3.3 million, primarily driven by the placement of the North Mist facility into service in May 2019. Pension Balancing Account From 2011 through October 31, 2018, NW Natural had OPUC approval to defer certain pension costs in excess of what was recovered in customer rates. This pension cost deferral was recorded to a regulatory balancing account, which stabilized the amount of pension expense recognized each year in the consolidated statements of comprehensive income (loss). Total pension cost deferrals, excluding interest, were $10.3 million and $6.5 million for the years ended December 31, 2018 and 2017, of which $7.9 million and 4.1 million was recognized in other income (expense), net, respectively. In October 2018, the OPUC issued an order freezing the pension balancing account and directing that future pension expense would be recovered through rates with an increase of $8.1 million to revenue requirement. In March 2019, the OPUC issued another order allowing for the application of certain deferred revenues and tax benefits from the TCJA to reduce NW Natural's pension regulatory balancing account. A corresponding total of $12.5 million in pension expenses were recognized, of which $7.9 million was recognized in other income (expense), net in the consolidated statements of comprehensive income in the first quarter of 2019, with offsetting benefits recorded within operating revenues and income taxes. The order also directed NW Natural to reduce the balancing account by an additional, disallowed, $10.5 million, of which $6.6 million was charged to other income (expense), net in the consolidated statements of comprehensive income. Amortization of the remaining amount of the balancing account began in the second quarter of 2019 in accordance with the order. Total amortization of the balancing account for the year ended December 31, 2019, inclusive of the $12.5 million recovery mentioned above, was $16.8 million, of which $10.7 million was recorded to other income (expense), net. See Note 10 and "Regulatory Matters-Regulatory Proceeding Updates - Pension Cost Deferral and Pension Balancing Account" for more information regarding the pension balancing account. 2018 COMPARED TO 2017. Other income (expense), net, decreased $3.3 million and $3.4 million at NW Holdings and NW Natural, respectively, primarily due to a $3.0 million increase in pension and other postretirement non-service costs and $0.8 million lower gains from company-owned life insurance, partially offset by a $1.4 million increase in the equity portion of AFUDC. Interest Expense, Net Interest expense, net highlights include: 2019 COMPARED TO 2018. Interest expense, net of amounts capitalized increased $5.6 million and $4.3 million at NW Holdings and NW Natural, respectively. The increase at NW Natural was primarily driven by $2.3 million higher interest on long term debt balances, $1.2 million lower AFUDC debt interest income, and $0.9 million higher commercial paper and line of credit interest. The additional increase at NW Holdings was driven by interest on long-term debt at NWN Water and interest on NW Holdings' line of credit. 2018 COMPARED TO 2017. Interest expense, net of amounts capitalized, decreased $0.4 million and $0.5 million at NW Holdings and NW Natural, respectively, primarily due to a $2.3 million increase in the interest-related portion of AFUDC, partially offset by increased commercial paper interest expenses of $1.6 million. Income Tax Expense NW Holdings income tax expense highlights include: (1) See the Non-GAAP Reconciliations table at the beginning of Item 7 for a reconciliation of this non-GAAP financial measure to its closest U.S.GAAP measure. NW Natural income tax expense highlights include: (1) See the Non-GAAP Reconciliations table at the beginning of Item 7 for a reconciliation of this non-GAAP financial measure to its closest U.S.GAAP measure. The significant drivers of changes in income tax expense discussed below apply to both NW Holdings and NW Natural. 2019 COMPARED TO 2018. The effective tax rate decreased by 10.2% and 9.5% at NW Holdings and NW Natural, respectively. The reduction was driven by the return of tax reform benefits to customers, including $5.4 million in tax benefits recognized in association with the OPUC 2018 Oregon rate case order which was offset by pension expenses. See "Executive Summary - Deferred TCJA benefits and timing variance" above. 2018 COMPARED TO 2017. The effective tax rate decreased by 9.9% and 10.2% at NW Holdings and NW Natural, respectively, primarily due to a decline in the statutory income tax rate from 39.5% to 26.5% as a result of the TCJA enactment in 2017. Income tax expense decreased due to the TCJA and lower pre-tax income, partially offset by a benefit of $3.4 million recognized in 2017 at NW Holdings and a benefit of $3.0 million recognized in 2017 at NW Natural from the remeasurement of deferred tax balances upon the TCJA enactment date. Excluding the impact of the 2017 remeasurement benefits of $3.4 million and $3.0 million at NW Holdings and NW Natural, respectively, the adjusted effective tax rate decreased 12.9% at both NW Holdings and NW Natural due to the statutory tax rate declining from the TCJA. See the Non-GAAP Reconciliations at the beginning of Item 7 for additional information. Pending Sale of Gill Ranch Storage On June 20, 2018, NWN Gas Storage, a wholly owned subsidiary of NW Holdings, entered into a Purchase and Sale Agreement (the Sale Agreement) that provides for the sale by NWN Gas Storage of all of its membership interests in Gill Ranch. Gill Ranch owns a 75% interest in the natural gas storage facility located near Fresno, California known as the Gill Ranch Gas Storage Facility. PG&E owns the remaining 25% interest in the Gill Ranch Facility. In the Sale Agreement, NWN Gas Storage makes representations and warranties concerning, among other things, Gill Ranch, the Gill Ranch Facility and Gill Ranch’s business and contractual relationships, and agrees to cause Gill Ranch to conduct its business and maintain its properties in the ordinary course, consistent with material agreements and past practice. The Sale Agreement provides for an initial cash purchase price of $25.0 million (subject to a working capital adjustment), plus potential additional payments to NWN Gas Storage of up to $26.5 million in the aggregate if Gill Ranch achieves certain economic performance levels for the first three full gas storage years (April 1 of one year through March 31 of the following year) occurring after the closing and the remaining portion of the gas storage year during which the closing occurs. The decision approving the transaction was issued by the CPUC on December 12, 2019 and the transaction is subject to other customary closing conditions and covenants, including the requirement that all of the representations and warranties be true and correct as of the closing date except, as would not, in the case of certain representations and warranties, be reasonably expected to have a material adverse effect on Gill Ranch. The agreement, as amended, is currently subject to termination by either party if the transaction has not closed by March 31, 2020. We continue to strive to close this transaction. On January 29, 2019, PG&E filed voluntary petitions for relief under chapter 11 bankruptcy. We cannot fully predict the course of the bankruptcy proceedings or the impact on the sale and will continue to monitor the situation closely. The results of Gill Ranch Storage have been determined to be discontinued operations and are presented separately, net of tax, from the results of continuing operations of NW Holdings for all periods presented. See Note 19 for more information on the Sale Agreement and the results of our discontinued operations. The CPUC regulates Gill Ranch under a market-based rate model which allows for the price of storage services to be set by the marketplace. The CPUC also regulates the issuance of securities, system of accounts, and regulates intrastate storage services. The Geologic Energy Management Division of the California Department of Conservation regulations for gas storage wells were finalized in June 2018, and the U.S. Department of Transportation's Pipeline and Hazardous Materials Safety Administration (PHMSA) proposed new federal regulations for underground natural gas storage facilities, which were finalized during 2019 and increased costs for all storage providers. NW Holdings will continue to monitor and assess additional new regulations until the sale is complete. Short-term liquidity for Gill Ranch is supported by cash balances, internal cash flow from operations, equity contributions from its parent company, and, if necessary, additional external financing. FINANCIAL CONDITION Capital Structure NW Holdings' long-term goal is to maintain a strong and balanced consolidated capital structure. NW Natural targets a regulatory capital structure of 50% common equity and 50% long-term debt, which is consistent with approved regulatory allocations in Oregon, which has an allocation of 50% common equity and 50% long-term debt without recognition of short-term debt, and Washington, which has an allocation of 50% long-term debt, 1% short-term debt, and 49% common equity. When additional capital is required, debt or equity securities are issued depending on both the target capital structure and market conditions. These sources of capital are also used to fund long-term debt retirements and short-term commercial paper maturities. See "Liquidity and Capital Resources" below and Note 9. Achieving our target capital structure and maintaining sufficient liquidity to meet operating requirements is necessary to maintain attractive credit ratings and provide access to the capital markets at reasonable costs. NW Holdings' consolidated capital structure, excluding short-term debt, was as follows: NW Natural's consolidated long-term capital structure, excluding short-term debt, was as follows: Including short-term debt balances, as of December 31, 2019 and 2018, NW Holdings' consolidated capital structure included common equity of 45.7% and 44.4%, long-term debt of 42.5% and 41.1%, and short-term debt including current maturities of long-term debt of 11.8% and 14.5%, respectively. As of December 31, 2019 and 2018, NW Natural's consolidated capital structure included common equity of 45.9% and 42.9%, long-term debt of 42.9% and 42.2%, and short-term debt including current maturities of long-term debt of 11.2% and 14.9%, respectively. During 2019, changes to NW Natural's capital structures were primarily due to capital contributions from NW Holdings and the issuance of long-term debt. Changes to NW Holdings' capital structure were primarily due to issuances of common equity at NW Holdings and the issuance of long-term debt at NW Natural. See further discussion below in "Cash Flows - Financing Activities". Liquidity and Capital Resources At December 31, 2019 and December 31, 2018, NW Holdings had approximately $9.6 million and $12.6 million, and NW Natural had approximately $5.9 million and $7.9 million, of cash and cash equivalents, respectively. In order to maintain sufficient liquidity during periods when capital markets are volatile, NW Holdings and NW Natural may elect to maintain higher cash balances and add short-term borrowing capacity. NW Holdings and NW Natural may also pre-fund their respective capital expenditures when long-term fixed rate environments are attractive. NW Holdings For NW Holdings, short-term liquidity is primarily provided by cash balances, dividends from its operating subsidiaries, in particular NW Natural, available cash from a multi-year credit facility, and short-term credit facilities. NW Holdings also has a universal shelf registration statement filed with the SEC for the issuance of debt and equity securities. NW Holdings long-term debt, if any, and equity issuances are primarily used to provide equity contributions to NW Holdings’ operating subsidiaries for operating and capital expenditures and other corporate purposes. NW Holdings' issuance of securities is not subject to regulation by state public utility commissions, but the dividends from NW Natural to NW Holdings are subject to regulatory ring-fencing provisions. NW Holdings guarantees the debt of its wholly-owned subsidiary, NWN Water. See "Long-Term Debt" below for more information regarding NWN Water debt. As part of the ring-fencing conditions agreed upon with the OPUC and WUTC in connection with the holding company reorganization, NW Natural may not pay dividends or make distributions to NW Holdings if NW Natural’s credit ratings and common equity ratio, defined as the ratio of equity to long-term debt, fall below specified levels. If NW Natural’s long-term secured credit ratings are below A- for S&P and A3 for Moody’s, dividends may be issued so long as NW Natural’s common equity ratio is 45% or more. If NW Natural’s long term secured credit ratings are below BBB for S&P and Baa2 for Moody’s, dividends may be issued so long as NW Natural’s common equity ratio is 46% or more. Dividends may not be issued if NW Natural’s long-term secured credit ratings are BB+ or below for S&P or Ba1 or below for Moody’s, or if NW Natural’s common equity ratio is below 44%, where the ratio is measured using common equity and long-term debt excluding imputed debt or debt-like lease obligations. In each case, common equity ratios are determined based on a preceding or projected 13-month average. In addition, there are certain OPUC notice requirements for dividends in excess of 5% of NW Natural’s retained earnings. Additionally, if NW Natural’s common equity (excluding goodwill and equity associated with non-regulated assets), on a preceding or projected 13-month average basis, is less than 46% of NW Natural’s capital structure, NW Natural is required to notify the OPUC, and if the common equity ratio falls below 44%, file a plan with the OPUC to restore its equity ratio to 44%. This condition is designed to ensure NW Natural continues to be adequately capitalized under the holding company structure. Under the WUTC order, the average common equity ratio must not exceed 56%. At December 31, 2019 and 2018, NW Natural satisfied the ring-fencing provisions described above. Based on several factors, including current cash reserves, committed credit facilities, its ability to receive dividends from its operating subsidiaries, in particular NW Natural, and an expected ability to issue long-term debt and equity securities in the capital markets, NW Holdings believes its liquidity is sufficient to meet anticipated near-term cash requirements, including all contractual obligations, investing, and financing activities as discussed in "Contractual Obligations" and "Cash Flows" below. NW HOLDINGS DIVIDENDS. Quarterly dividends have been paid on common stock each year since NW Holdings’ predecessor’s stock was first issued to the public in 1951. Annual common stock dividend payments per share, adjusted for stock splits, have increased each year since 1956. The declarations and amount of future dividends to shareholders will depend upon earnings, cash flows, financial condition, NW Natural’s ability to pay dividends to NW Holdings and other factors. The amount and timing of dividends payable on common stock is at the sole discretion of the NW Holdings Board of Directors. Natural Gas Distribution Segment For the NGD business segment, short-term borrowing requirements typically peak during colder winter months when the NGD business borrows money to cover the lag between natural gas purchases and bill collections from customers. Short-term liquidity for the NGD business is primarily provided by cash balances, internal cash flow from operations, proceeds from the sale of commercial paper notes, as well as available cash from multi-year credit facilities, short-term credit facilities, company-owned life insurance policies, the sale of long-term debt, and equity contributions from NW Holdings. NW Natural's long-term debt and contributions from NW Holdings are primarily used to finance NGD capital expenditures, refinance maturing debt, and provide temporary funding for other general corporate purposes of the NGD business. Based on its current debt ratings (see "Credit Ratings" below), NW Natural has been able to issue commercial paper and long-term debt at attractive rates and has not needed to borrow or issue letters of credit from its back-up credit facility. In the event NW Natural is not able to issue new debt due to adverse market conditions or other reasons, NW Natural expects that near-term liquidity needs can be met using internal cash flows, issuing commercial paper, receiving equity contributions from NW Holdings, or, for the NGD segment, drawing upon a committed credit facility. NW Natural also has a universal shelf registration statement filed with the SEC for the issuance of secured and unsecured debt securities. In the event senior unsecured long-term debt ratings are downgraded, or outstanding derivative positions exceed a certain credit threshold, counterparties under derivative contracts could require NW Natural to post cash, a letter of credit, or other forms of collateral, which could expose NW Natural to additional cash requirements and may trigger increases in short-term borrowings while in a net loss position. NW Natural was not required to post collateral at December 31, 2019. However, if the credit risk-related contingent features underlying these contracts were triggered on December 31, 2019, assuming long-term debt ratings dropped to non-investment grade levels, NW Natural could have been required to post $0.1 million in collateral with our counterparties. See "Credit Ratings" below and Note 16. Other items that may have a significant impact on NW Natural's liquidity and capital resources include NW Natural's pension contribution requirements and environmental expenditures. PENSION CONTRIBUTION. NW Natural expects to make contributions to its company-sponsored defined benefit plan, which is closed to new employees, over the next several years until the plan is fully funded under the Pension Protection Act rules, including the rules issued under the Moving Ahead for Progress in the 21st Century Act (MAP-21), as amended. See "Application of Critical Accounting Policies-Accounting for Pensions and Postretirement Benefits" below and Note 10 for more information. ENVIRONMENTAL EXPENDITURES. NW Natural expects to continue using cash resources to fund environmental liabilities. NW Natural has authorizations in Oregon and Washington to defer costs related to remediation of properties that are owned or were previously owned by NW Natural. In Oregon, a Site Remediation and Recovery Mechanism (SRRM) is currently in place to recovery prudently incurred costs allocable to Oregon customers, subject to an earnings test. On October 21, 2019 the WUTC authorized an Environmental Cost Recovery Mechanism (ECRM) for recovery of prudently incurred costs allocable to Washington customers beginning November 1, 2019. See Note 18, and "Results of Operations-Regulatory Matters-Environmental Cost Deferral and Recovery" above. Based on several factors, including current credit ratings, NW Natural's commercial paper program, current cash reserves, committed credit facilities, and an expected ability to issue long-term debt and receive equity contributions from NW Holdings, NW Natural believes its liquidity is sufficient to meet anticipated near-term cash requirements, including all contractual obligations, investing, and financing activities as discussed in "Contractual Obligations" and "Cash Flows" below. NW NATURAL DIVIDENDS. The declarations and amount of future dividends to NW Holdings will depend upon earnings, cash flows, financial condition, the satisfaction of OPUC and WUTC regulatory ring-fencing restrictions, and other factors. The amount and timing of dividends payable on common stock is subject to approval of the NW Natural Board of Directors. OFF-BALANCE SHEET ARRANGEMENTS. Except for certain lease and purchase commitments, NW Holdings and NW Natural have no material off-balance sheet financing arrangements. See "Contractual Obligations" below. In October 2017, NW Natural entered into a 20-year lease agreement for a new corporate operations center location in Portland, Oregon. The existing lease expires in 2020 and after an extensive search and evaluation process with a focus on seismic preparedness, safety, reliability, least cost to customers and a continued commitment to NW Natural's employees and the communities NW Natural serves, NW Natural executed a new lease for suitable commercial office space in Portland, Oregon. Payments under the lease are expected to commence in the third quarter of 2020 and total estimated base rent payments over the 20-year life of the lease are approximately $160 million. NW Natural has the option to extend the term of the lease for two additional seven-year periods. Additionally, the lease was analyzed in consideration of build-to-suit lease accounting guidance with the conclusion that NW Natural is the accounting owner of the asset during construction. As a result, NW Natural recognized $25.5 million during 2018 in property, plant and equipment and an obligation in other non-current liabilities for the same amount on its consolidated balance sheet. These accounting transactions are non-cash in nature, and as such, are not included in the cash flow analysis and capital expenditures forecasts below, and have no impact on short-term liquidity. When the new lease accounting standard, ASC 842, became effective for NW Holdings and NW Natural in 2019, the associated build-to-suit asset and liability were de-recognized in accordance with the new standard. See Note 2 for more information on the impacts of the new lease standard. Contractual Obligations The following table shows contractual obligations from continuing operations at December 31, 2019 by maturity and type of obligation: (1) Postretirement benefit payments primarily consists of two NW Natural items: (1) estimated pension and other postretirement plan payments, which are funded by plan assets and future cash contributions, and (2) required payments to the Western States multiemployer pension plan due to NW Natural's withdrawal from the plan in December 2013. See Note 10. (2) Gas purchases include contracts which use price formulas tied to monthly index prices. The commitment amounts presented incorporate the December 2019 first of month index price for each supply basin from which gas is purchased. For a summary of gas purchase and gas pipeline capacity commitments, see Note 17. (3) Other purchase commitments primarily consist of remaining balances under existing purchase orders. (4) Other long-term liabilities includes accrued deferred compensation plan liabilities for executives and directors. The timing of these payments are uncertain; however, these payments are unlikely to all occur in the next 12 months. (5) Short- and long-term obligations include short- and long-term debt obligations and other immaterial liabilities. In addition to known contractual obligations listed in the above table, NW Natural has also recognized liabilities for future environmental remediation or action. The exact timing of payments beyond 12 months with respect to those liabilities cannot be reasonably estimated due to numerous uncertainties surrounding the course of environmental remediation and the preliminary nature of site investigations. See Note 18 for a further discussion of environmental remediation cost liabilities. At December 31, 2019, 626 of NW Natural's natural gas distribution employees were members of the Office and Professional Employees International Union (OPEIU) Local No. 11. In November 2019, union employees ratified a new collective bargaining agreement that took effect on December 1, 2019, expires on May 31, 2024, and is effective thereafter from year to year unless either party serves notice of its intent to negotiate modifications to the collective bargaining agreement. The remaining terms of the collective bargaining agreement include the following items: a 1.5% wage increase effective December 1, 2019, a 2.0% wage increase effective June 1, 2020, and scheduled wage increases effective June 1 of each subsequent year of 3.5%; competitive health benefits, including 15% to 20% premium cost sharing by employees; a 401(k) contribution of 4% for employees hired after our pension plan was closed on December 31, 2009; and a 401(k) match of 50% of the first 8% of savings. Short-Term Debt The primary source of short-term liquidity for NW Holdings is cash balances, dividends from its operating subsidiaries, in particular NW Natural, available cash from a multi-year credit facility, and short-term credit facilities it may enter into from time to time. The primary source of short-term liquidity for NW Natural is from the sale of commercial paper, available cash from a multi-year credit facility, and short-term credit facilities. NW Natural has a separate commercial paper program and separate bank facilities. In addition to issuing commercial paper or bank loans to meet working capital requirements, including seasonal requirements to finance gas purchases and accounts receivable, short-term debt may also be used to temporarily fund capital requirements. For NW Natural, commercial paper and bank loans are periodically refinanced through the sale of long-term debt or equity contributions from NW Holdings. Commercial paper, when outstanding, is sold through two commercial banks under an issuing and paying agency agreement and is supported by one or more unsecured revolving credit facilities. See “Credit Agreements” below. At December 31, 2019 and 2018, NW Holdings had short-term debt outstanding of $149.1 million and $217.6 million, respectively, and NW Natural had short-term debt outstanding of $125.1 million and $217.5 million, respectively. The weighted average interest rate on short-term debt outstanding at December 31, 2019 and 2018 was 2.0% and 3.0%, respectively, at both NW Holdings and NW Natural. Credit Agreements NW Holdings NW Holdings has a $100 million credit agreement, with a feature that allows it to request increases in the total commitment amount, up to a maximum of $150 million. The maturity date of the agreement is October 2, 2023, with available extensions of commitments for two additional one-year periods, subject to lender approval. All lenders under the NW Holdings credit agreement are major financial institutions with committed balances and investment grade credit ratings as of December 31, 2019 as follows: Based on credit market conditions, it is possible one or more lending commitments could be unavailable to NW Holdings if the lender defaulted due to lack of funds or insolvency; however, NW Holdings does not believe this risk to be imminent due to the lenders' strong investment-grade credit ratings. The NW Holdings credit agreement permits the issuance of letters of credit in an aggregate amount of up to $40 million. The principal amount of borrowings under the credit agreement is due and payable on the maturity date. The credit agreement requires NW Holdings to maintain a consolidated indebtedness to total capitalization ratio of 70% or less. Failure to comply with this covenant would entitle the lenders to terminate their lending commitments and accelerate the maturity of all amounts outstanding. NW Holdings was in compliance with this covenant at December 31, 2019 and 2018, with consolidated indebtedness to total capitalization ratios of 54.3% and 55.6%, respectively. The agreement also requires NW Holdings to maintain debt ratings (which are defined by a formula using NW Natural's credit ratings in the event NW Holdings does not have a credit rating) with Standard & Poor's (S&P) and Moody's Investors Service, Inc. (Moody’s) and notify the lenders of any change in its senior unsecured debt ratings or senior secured debt ratings, as applicable, by such rating agencies. A change in NW Holdings' debt ratings by S&P or Moody’s is not an event of default, nor is the maintenance of a specific minimum level of debt rating a condition of drawing upon the credit agreement. Rather, interest rates on any loans outstanding under the credit agreements are tied to debt ratings and therefore, a change in the debt rating would increase or decrease the cost of any loans under the credit agreements when ratings are changed. NW Holdings does not currently maintain ratings with S&P or Moody's. Interest charges on the credit agreement are indexed to the London Interbank Offered Rate (LIBOR). The agreement contains a provision to transition to an equivalent replacement rate upon the phase-out of LIBOR in 2021. NW Holdings had $1.0 million and $2.8 million of letters of credit issued and outstanding in support of acquisitions of water companies, separate from the aforementioned credit agreement, at December 31, 2019 and 2018, respectively. The $1.0 million letter of credit outstanding at NW Holdings as of December 31, 2019 for purposes of facilitating the Suncadia acquisition was extinguished after the close of the transaction on January 31, 2020. NW Natural NW Natural has a multi-year credit agreement for unsecured revolving loans totaling $300 million, with a feature that allows NW Natural to request increases in the total commitment amount, up to a maximum of $450 million. The maturity date of the agreement is October 2, 2023 with an available extension of commitments for two additional one-year periods, subject to lender approval. All lenders under the NW Natural credit agreement are major financial institutions with committed balances and investment grade credit ratings as of December 31, 2019 as follows: Based on credit market conditions, it is possible one or more lending commitments could be unavailable to NW Natural if the lender defaulted due to lack of funds or insolvency; however, NW Natural does not believe this risk to be imminent due to the lenders' strong investment-grade credit ratings. The NW Natural credit agreement permits the issuance of letters of credit in an aggregate amount of up to $60 million. The principal amount of borrowings under the credit agreement is due and payable on the maturity date. There were no outstanding balances under this credit agreement or the prior credit agreement at December 31, 2019 or 2018. The credit agreement requires NW Natural to maintain a consolidated indebtedness to total capitalization ratio of 70% or less. Failure to comply with this covenant would entitle the lenders to terminate their lending commitments and accelerate the maturity of all amounts outstanding. NW Natural was in compliance with this covenant at December 31, 2019 and 2018, with consolidated indebtedness to total capitalization ratios of 54.1% and 57.1%, respectively. The agreement also requires NW Natural to maintain credit ratings with S&P and Moody’s and notify the lenders of any change in NW Natural's senior unsecured debt ratings or senior secured debt ratings, as applicable, by such rating agencies. A change in NW Natural's debt ratings by S&P or Moody’s is not an event of default, nor is the maintenance of a specific minimum level of debt rating a condition of drawing upon the credit agreement. Rather, interest rates on any loans outstanding under the agreement are tied to debt ratings and therefore, a change in the debt rating would increase or decrease the cost of any loans under the credit agreement when ratings are changed. See "Credit Ratings" below. Interest charges on the credit agreement are indexed to LIBOR. The agreement contains a provision to transition to an equivalent replacement rate upon the phase-out of LIBOR in 2021. Credit Ratings NW Holdings does not currently maintain ratings with S&P or Moody's. NW Natural's credit ratings are a factor of liquidity, potentially affecting access to the capital markets including the commercial paper market. NW Natural's credit ratings also have an impact on the cost of funds and the need to post collateral under derivative contracts. The following table summarizes NW Natural's current credit ratings: In May 2019, Moody's revised NW Natural's ratings outlook from negative to stable. In addition, the senior secured (long-term debt) rating changed from A1 to A2 and the senior unsecured (long-term debt) rating was revised from A3 to Baa1. The above credit ratings and ratings outlook are dependent upon a number of factors, both qualitative and quantitative, and are subject to change at any time. The disclosure of or reference to these credit ratings is not a recommendation to buy, sell or hold NW Holdings or NW Natural securities. Each rating should be evaluated independently of any other rating. As part of the ring-fencing conditions agreed upon with the OPUC and WUTC in connection with the holding company reorganization, NW Holdings and NW Natural are required to maintain separate credit ratings, long-term debt ratings, and preferred stock ratings, if any. Long-Term Debt The following NW Natural debentures were retired in the periods indicated: In June 2019, NWN Water, a wholly-owned subsidiary of NW Holdings, entered into a two-year term loan agreement for $35.0 million. The loan carried an interest rate of 2.35% at December 31, 2019, which is based upon the one-month LIBOR rate. The loan is guaranteed by NW Holdings and requires NW Holdings to maintain a consolidated indebtedness to total capitalization ratio of 70% or less. Failure to comply with this covenant would entitle the lenders to terminate their lending commitments and accelerate the maturity of all amounts outstanding. NW Holdings was in compliance with this covenant at December 31, 2019, with a consolidated indebtedness to total capitalization ratio of 54.3%. In June 2019, NW Natural issued $140.0 million of FMBs consisting of $50.0 million with an interest rate of 3.141%, due in 2029, and $90.0 million with an interest rate of 3.869%, due in 2049. In September 2019, NW Natural retired $10.0 million of FMBs with an interest rate of 8.310%, and retired $20.0 million of FMBs with an interest rate of 7.630% in December 2019. $75.0 million of FMBs with an interest rate of 5.370% matured in February 2020. No other long-term debt is scheduled to mature over the next twelve months. See "Financial Condition-Contractual Obligations" above for long-term debt maturing over the next five years. Bankruptcy Ring-fencing Restrictions As part of the ring-fencing conditions agreed upon with the OPUC and WUTC in connection with the holding company reorganization, NW Natural is required to have one director who is independent from NW Natural management and from NW Holdings and to issue one share of NW Natural preferred stock to an independent third party. NW Natural was in compliance with both of these ring-fencing provisions as of December 31, 2019 and 2018. NW Natural may file a voluntary petition for bankruptcy only if approved unanimously by the Board of Directors of NW Natural, including the independent director, and by the holder of the preferred share. Cash Flows Operating Activities Changes in our operating cash flows are primarily affected by net income or loss, changes in working capital requirements, and other cash and non-cash adjustments to operating results. Operating activity highlights include: The significant drivers of changes in cash provided by operating activities discussed below apply to both NW Holdings and NW Natural. 2019 COMPARED TO 2018. The significant factors contributing to the $16.5 million and $12.7 million increases in NW Holdings and NW Natural cash flow provided by operating activities, respectively, were as follows: • an increase of $27.5 million at NW Holdings and $24.9 million at NW Natural due to net income tax refunds in 2019 compared to payments in 2018. The refunds were primarily due to bonus depreciation taken on NW Natural's North Mist gas storage expansion which was placed into service in May 2019, as well as $6.0 million in income taxes paid in 2018 and refunded to NW Natural in 2019; • an increase of $10.6 million from collections of both current and deferred pension expenses as a result of NW Natural's Oregon rate case; and • an increase of $4.6 million due to lower contributions paid to qualified defined benefit pension plans in the current period compared to prior periods; partially offset by • a net decrease of $28.5 million at NW Natural from changes in receivables, inventories, and accounts payable, primarily reflecting increased gas purchase expenditures from average weather in the current period compared to warmer-than average weather in the prior period as well as higher gas costs than those included in customer rates. 2018 COMPARED TO 2017. The significant factors contributing to the $37.9 million and $33.0 million decreases in NW Holdings and NW Natural cash flow provided by operating activities, respectively, were as follows: • a decrease of $31.5 million in cash flow benefits from changes in deferred gas cost balances primarily due to higher gas prices in the fourth quarter of 2018 and lower current year PGA rates reflecting over-collections of certain fixed costs from customers in the prior year when weather was colder than average; • a decrease of $12.6 million due to $27.4 million income taxes paid in 2018 due to the elimination of bonus depreciation as a result of the TCJA, compared to income taxes paid of $14.8 million in 2017; partially offset by • a net increase of $10.2 million from changes in working capital related to receivables, inventories, and accounts payable reflecting warmer than average weather in 2018 compared to the prior period; and • an increase of $3.9 million due to a decrease in contributions paid to qualified defined benefit pension plans. During the year ended December 31, 2019, NW Natural contributed $11.0 million to its qualified defined benefit pension plan, compared to $15.5 million for 2018 and $19.4 million in 2017. The amount and timing of future contributions will depend on market interest rates and investment returns on the plans’ assets. See Note 10. Bonus income tax depreciation of 50% was available in 2017 for a large portion of capital expenditures, and bonus depreciation of 40% was available in 2019 for a large portion of North Mist gas storage expansion capital expenditures for federal and Oregon purposes. This reduced taxable income and provided cash flow benefits in 2017 and 2019. As a result of the enactment of the TCJA on December 22, 2017, bonus depreciation was eliminated for other NGD business property acquired and placed in service after December 31, 2017. Accordingly, bonus depreciation was not available for such property in 2018 and 2019, and we do not anticipate similar cash flow benefits related to bonus depreciation in the future. We have lease and purchase commitments relating to our operating activities that are financed with cash flows from operations. For information on cash flow requirements related to leases and other purchase commitments, see “Financial Condition-Contractual Obligations” above and Note 17. Investing Activities Investing activity highlights include: 2019 COMPARED TO 2018. Cash used in investing activities increased $86.3 million and $4.6 million at NW Holdings and NW Natural, respectively. The increase at NW Natural was driven by continued capital expenditures for customer growth, system reinforcement, and technology, as well as leasehold improvement additions at NW Natural's new corporate operations center. The increase was partially offset by lower capital expenditures due to the completion of the North Mist gas storage expansion in May 2019. The increase at NW Holdings was driven by $55.9 million higher expenditures for acquisitions, net of cash acquired. 2018 COMPARED TO 2017. The $3.3 million increase in cash used in investing activities at NW Holdings was primarily due to continued capital expenditures primarily related to NW Natural's North Mist gas storage expansion facility as well as customer growth, system reinforcement, technology, and facilities. The additional increase in cash used in investing activities at NW Natural was primarily due to NW Natural's initial cash contribution of $20 million to its then subsidiary, and now parent, NW Holdings. NW Holdings capital expenditures in 2020 are anticipated to be between $240 million and $280 million, of which between $230 million and $270 million are anticipated to occur at the NGD business. The total capital investment for the five-year period from 2020 to 2024 is expected to range from $980 million to $1.14 billion, with $950 million to $1.10 billion relating to the natural gas distribution segment and $30 million to $40 million related to maintenance capital expenditures for water utilities we currently own or have under a purchase and sale agreement. The timing and amount of the core capital expenditures and projects for 2020 and the next five years could change based on regulation, growth, and cost estimates. Additional investments in our infrastructure during and after 2020 that are not incorporated in the estimates provided above will depend largely on additional regulations, growth, and expansion opportunities. Required funds for the investments are expected to be internally generated or financed with long-term debt or equity, as appropriate. Financing Activities Financing activity highlights include: 2019 COMPARED TO 2018. Cash provided by financing activities increased $57.7 million and decreased $14.9 million at NW Holdings and NW Natural, respectively. The decrease in cash provided by financing activities at NW Natural was primarily driven by $255.7 million in higher repayments of short-term debt compared to the prior period and $15.0 million higher cash dividends paid. The decrease was partially offset by net issuances of $110.0 million in long-term debt in the current period compared to net repayments of $47.0 million in the prior period as well as a capital contribution from NW Holdings to NW Natural of $93.0 million. The increase at NW Holdings was primarily due to proceeds of $93.0 million from the June 2019 issuance of NW Holdings common stock, the issuance of $35.0 million of long-term debt at NW Natural Water, and short-term debt issuances of $24 million at NW Holdings. These increases were partially offset by the debt activity at NW Natural described above. 2018 COMPARED TO 2017. The $50.4 million increase in cash provided by financing activities at NW Holdings was primarily due to $162.4 million higher short-term debt issuances, partially offset by $107.0 million lower net proceeds from long-term debt activity in 2018. NW Natural cash provided by financing activities was $12.0 million higher in comparison to NW Holdings primarily due to the payment of the November 15, 2018 dividend to NW Holdings shareholders using NW Holdings funds. Pension Cost and Funding Status of Qualified Retirement Plans NW Natural's pension costs are determined in accordance with accounting standards for compensation and retirement benefits. See “Application of Critical Accounting Policies and Estimates - Pensions and Postretirement Benefits” below. Pension expense for NW Natural's qualified defined benefit plan, which is allocated between operations and maintenance expenses, capital expenditures, and through October 31, 2018, the deferred regulatory balancing account, totaled $16.5 million in 2019, a decrease of $4.2 million from 2018. The fair market value of pension assets in this plan increased to $313.1 million at December 31, 2019 from $257.8 million at December 31, 2018. The increase was due to a gain on plan assets of $65.1 million and $11.0 million in employer contributions, partially offset by benefit payments of $20.8 million. Contributions made to NW Natural's company-sponsored qualified defined benefit pension plan are based on actuarial assumptions and estimates, tax regulations, and funding requirements under federal law. The qualified defined benefit pension plan was underfunded by $164.3 million at December 31, 2019. NW Natural plans to make contributions during 2020 of $29.0 million. See Note 10 for further pension disclosures. Contingent Liabilities Loss contingencies are recorded as liabilities when it is probable that a liability has been incurred and the amount of the loss is reasonably estimable in accordance with accounting standards for contingencies. See “Application of Critical Accounting Policies and Estimates” below. At December 31, 2019, NW Natural's total estimated liability related to environmental sites was $136.0 million. See Note 18 and "Results of Operations-Regulatory Matters-Rate Mechanisms-Environmental Cost Deferral and Recovery" above. NW Holdings is not currently party to any direct claims or litigation, though in the future it may be subject to claims and litigation arising in the ordinary course of business. New Accounting Pronouncements For a description of recent accounting pronouncements that may have an impact on our financial condition, results of operations, or cash flows, see Note 2. APPLICATION OF CRITICAL ACCOUNTING POLICIES AND ESTIMATES In preparing financial statements in accordance with U.S. GAAP, management exercises judgment in the selection and application of accounting principles, including making estimates and assumptions that affect reported amounts of assets, liabilities, revenues, expenses, and related disclosures in the financial statements. Management considers critical accounting policies to be those which are most important to the representation of financial condition and results of operations and which require management’s most difficult and subjective or complex judgments, including accounting estimates that could result in materially different amounts if reported under different conditions or used different assumptions. Our most critical estimates and judgments for both NW Holdings and NW Natural include accounting for: • regulatory accounting; • revenue recognition; • derivative instruments and hedging activities; • pensions and postretirement benefits; • income taxes; • environmental contingencies; and • impairment of long-lived assets and goodwill. Management has discussed its current estimates and judgments used in the application of critical accounting policies with the Audit Committees of the Boards of NW Holdings and NW Natural. Within the context of critical accounting policies and estimates, management is not aware of any reasonably likely events or circumstances that would result in materially different amounts being reported. Regulatory Accounting The NGD segment is regulated by the OPUC and WUTC, which establish the rates and rules governing services provided to customers, and, to a certain extent, set forth special accounting treatment for certain regulatory transactions. In general, the same accounting principles as non-regulated companies reporting under U.S. GAAP are used. However, authoritative guidance for regulated operations (regulatory accounting) requires different accounting treatment for regulated companies to show the effects of such regulation. For example, NW Natural accounts for the cost of gas using a PGA deferral and cost recovery mechanism, which is submitted for approval annually to the OPUC and WUTC. See "Results of Operations-Regulatory Matters-Rate Mechanisms-Purchased Gas Adjustment" above. There are other expenses and revenues that the OPUC or WUTC may require NW Natural to defer for recovery or refund in future periods. Regulatory accounting requires NW Natural to account for these types of deferred expenses (or deferred revenues) as regulatory assets (or regulatory liabilities) on the balance sheet. When the recovery of these regulatory assets from, or refund of regulatory liabilities to, customers is approved, NW Natural recognizes the expense or revenue on the income statement at the same time the adjustment to amounts included in rates charged to customers. The conditions that must be satisfied to adopt the accounting policies and practices of regulatory accounting include: • an independent regulator sets rates; • the regulator sets the rates to cover specific costs of delivering service; and • the service territory lacks competitive pressures to reduce rates below the rates set by the regulator. Because NW Natural's NGD operations satisfy all three conditions, NW Natural continues to apply regulatory accounting to NGD operations. Future accounting changes, regulatory changes, or changes in the competitive environment could require NW Natural to discontinue the application of regulatory accounting for some or all of our regulated businesses. This would require the write-off of those regulatory assets and liabilities that would no longer be probable of recovery from or refund to customers. Based on current accounting and regulatory competitive conditions, NW Natural believes it is reasonable to expect continued application of regulatory accounting for NGD activities. Further, it is reasonable to expect the recovery or refund of NW Natural's regulatory assets and liabilities at December 31, 2019 through future customer rates. If it is determined that all or a portion of these regulatory assets or liabilities no longer meet the criteria for continued application of regulatory accounting, then NW Natural would be required to write-off the net unrecoverable balances against earnings in the period such determination is made. The net balance in regulatory asset and liability accounts was a net liability of $285.3 million and a net liability of $245.3 million as of December 31, 2019 and 2018, respectively. See Note 2 for more detail on regulatory balances. Revenue Recognition Revenues, which are derived primarily from the sale, transportation, and storage of natural gas, are recognized upon the delivery of gas commodity or services rendered to customers. Accrued Unbilled Revenue For a description of the policy regarding accrued unbilled revenue, most of which relates to the NGD business at NW Natural, see Note 2. The following table presents changes in key metrics if the estimated percentage of unbilled volume at December 31 was adjusted up or down by 1%: (1) Includes impact of regulatory mechanisms including decoupling mechanism and excludes the impact of unbilled revenue from water services. Derivative Instruments and Hedging Activities NW Natural's gas acquisition and hedging policies set forth guidelines for using financial derivative instruments to support prudent risk management strategies. These policies specifically prohibit the use of derivatives for trading or speculative purposes. Financial derivative contracts are utilized to hedge a portion of natural gas sale requirements. These contracts include swaps, options, and combinations of option contracts. NW Natural primarily uses these derivative financial instruments to manage commodity price variability. A small portion of NW Natural's derivative hedging strategy involves foreign currency exchange contracts. Derivative instruments are recorded on the balance sheet at fair value. If certain regulatory conditions are met, then the derivative instrument fair value is recorded together with an offsetting entry to a regulatory asset or liability account pursuant to regulatory accounting, and no unrealized gain or loss is recognized in current income or loss. See "Regulatory Accounting" above for additional information. The gain or loss from the fair value of a derivative instrument subject to regulatory deferral is included in the recovery from, or refund to, NGD business customers in future periods. If a derivative contract is not subject to regulatory deferral, then the accounting treatment for unrealized gains and losses is recorded in accordance with accounting standards for derivatives and hedging which is either in current income or loss or in accumulated other comprehensive income or loss (AOCI or AOCL). Derivative contracts outstanding at December 31, 2019, 2018 and 2017 were measured at fair value using models or other market accepted valuation methodologies derived from observable market data. Estimates of fair value may change significantly from period-to-period depending on market conditions, notional amounts, and prices. These changes may have an impact on results of operations, but the impact would largely be mitigated due to the majority of derivative activities being subject to regulatory deferral treatment. For more information on derivative activity and associated regulatory treatment, see Note 2 and Note 16. The following table summarizes the amount of losses realized from commodity price transactions for the last three years: Realized gains and losses from commodity hedges shown above were recorded in cost of gas and were, or will be, included in annual PGA rates. Pensions and Postretirement Benefits NW Natural maintains a qualified non-contributory defined benefit pension plan, non-qualified supplemental pension plans for eligible executive officers and certain key employees, and other postretirement employee benefit plans covering certain non-union employees. NW Natural also has a qualified defined contribution plan (Retirement K Savings Plan) for all eligible employees. Only the qualified defined benefit pension plan and Retirement K Savings Plan have plan assets, which are held in qualified trusts to fund the respective retirement benefits. The qualified defined benefit retirement plan for union and non-union employees was closed to new participants several years ago. Non-union and union employees hired or re-hired after December 31, 2006 and 2009, respectively, and employees of certain NW Holdings subsidiaries are provided an enhanced Retirement K Savings Plan benefit. The postretirement Welfare Benefit Plan for non-union employees was also closed to new participants several years ago. Net periodic pension and postretirement benefit costs (retirement benefit costs) and projected benefit obligations (benefit obligations) are determined using a number of key assumptions including discount rates, rate of compensation increases, retirement ages, mortality rates and an expected long-term return on plan assets. See Note 10. Accounting standards also require balance sheet recognition of unamortized actuarial gains and losses and prior service costs in AOCI or AOCL, net of tax. However, the retirement benefit costs related to qualified defined benefit pension and postretirement benefit plans are generally recovered in rates charged to NGD customers, which are set based on accounting standards for pensions and postretirement benefit expenses. As such, NW Natural received approval from the OPUC to recognize the unamortized actuarial gains and losses and prior service costs as a regulatory asset or regulatory liability based on expected rate recovery, rather than including it as AOCI or AOCL under common equity. See "Regulatory Accounting" above and Note 2, "Industry Regulation". In 2011, NW Natural received regulatory approval from the OPUC and began deferring a portion of pension expense above or below the amount set in rates to a regulatory balancing account on the balance sheet. As part of general rate case proceedings, on October 26, 2018, the OPUC issued an order to freeze NW Natural's pension balancing account as of October 31, 2018. In March 2019, the OPUC issued an order resolving the remaining open items for NW Natural's 2018 Oregon general rate case regarding recovery of the pension balancing account. At December 31, 2019, the cumulative amount deferred for future pension cost recovery was $54.2 million, including accrued interest. The regulatory balancing account includes the recognition of accrued interest on the account balance at NW Natural's authorized rate of return from 2011 through October 31, 2018, and at 4.3% thereafter. See "Regulatory Matters - Rate Mechanisms - Pension Cost Deferral and Pension Balancing Account" above for more information. A number of factors, as discussed above, are considered in developing pension and postretirement benefit assumptions. For the December 31, 2019 measurement date, NW Natural reviewed and updated: • the weighted-average discount rate assumptions for pensions decreased from 4.20% for 2018 to 3.16% for 2019, and our weighted-average discount rate assumptions for other postretirement benefits decreased from 4.13% for 2018 to 3.11% for 2019. The new rate assumptions were determined for each plan based on a matching of benchmark interest rates to the estimated cash flows, which reflect the timing and amount of future benefit payments. Benchmark interest rates are drawn from the FTSE Above Median Curve, which consists of high quality bonds rated AA- or higher by S&P or Aa3 or higher by Moody’s; • the expected annual rate of future compensation increases for bargaining unit employees, which was updated from a range of 3.25% to 3.50% for 2018, to the 2019 assumption of 6.50% in 2020 and 3.50% thereafter. The increase was a result of a new collective bargaining agreement that took effect December 1, 2019. The assumed range of 3.25% to 3.50% for non-bargaining employees remained unchanged; • the expected long-term return on qualified defined benefit plan assets decreased from 7.50% to 7.25%; • the mortality rate assumptions were updated RP-2014 mortality tables using scale MP-2018 to Pri-2012 mortality tables using scale MP-2019, which partially offset the increase of our projected benefit obligation; and • other key assumptions, which were based on actual plan experience and actuarial recommendations. At December 31, 2019, the net pension liability (benefit obligations less market value of plan assets) for NW Natural's qualified defined benefit plan increased $1.9 million compared to 2018. The increase in the net pension liability is primarily due to the $57.1 million increase to the pension benefit obligation, partially offset by a $55.3 million increase in plan assets. The liability for non-qualified plans increased $3.0 million, and the liability for other postretirement benefits increased $1.4 million in 2019. The expected long-term rate of return on plan assets is determined by averaging the expected earnings for the target asset portfolio. In developing expected return, historical actual performance and long-term return projections are analyzed, which gives consideration to the current asset mix and target asset allocation. NW Natural believes its pension assumptions are appropriate based on plan design and an assessment of market conditions. The following shows the sensitivity of retirement benefit costs and benefit obligations to changes in certain actuarial assumptions: In July 2012, President Obama signed MAP-21 into law. This legislation changed several provisions affecting pension plans, including temporary funding relief and Pension Benefit Guaranty Corporation (PBGC) premium increases, which shifts the level of minimum required contributions from the short-term to the long-term as well as increasing the operational costs of running a pension plan. MAP-21 established a new minimum and maximum corridor for segment rates based on a 25-year average of bond yields, which resulted in lower minimum contributions requirements than those under previous regulations. MAP-21, as amended, provides for the current corridor to be in effect through 2020 and subsequently broaden on an annual basis from 2021 through 2024. Income Taxes Valuation Allowances Deferred tax assets are recognized to the extent that these assets are believed to be more likely than not to be realized. In making such a determination, available positive and negative evidence is considered, including future reversals of existing taxable temporary differences, projected future taxable income, tax-planning strategies, and results of recent operations. NW Holdings and NW Natural have determined that all recorded deferred tax assets are more likely than not to be realized as of December 31, 2019. See Note 11. Uncertain Tax Benefits The calculation of tax liabilities involves dealing with uncertainties in the application of complex tax laws and regulations in the jurisdictions in which we operate. A tax benefit from a material uncertain tax position will only be recognized when it is more likely than not that the position, or some portion thereof, will be sustained upon examination, including resolution of any related appeals or litigation processes, on the basis of the technical merits. NW Holdings and NW Natural participate in the Compliance Assurance Process (CAP) with the Internal Revenue Service (IRS). Under the CAP program companies work with the IRS to identify and resolve material tax matters before the federal income tax return is filed each year. No reserves for uncertain tax benefits were recorded during 2019, 2018, or 2017. See Note 11. Tax Legislation When significant proposed or enacted changes in income tax rules occur we consider whether there may be a material impact to our financial position, results of operations, cash flows, or whether the changes could materially affect existing assumptions used in making estimates of tax related balances. On December 22, 2017, 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, also known as the Tax Cuts and Jobs Act (TCJA), was enacted. The TCJA lowers the U.S. federal corporate income tax rate to 21% from the existing maximum rate of 35%, effective for our tax year beginning January 1, 2018. The TCJA includes specific provisions related to regulated public utilities that generally provide for the continued deductibility of interest expense and the elimination of bonus depreciation. Certain rate normalization requirements for accelerated cost recovery benefits related to regulated plant balances also continue. See Note 11 for more information on how we are impacted by the TCJA. With respect to other tax legislation, the final tangible property regulations applicable to all taxpayers were issued on September 13, 2013 and were generally effective for taxable years beginning on or after January 1, 2014. In addition, procedural guidance related to the regulations was issued under which taxpayers may make accounting method changes to comply with the regulations. We have evaluated the regulations and do not anticipate any material impact. However, unit-of-property guidance applicable to natural gas distribution networks has not yet been issued and is expected in the near future. We will further evaluate the effect of these regulations after this guidance is issued, but believe the current method is materially consistent with the new regulations and do not expect this additional guidance to have a material effect on our financial statements. Regulatory Matters Regulatory tax assets and liabilities are recorded to the extent it is probable they will be recoverable from, or refunded to, customers in the future. At December 31, 2019 and 2018, NW Natural had net regulatory income tax assets of $19.4 million and $21.4 million, respectively, representing future rate recovery of deferred tax liabilities resulting from differences in NGD plant financial statement and tax bases and NGD plant removal costs. These regulatory assets are currently being recovered through customer rates. At December 31, 2019 and 2018, regulatory income tax assets of $2.5 million and $2.3 million, respectively, were recorded by NW Natural, representing probable future rate recovery of deferred tax liabilities resulting from the equity portion of AFUDC. At December 31, 2019 and 2018, regulatory liability balances, representing the estimated net benefit to NGD customers resulting from the change in deferred taxes as a result of the TCJA, of $205.0 million and $217.1 million, respectively, were recorded by NW Natural. These balances include a gross up for income taxes of $54.3 million and $57.5 million, respectively. The TCJA includes specific guidance for determining the shortest time period over which the portion of this regulatory liability resulting from accelerated cost recovery of NGD plant may accrue to the benefit of customers to avoid incurring federal normalization penalties. However, it is anticipated that until such time that customers receive the direct benefit of this regulatory liability, the balance, net of the additional gross up for income taxes, will continue to provide an indirect benefit to customers by reducing the NGD rate base which determines customer rates for service. Regulatory orders were issued by Oregon in March 2019 and by Washington in October 2019 addressing the provision of these TCJA tax benefits to customers. See "Regulatory Matters-Regulatory Proceeding Updates-Tax Reform Deferral" for more information. NGD rates in effect for Oregon through October 31, 2018 and for Washington through October 31, 2019 included an allowance to provide for the recovery of the anticipated provision for income taxes incurred as a result of providing regulated services. The provision for income taxes during these periods included an allowance for federal income taxes determined by utilizing the pre-TCJA federal corporate income tax rate of 35 percent. NW Natural recorded an additional regulatory liability in 2018 and 2019 reflecting the deferral of estimated rate benefit for customers due to the newly enacted 21 percent federal corporate income tax rate. As of December 31, 2019 and 2018, regulatory liabilities of $1.7 million and $8.3 million, respectively, were recorded to reflect the estimated revenue deferral benefit to be provided to Oregon and Washington customers. Environmental Contingencies Environmental liabilities are accounted for in accordance with accounting standards under the loss contingency guidance when it is probable that a liability has been incurred and the amount of the loss is reasonably estimable. Amounts recorded for environmental contingencies take numerous factors into consideration, including, among other variables, changes in enacted laws, regulatory orders, estimated remediation costs, interest rates, insurance proceeds, participation by other parties, timing of payments, and the input of legal counsel and third-party experts. Accordingly, changes in any of these variables or other factual circumstances could have a material impact on the amounts recorded for our environmental liabilities. For a complete discussion of environmental accounting policies refer to Note 2. For a discussion of current environmental sites and liabilities refer to Note 18. In addition, for information regarding the regulatory treatment of these costs and NW Natural's regulatory recovery mechanism, see "Results of Operations-Regulatory Matters-Rate Mechanisms-Environmental Cost Deferral and Recovery" above. Impairment of Long-Lived Assets and Goodwill Long-lived assets We review the carrying value of long-lived assets whenever events or changes in circumstances indicate the carrying amount of the assets might not be recoverable. Factors that would necessitate an impairment assessment of long-lived assets include a significant adverse change in the extent or manner in which the asset is used, a significant adverse change in legal factors or business climate that could affect the value of the asset, or a significant decline in the observable market value or expected future cash flows of the asset, among others. When such factors are present, we assess the recoverability by determining whether the carrying value of the asset will be recovered through expected future cash flows. An asset is determined to be impaired when the carrying value of the asset exceeds the expected undiscounted future cash flows from the use and eventual disposition of the asset. If an impairment is indicated, we record an impairment loss for the difference between the carrying value and the fair value of the long-lived assets. Fair value is estimated using appropriate valuation methodologies, which may include an estimate of discounted cash flows. In the fourth quarter of 2017, we recognized a non-cash pre-tax impairment of long-lived assets at the Gill Ranch Facility of $192.5 million. We determined circumstances existed that indicated the carrying value of the assets may not be recoverable. Those circumstances included the completion of a comprehensive strategic review process that evaluated various alternatives including a potential sale, as well as contracting for available storage at lower than anticipated values for the coming storage year. Given these considerations, management was required to re-evaluate the estimated cash flows from our interests in the Gill Ranch Facility, and determined that those estimated cash flows were no longer sufficient to cover the carrying value of the assets. We used the income approach to estimate fair value, using the estimated future net cash flows. We also compared the results of the income approach to our own recent sale experience and recent market comparable transactions in order to estimate fair value. Many factors and assumptions impact the net cash flows used. The most significant and uncertain estimates included our forecast of gas storage pricing, our ability to successfully identify and contract with higher-value customers in and/or near the northern California market that Gill Ranch serves, and exploring the possibility of providing energy storage services such as compressed gas energy storage (CGES). After completing the strategic evaluation, which included a potential sale in the fourth quarter of 2017, we lowered our views of a near-term market recovery and decreased the likelihood associated with contracting with higher-value customers. These changes were the most significant estimates that caused our cash flow projections to decrease to a point where they were no longer sufficient to cover the carrying value of the asset. On June 20, 2018, NWN Gas Storage, NW Holdings' wholly-owned subsidiary, entered into a Purchase and Sale Agreement that provides for the sale by NWN Gas Storage of all of the membership interests in Gill Ranch. As a result of our strategic shift away from California gas storage operations and the significance of Gill Ranch's financial results in 2017, we concluded that the pending sale of Gill Ranch qualifies as assets and liabilities held for sale and discontinued operations. As such, the assets and liabilities associated with Gill Ranch have been classified as discontinued operations assets and discontinued operations liabilities, respectively, and, the results of Gill Ranch are presented separately from the results of continuing operations, net of tax, as discontinued operations for the consolidated results of NW Holdings in all periods presented. The expenses included in the results of discontinued operations within the consolidated results of NW Holdings are the direct operating expenses incurred by Gill Ranch that may be reasonably segregated from the costs of our continuing operations. See "Results of Operations - Pending Sale of Gill Ranch Storage" above, Note 4, and Note 19 for additional information. Goodwill and Business Combinations In a business combination, goodwill is initially measured as any excess of the acquisition-date fair value of the consideration transferred over the acquisition-date fair value of the net identifiable assets acquired. The carrying value of goodwill is reviewed annually during the fourth quarter using balances as of October 1, or whenever events or changes in circumstance indicate that such carrying values may not be recoverable. NW Holdings and NW Natural early-adopted ASU 2017-04, "Simplifying the Test for Goodwill Impairment" in the third quarter of 2018. The ASU removes Step 2 from the goodwill impairment test and under the amended guidance an entity should perform its annual goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount and recognize an impairment charge for the amount in which the carrying amounts exceed the fair value of the reporting unit. In accordance with the updated guidance per ASU 2017-04, NW Holdings' and NW Natural's policy for goodwill assessments begins with a qualitative analysis in which events and circumstances are evaluated, including macroeconomic conditions, industry and market conditions, regulatory environments, and the overall financial performance of the reporting unit. If the qualitative assessment indicates that the carrying value may be at risk of recoverability, a quantitative evaluation is performed to measure the carrying value against the fair value of the reporting unit. This evaluation may involve the assessment of future cash flows and other subjective factors for which uncertainty exists and could impact the estimation of future cash flows. These factors include, but are not limited to, the amount and timing of future cash flows, future growth rates, and the discount rate. Unforeseen events and changes in circumstances or market conditions could adversely affect these estimates, which could result in an impairment charge. A qualitative assessment was performed during the fourth quarter of 2019 which indicated a quantitative assessment was not required; thus, no goodwill impairment was recorded. See Note 2 and Note 15 for additional information. Business combinations are accounted for using the acquisition method. The cost of an acquisition is measured as the aggregate of the consideration transferred, measured at fair value at the acquisition date, and the fair value of any non-controlling interest in the acquiree. Acquisition-related costs are expensed as incurred. When NW Natural acquires a business, it assesses the financial assets acquired and liabilities assumed for appropriate classification and designation in accordance with the contractual terms, economic circumstances and pertinent conditions as of the acquisition date. When there is substantial judgment or uncertainty around the fair value of acquired assets, we may engage a third party expert to assist in determining the fair values of certain assets or liabilities.
-0.026929
-0.026825
0
<s>[INST] NW Holdings' direct and indirect whollyowned subsidiaries include: Northwest Natural Gas Company (NW Natural); ◦ Northwest Energy Corporation (Energy Corp); ▪ NWN Gas Reserves LLC (NWN Gas Reserves); NW Natural Energy, LLC (NWN Energy); ◦ NW Natural Gas Storage, LLC (NWN Gas Storage); ▪ Gill Ranch Storage, LLC (Gill Ranch), which is presented as a discontinued operation; NNG Financial Corporation (NNG Financial); ◦ KB Pipeline Company (KB); NW Natural Water Company, LLC (NWN Water); ◦ Falls Water Co., Inc. (Falls Water); ◦ Salmon Valley Water Company; ◦ NW Natural Water of Oregon, LLC (NWN Water of Oregon); ▪ Sunstone Water, LLC; ▪ Sunstone Infrastructure, LLC; ▪ Sunriver Water, LLC (Sunriver Water); ▪ Sunriver Environmental, LLC (Sunriver Environmental) ◦ NW Natural Water of Washington, LLC (NWN Water of Washington); ▪ Cascadia Water, LLC (Cascadia Water); ▪ Cascadia Infrastructure, LLC; ▪ Suncadia Water Company, LLC (Suncadia Water); ▪ Suncadia Environmental Company, LLC (Suncadia Environmental); ◦ NW Natural Water of Idaho, LLC (NWN Water of Idaho); ▪ Gem State Water Company, LLC (Gem State Water); ▪ Gem State Infrastructure, LLC; and ◦ NW Natural Water of Texas, LLC (NWN Water of Texas); ▪ Blue Topaz Water, LLC; and ▪ Blue Topaz Infrastructure, LLC. On October 1, 2018, we completed a reorganization into a holding company structure. We believe that our holding company structure is an agile and efficient platform from which to pursue, finance, and oversee new opportunities, such as in the water sector, while also providing legal separation between regulated natural gas distribution operations and other businesses. In this reorganization, shareholders of NW Natural (the predecessor publicly held parent company) became shareholders of NW Holdings, on a oneforone basis, with the same number of shares and same ownership percentage as they held in NW Natural immediately prior to the reorganization. NW Natural became a whollyowned subsidiary of NW Holdings. Additionally, certain subsidiaries of NW Natural were transferred to NW Holdings. As required under accounting guidance, these subsidiaries are presented as discontinued operations in the 2018 and 2017 consolidated results of NW Natural within this report. NW Natural's natural gas distribution activities are reported in the natural gas distribution (NGD) segment. The NGD segment also includes NWN Gas Reserves, which is a whollyowned subsidiary of Energy Corp, and the NGDportion of NW Natural's Mist storage facility in Oregon. Other activities aggregated and reported as other at NW Natural include the nonNGD storage activity at Mist as well as asset management services and the appliance retail center operations. Other activities aggregated and reported as other at NW Holdings include NWN Energy's equity investment in Trail West Holding, LLC (TWH), which is pursuing the development of a proposed natural gas pipeline through its whollyowned subsidiary, Trail West Pipeline, LLC (TWP); NNG Financial's investment in KelsoBeaver Pipeline (KB Pipeline); and NWN Water, which owns and continues to pursue investments in the water sector. See Note 4 for further discussion of our business segment and other, as well as our direct and indirect whollyowned subsidiaries. In addition, NW Holdings has reported discontinued operations results related to the pending sale of Gill Ranch Storage, LLC (Gill Ranch). NW Natural Gas Storage, LLC (NWN Gas Storage), currently an indirect whollyowned subsidiary of NW Holdings, entered into a Purchase [/INST] Negative. </s>
2,020
22,576
1,661,998
Homology Medicines, Inc.
2019-03-12
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 “Selected Consolidated Financial Data” and our consolidated financial statements, related notes and other financial information included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties such as our plans, objectives, expectations and intentions. As a result of many important factors, including those set forth in the section captioned “Risk Factors” and elsewhere in this Annual Report on Form 10-K, our actual results could differ materially from the results described in, or implied by, these forward-looking statements. Overview We are a genetic medicines company dedicated to transforming the lives of patients suffering from rare genetic diseases with significant unmet medical needs by curing the underlying cause of the disease. Our proprietary platform is designed to utilize our AAVHSCs to precisely and efficiently deliver single administration genetic medicines in vivo either through a gene therapy or nuclease-free gene editing modality across a broad range of genetic disorders. The unique properties of our proprietary suite of 15 novel AAVHSCs enable us to focus on a method of gene editing called gene correction, either through the replacement of an entire diseased gene in the genome with a whole functional copy or the precise repair of individual mutated nucleotides, by harnessing the naturally occurring DNA repair process of HR. We believe our HR-driven gene editing approach will allow us to efficiently perform gene correction at therapeutic levels without unwanted on- and off-target modifications, and to directly measure and confirm those modifications in an unbiased manner to ensure only the intended changes are made. By utilizing the body’s natural mechanism of correcting gene defects, we also avoid the need for exogenous nucleases, or bacteria-derived enzymes used in other gene editing approaches to cut DNA, that are known to significantly increase the risk of unwanted modifications. Our diverse set of AAVHSCs allows us to precisely target, via a single injection, a wide range of disease-relevant tissues, including the liver, CNS, bone marrow, lung, muscle and eye, across both modalities-gene editing and gene therapy. We believe these advantages will allow us to safely provide transformative cures using either modality. We have generated compelling preclinical data for our first and lead product candidate, HMI-102, a gene therapy for the treatment of PKU, and expect to advance HMI-102 into a Phase 1/2 clinical trial in adult PKU patients and report initial clinical data in 2019. We continue to advance our gene editing modality and have generated in vivo preclinical data demonstrating achievement of gene correction efficiencies in the liver that are significantly greater than both nuclease-based and other AAV-based approaches and are at a therapeutic level. We have nominated a lead gene editing product development candidate, HMI-103, for the treatment of PKU in pediatric patients. We have also nominated a lead gene therapy CNS product development candidate, HMI-202, for the treatment of MLD. We have initiated IND-enabling studies for both programs. We will require additional capital in order to advance HMI-102 and our other product candidates through clinical development and commercialization. Our management team has a successful track record of discovering, developing and commercializing therapeutics with a particular focus on rare diseases. Our genetic medicines platform is based on gene editing and gene therapy technologies resulting from the pioneering work conducted on AAVHSCs in the laboratory of COH. We have a robust intellectual property portfolio with issued composition of matter patents in the United States for our suite of 15 AAVHSCs and we believe the breadth and depth of our intellectual property is a strategic asset that has the potential to provide us with a significant competitive advantage. We continue to build on our intellectual property estate through our ongoing product and platform development efforts. We have internal process development and GMP manufacturing capabilities and recently completed the build-out of a cGMP manufacturing facility to support our clinical development programs in both gene therapy and gene editing expect to commence manufacturing in the first half of 2019. In November 2017, we entered into a collaboration with Novartis to develop new genetic medicines using our HR-based gene correction approach in ophthalmology, which leverages our platform technology into a new therapeutic area. On February 6, 2019, Novartis elected to discontinue our collaboration on the sickle cell disease program under our agreement effective in August 2019. Since our inception in 2015, we have raised approximately $288 million in net proceeds through our initial public offering in April 2018 and preferred stock financings. We believe that our compelling preclinical data, scientific expertise, product development strategy, manufacturing capabilities, and robust intellectual property position us as a leader in the development of genetic medicines. We were incorporated and commenced operations in 2015. Since our incorporation, we have devoted substantially all of our resources to organizing and staffing our company, business planning, raising capital, developing our technology platform, advancing our lead product candidate, HMI-102 for the treatment of PKU, researching and identifying additional product candidates, developing manufacturing processes, building out our manufacturing and research and development space, enhancing our intellectual property portfolio, and providing general and administrative support for these operations. To date, we have financed our operations primarily through the sale of common stock in our initial public offering, or the IPO, through the sales of preferred stock, and through funding from our collaboration partner. We are a development stage company and our lead product candidate and our research initiatives are all at a preclinical stage of development. To date, we have not generated any revenue from product sales and do not expect to generate any revenue from the sale of products in the foreseeable future, if at all. We recognized $3.7 million in collaboration revenue for the year ended December 31, 2018. We did not recognize any collaboration revenue for the same period in 2017. Since inception, we have incurred significant operating losses. Our net losses for the years ended December 31, 2018 and 2017 were $57.2 million and $30.0 million, respectively. As of December 31, 2018, we had an accumulated deficit of $97.4 million. Our total operating expenses were $65.2 million and $29.7 million for the years ended December 31, 2018 and 2017, respectively. We expect our operating expenses to continue to increase substantially in connection with our ongoing development activities related to our product candidates. Specifically, we anticipate that our expenses will increase substantially due to costs associated with preclinical activities for HMI-102, our lead gene therapy product candidate for the treatment of PKU and the advancement of this product candidate into a Phase 1/2 clinical trial in the U.S., which we expect to commence and report initial clinical data for in 2019, development activities including IND-enabling studies associated with our other gene editing and gene therapy product candidates, including HMI-103, our gene editing product candidate for PKU, and HMI-202, our gene therapy product candidate for MLD, research activities in additional therapeutic areas to expand our pipeline, hiring additional personnel in manufacturing, research, clinical and regulatory, quality and other functional areas, increased expenses incurred with CMOs to supply us with product for our preclinical and clinical studies, as well as costs associated with the qualification of our internal manufacturing facility, costs to manufacture product for preclinical and clinical studies in this facility and other costs including the maintenance and expansion of our intellectual property portfolio. In addition, we expect to incur additional costs associated with operating as a public company. We have incurred significant capital expenditures for the buildout of a new facility we have leased, including research and development labs, office space and manufacturing suites and the procurement of equipment and furniture for this new facility and in support of our product development candidates and research initiatives. We expect to incur additional capital expenditures in 2019 and beyond in support of our research and development activities and our manufacturing facility. Because of the numerous risks and uncertainties associated with the development of our current and any future product candidates and our platform and technology and because the extent to which we may enter into collaborations with third parties for development of any of our product candidates is unknown, we are unable to predict the timing and amount of increased operating expenses and capital expenditures associated with completing the research and development of our product candidates. Our future capital requirements will depend on many factors, including: • the costs, timing, and results of our ongoing research and development efforts, including clinical trials, on HMI-102; • the costs, timing, and results of our ongoing research and development efforts on HMI-103 and HMI-202, both of which have entered into IND-enabling studies; • the costs, timing, and results of our research and development efforts on current and future product candidates in our gene editing and gene therapy pipeline; • the costs and timing of process development and manufacturing scale-up activities, supplies of our product candidates for preclinical studies and clinical trials through CMOs and internal manufacturing; • the costs and timing of capital expenditures for potential additional manufacturing capacity and related equipment and furniture; • the costs and timing of preparing, filing, and prosecuting patent applications, maintaining and enforcing our intellectual property rights and defending any intellectual property-related claims, including any claims by third parties that we are infringing upon their intellectual property rights; • the effect of competitors and market developments; and • our ability to establish and maintain strategic collaborations, licensing or other agreements and the financial terms of such agreements for our product candidates. We believe that our existing cash, cash equivalents and short-term investments will enable us to fund our current projected operating expenses and capital expenditures through the end of 2020. 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. If we raise additional funds through 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 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 programs or any future commercialization efforts or grant rights to develop and market product candidates that we would otherwise prefer to develop and market ourselves. Because of the numerous risks and uncertainties associated with drug development, we are unable to predict when or if we will be able to achieve or maintain profitability. Even if we are able to generate revenue from product sales, we may not become profitable. If we fail to become profitable or are unable to sustain profitability on a continuing basis, then we may be unable to continue our operations at planned levels and be forced to reduce or terminate our operations. Components of Our Results of Operations Revenue To date, we have not generated any revenue from product sales and do not expect to generate any revenue from the sale of products in the foreseeable future. We recorded $3.7 million in collaboration revenue for the year ended December 31, 2018 (see Note 16 to our Financial Statements for additional information regarding Novartis revenue recognition discussion). Operating Expenses Our operating expenses since inception have consisted solely of research and development costs and general and administrative costs. Research and Development Expenses Research and development expenses consist primarily of costs incurred for our research activities, including our discovery efforts, and the development of our product candidates, and include: • salaries, benefits and other related costs, including stock-based compensation expense, for personnel engaged in research and development functions; • expenses incurred under agreements with third parties, including CROs and other third parties that conduct research, preclinical activities and clinical trials on our behalf as well as CMOs and our internal technical operations team that manufacture our product candidates for use in our preclinical and potential future clinical trials; • costs of outside consultants, including their fees and related travel expenses; • the costs of laboratory supplies and acquiring, developing and manufacturing preclinical study and clinical trial materials; and • facility-related expenses, which include direct depreciation costs and other operating costs. We expense research and development costs as incurred. We typically use our employee and infrastructure resources across our development programs. We track outsourced development costs by product candidate or development program, but we do not allocate personnel costs, license payments made under our licensing arrangements or other internal costs to specific development programs or product candidates. These costs are included in other research and development expenses in the table below. The following table summarizes our research and development expenses by product candidate or development program: Research and development activities are central to our business model. We expect that our research and development expenses will continue to increase substantially for the foreseeable future as we initiate clinical trials of HMI-102, including our Phase 1/2 clinical trial, continue to advance both HMI-103 and HMI-202 through IND-enabling studies and into clinical trials and continue to discover and develop additional product candidates. We cannot determine with certainty the duration and costs of future clinical trials of HMI-102 and IND-enabling studies and future clinical trials of our other product candidates in development or any other future product candidate we may develop or if, when, or to what extent we will generate revenue from the commercialization and sale of any product candidate for which we obtain marketing approval. We may never succeed in obtaining marketing approval for any product candidate. The duration, costs and timing of clinical trials and development of HMI-102, our other product candidates in development and any other future product candidate we may develop will depend on a variety of factors, including: • the scope, rate of progress, expense and results of clinical trials of HMI-102, HMI-103, HMI-202, as well as of any future clinical trials of other product candidates and other research and development activities that we may conduct; • uncertainties in clinical trial design and patient enrollment rates; • the actual probability of success for our product candidates, including the safety and efficacy results, early clinical data, competition, manufacturing capability and commercial viability; • significant and changing government regulation and regulatory guidance; • the timing and receipt of any marketing approvals; and • the expense of filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights. A change in the outcome of any of these variables with respect to the development of a product candidate could mean a significant change in the costs and timing associated with the development of that product candidate. For example, if the FDA or another regulatory authority were to require us to conduct clinical trials beyond those that we anticipate will be required for the completion of clinical development of a product candidate, or if we experience significant delays in our clinical trials due to patient enrollment or other reasons, we would be required to expend significant additional financial resources and time on the completion of clinical development. General and Administrative Expenses General and administrative expenses consist primarily of salaries and other related costs, including stock-based compensation, for personnel in our executive, finance, human resources, business development and administrative functions. General and administrative expenses also include legal fees relating to intellectual property and corporate matters; professional fees for accounting, auditing, tax and consulting services; insurance costs; travel expenses; and facility-related expenses, which include direct depreciation costs, rent expense, maintenance of facilities and other operating costs. We expect that our general and administrative expenses will increase in the future as we increase our personnel headcount to support increased research and development activities relating to HMI-102, HMI-103, HMI-202, and any other product candidate we may develop. We also have incurred and expect to continue to incur increased expenses associated with being a public company, including costs of accounting, audit, legal, regulatory and tax-related services associated with maintaining compliance with Nasdaq and SEC requirements; director and officer insurance costs; and investor and public relations costs. Interest Income Interest income consists of interest income earned on our cash, cash equivalents and short-term investments. Our interest income has increased due to higher investment balances and higher yields on invested funds in 2018 as compared to 2017. Income Taxes Since our inception in 2015, we have not recorded any U.S. federal or state income tax benefits for the net losses we have incurred in any year or for our earned research and development tax credits, due to our uncertainty of realizing a benefit from those items. As of December 31, 2018, we had federal and state net operating loss carryforwards of $52.4 million and $46.6 million, respectively, that expire at various dates through 2038. As of December 31, 2018, we also had federal and state research and development tax credit carryforwards of $2.5 million and $3.5 million, respectively, that expire at various dates through 2038. Change in Fair Value of Convertible Preferred Stock Tranche Liability We determined that our obligation to issue, and our investors’ obligation to purchase, additional shares of Series A preferred stock in the second of two tranches represented a freestanding financial instrument. The freestanding tranche liability was initially recorded at fair value, with gains and losses arising from changes in fair value recognized in other income in the statements of operations at each period end such instruments were outstanding. The liability was valued using an income approach, specifically the discounted cash flow method. On February 10, 2017, we issued 28,873,237 shares of our Series A preferred stock at $0.71 per share upon the achievement of certain development milestones, resulting in net proceeds of approximately $20.5 million. We adjusted the carrying value of the convertible preferred stock tranche liability to its estimated fair value at each reporting date and upon issuance of the second tranche of Series A preferred stock on February 10, 2017, recognizing the changes in fair value in other income (expense) in the consolidated statement of operations. During the year ended December 31, 2017, we recognized total other expense of $0.9 million related to changes in the fair value of the convertible preferred stock tranche liability. We had no liability related to the convertible preferred stock as of December 31, 2018. Critical Accounting Policies and Use of Estimates Our management’s discussion and analysis of financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States. The preparation of our consolidated financial statements and related disclosures requires us to make estimates, assumptions and judgements that affect the reported amount of assets, liabilities, revenue, costs and expenses, and related disclosures. We base our estimates on historical experience, known trends and events and various other factors that we believe are 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. We evaluate our estimates and assumptions on an ongoing basis. Our 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 at the end of 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 financial statements. Revenue Recognition-We recognize revenue when all of the following criteria are met: persuasive evidence of an arrangement exists; delivery has occurred or services have been rendered; our price to the buyer is fixed or determinable; and collectability is reasonably assured. We record as deferred revenue any amounts received or billed prior to satisfying the revenue recognition criteria. Deferred revenue not expected to be recognized within the next twelve months is reported as non-current deferred revenue. In November 2017, we entered into a collaboration and license agreement for research, development, manufacturing and commercialization of products using our gene editing technology for the treatment of certain diseases (see Note 16 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K). Consideration we may receive under the collaboration and license agreement includes upfront nonrefundable payments, payments for research and manufacturing activities, payments based upon the achievement of certain milestones and royalties on any resulting net product sales. Multiple Element Arrangements The terms of the collaboration and license agreement contain multiple deliverables, including licenses, research and development activities, participation on steering committees and manufacturing activities. We evaluate the activities in our collaboration agreements to determine if the activities are consistent with a typical vendor-customer relationship, and if so, account for them in accordance with Accounting Standards Codification, or ASC, Topic 605-25, Revenue Recognition-Multiple Element Arrangements. If not, we evaluate other applicable guidance. We evaluate multiple element arrangements to determine the deliverables included in the arrangement and whether the individual deliverables represent separate units of accounting, or whether they must be accounted for as a combined 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. This evaluation requires us to make judgments about the individual deliverables and whether such deliverables (1) have value to the customer on a standalone basis and (2) if the arrangement includes a general right of return with respect to the delivered item, delivery or performance of the undelivered item is considered probable and substantially in our control. In assessing whether an item has standalone value, we consider factors such as the research, development, manufacturing and commercialization capabilities of the collaboration partner and the availability of the associated expertise in the general marketplace. In addition, we consider whether the collaboration partner can use any other deliverable for its intended purpose without the receipt of the remaining deliverables, whether the value of the deliverable is dependent on any undelivered item, and whether there are other vendors that can provide the undelivered items. The consideration received under the arrangement that is fixed or determinable is then allocated among the separate units of accounting based on the relative selling prices of the separate units of accounting. For arrangements identified with multiple units of accounting, an allocation of the consideration is performed. We determine the estimated selling price for units of accounting within each arrangement using vendor-specific objective evidence, or VSOE, if available; third-party evidence, or TPE, of selling price if VSOE is not available; or best estimate of selling price, or BESP, if neither VSOE nor TPE is available. We typically use BESP to estimate the selling price as we generally do not have VSOE or TPE of selling price for the units of accounting. Determining the BESP for a unit of accounting requires significant judgment. In developing the BESP for a unit of accounting, we consider applicable market conditions and relevant entity-specific factors, including factors that were contemplated in negotiating the agreement with the customer and estimated costs. We recognize arrangement consideration allocated to each unit of accounting when all of the revenue recognition criteria are satisfied for that particular unit of accounting. We recognize revenue from a combined unit of accounting over the contractual or estimated performance period for the undelivered items. If there is no discernible pattern of performance or objectively measurable performance measures do not exist for a unit of accounting, then we recognize revenue on a straight-line basis over the period we are expected to complete our performance obligations. Conversely, if the pattern of performance over which the service is provided to the customer can be determined and objectively measurable performance measures exist, then we recognize revenue under the arrangement using the proportional performance method. Amounts received prior to satisfying the associated revenue recognition criteria are recorded as deferred revenue on the consolidated balance sheets. Significant management judgment is required in determining the level of effort required under an arrangement and the period over which we expect to complete our performance obligations under an arrangement. Steering committee services that are not inconsequential or perfunctory and that are determined to be performance obligations are combined with other research services or performance obligations required under an arrangement, if any, in determining the level of effort required in an arrangement and the period over which we expect to complete our aggregate performance obligations. Consideration for development and sales milestones are generally not considered fixed or determinable until the milestone is achieved. Consideration due to or received by us for the achievement of milestones are allocated to the units of accounting, if applicable, and recognized as revenue for the portion of the performance obligation that is complete at the time the milestone is achieved. We will defer the remaining portion of the milestone payment and recognize it as revenue over the remaining term of the performance obligation. If no such performance obligation exists, milestone payments are recognized as revenue upon achievement, assuming all other revenue recognition criteria are met. Royalties earned on product sales, if any, are recognized based on contractual terms of the agreement when reported sales are reliably measurable and collectibility is reasonably assured, provided that there are no performance obligations then remaining. To date, none of our product candidates have been approved and, therefore, we have not earned any royalty revenue from product sales. In the event that the agreement were to be terminated and we had no further performance obligations at that time, we would recognize as revenue any portion of the upfront payment and other payments that had not previously been recorded as revenue and were classified as deferred revenue at the date of such termination. Accrued Research and Development Expenses-As part of the process of preparing our financial statements, we are required to estimate our accrued research and development expenses. This process involves reviewing open contract and purchase orders, communicating with our personnel and vendors to identify services that have been performed on our behalf and estimating the level of service performed and the associated costs incurred for the services when we have not yet been invoiced or otherwise notified of the actual costs. The majority of our service providers invoice us in arrears for services performed, on a pre-determined schedule or when contractual milestones are met; however, some require advanced payments. 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. Examples of estimated accrued research and development expenses include fees paid to: • CROs and other third parties in connection with performing research activities on our behalf and conducting preclinical studies on our behalf and CMOs in connection with producing product for our preclinical studies; • vendors in connection with preclinical development activities; and • vendors related to product manufacturing and development and distribution of preclinical supplies. We base our expenses related to preclinical studies on our estimates of the services received and efforts expended pursuant to quotes and contracts with CROs that conduct and manage preclinical studies and clinical trials and CMOs that manufacture product for our research and development 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 expense. In accruing 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 amount of 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 may result in us reporting amounts that are too high or too low in any particular period. To date, we have not made any material adjustments to our prior estimates of accrued research and development expenses. Stock-Based Compensation-We account for stock-based compensation transactions using a grant-date fair-value-based method under FASB Codification Topic 718, Compensation-Stock Compensation. We measure stock options and other stock-based awards granted to employees, directors, consultants or advisors of the company or its affiliates based on their fair value on the date of the grant and recognize compensation expense of those awards, over the requisite service period, which is generally the vesting period of the respective award. We apply the straight-line method of expense recognition to all awards with only service-based vesting conditions and apply the graded-vesting method to all awards with performance-based vesting conditions or to awards with both service-based and performance-based vesting conditions. We estimate the fair value of each stock option grant on the date of 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. Emerging Growth Company Status The Jumpstart Our Business Startups Act of 2012, or the JOBS Act, permits an “emerging growth company,” which we are, 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 elected to take advantage of this extended transition period. Recent Accounting Pronouncements In May 2014, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update, or ASU, No. 2014-09, Revenue (Topic 606): Revenue from Contracts with Customers, or ASU 2014-09, which will replace existing revenue recognition standards and significantly expand the disclosure requirements for revenue arrangements. This new standard requires a company to recognize revenue when it transfers goods or services to customers in an amount that reflects the consideration that the company expects to receive for those goods or services. This will require companies to use more judgement and make more estimates than under current guidance. We have substantially completed our evaluation of the impact of the adoption of ASU 2014-09 on our consolidated financial statements. Under ASU 2014-09, with respect to our collaboration with Novartis, we expect to account for the (1) research, development and commercialization and manufacturing licenses, (2) the research activities performed by us, (3) service on the joint committees and (4) manufacturing during the research and development terms as a single performance obligation, which is consistent with our accounting under the existing standard. We expect to recognize revenue from this collaboration using the cost-to-cost method, whereby the extent of progress towards completion is measured based on the ratio of actual costs incurred to the total estimated costs expected. Significant judgment is required in making estimates of total expected costs to complete the single performance obligation over the performance period. Revenue will be recorded as a percentage of the estimated transaction price based on the extent of progress towards completion. The estimated transaction price will include variable consideration for milestone payments, however such milestone payments will remain fully constrained as of our adoption date as it is not probable at this time that we will achieve those milestones. The estimate of total costs expected and the estimate of variable consideration to be included in the transaction price will be updated at each reporting date. The cumulative effect of revisions to these estimates will be recorded in the period in which changes are identified. Under the new standard, we expect to recognize revenue from our collaboration agreement with Novartis earlier during the performance period as a result of applying the cost-to-cost method, in contrast to recognizing revenue on a straight-line basis over the estimated performance period under the existing standard. We plan to adopt the new standard using the full retrospective method, and thus will apply the new standard retrospectively to each prior reporting period. As a result, we expect an increase to collaboration revenue for the year ended December 31, 2018 of approximately $1.5 to $2.0 million, with a corresponding decrease to deferred revenue. The impact to the year ended December 31, 2017 is insignificant. In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842), which eliminates the current tests for lease classification under U.S. GAAP and requires lessees to recognize the right-to-use assets and related lease liabilities in the balance sheet. ASU No. 2016-02 is effective for us beginning January 1, 2020 with early application permitted. The new standard provides for a modified retrospective application. We are in the process of evaluating the impact of the adoption of ASU No. 2016-02 on our consolidated financial statements. In December 2016, the FASB issued ASU No. 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash (a consensus of the FASB Emerging Issues Task Force), which requires that amounts described as restricted cash or cash equivalents must be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. ASU 2016-18 is effective for us beginning January 1, 2019, with early application permitted. The new standard must be applied retrospectively to all periods presented. We do not expect the adoption of this standard to have a material impact on our consolidated financial statements. In June 2018, the FASB issued ASU No. 2018-07, Compensation-Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting, which changes certain aspects of the accounting for share-based payments granted to nonemployees. Under the ASU, most of the guidance on such payments to nonemployees would be aligned with the requirements for share-based payments granted to employees. ASU 2018-07 is effective for us beginning January 1, 2020. Early application of this standard is permitted however companies may not apply this standard earlier than it applies ASU 2014-09. We are evaluating the impact adoption of this standard will have on our consolidated financial statements. Results of Operations Comparison of Years Ended December 31, 2018 and 2017 The following table summarizes our results of operations for the years ended December 31, 2018 and 2017, respectively: Collaboration Revenue Revenues for the year ended December 31, 2018 were $3.7 million and consisted solely of collaboration revenue under our Collaboration Agreement with Novartis that we entered into in November 2017, representing the portion of the $35.0 million upfront payment and research funding payments that were recognized in the year ended December 31, 2018. We recognize revenues based on a straight-line basis over the estimated period of performance taking into consideration all upfront payments and research funding payments, under this arrangement, together as a single unit. We did not recognize any revenue in the year ended December 31, 2017. Research and Development Expenses Research and development expenses for the year ended December 31, 2018 were $47.9 million, compared to $21.4 million for the year ended December 31, 2017. The increase of $26.6 million was primarily due to an increase of $13.6 million in direct research expenses, primarily CMO costs, related to our HMI-102 program, a $9.4 million increase in employee-related costs due to an increase in employee headcount to support our ongoing development programs, research initiatives, technology platform and manufacturing capabilities and a $3.6 million increase in other research and development costs related to laboratory supplies, research materials and outside services for the further advancement of our research and development programs. General and Administrative Expenses General and administrative expenses were $17.3 million for the year ended December 31, 2018, compared to $8.3 million for the year ended December 31, 2017. The increase of $9.0 million was primarily due to $4.4 million in increased employee-related costs, $2.8 million in increased facility costs, $0.7 million in increased consulting costs and $0.8 million in increased insurance and other public company related expenses. Change in Fair Value of Tranche Liability For the year ended December 31, 2017, the changes in fair value of our preferred stock tranche liability resulted in a $0.9 million loss due to the re-measurement and subsequent de-recognition of the tranche liability upon achievement of a development milestone in February 2017 and the issuance of shares of our Series A preferred stock. There was no impact during the year ended December 31, 2018, due to the de-recognition of the tranche liability in February 2017. Interest Income Interest income was $4.3 million for the year ended December 31, 2018 compared to approximately $0.5 million for the year ended December 31, 2017. The increase was the result of interest income generated on our higher average cash, cash equivalent and short-term investment balances and higher yields on invested funds for the year ended December 31, 2018 compared to the year ended December 31, 2017, due to the receipt of $83.1 million in net proceeds from our Series B preferred stock financing in July 2017, Novartis’ up-front payment of $35.0 million, additional proceeds of $10.0 million from the issuance of Series B preferred stock to Novartis in November 2017 and the receipt of $150.8 million in net proceeds from the initial public offering of our common stock in April 2018. Net Loss Net loss for the year ended December 31, 2018 was $57.2 million, compared to $30.0 million for the year ended December 31, 2017. The increase in net loss was primarily due to the increases in research and development and general and administrative expenses discussed above, partially offset by the increases in collaboration revenue and interest income discussed above. Liquidity and Capital Resources Since our inception, we have incurred significant operating losses. We expect to incur significant expenses and operating losses for the foreseeable future as we advance the preclinical and clinical development of our product candidates. We expect that our research and development and general and administrative costs and our capital expenditures will increase in connection with conducting preclinical studies and clinical trials for our product candidates, contracting with CMOs and building out internal capacity to have product manufactured to support preclinical studies and clinical trials, expanding our research and development laboratories, expanding our intellectual property portfolio, and providing general and administrative support for our operations. As a result, we will need additional capital to fund our operations, which we may obtain from additional equity or debt financings, collaborations, licensing arrangements, or other sources. We do not currently have any approved products and have never generated any revenue from product sales. To date, we have financed our operations primarily through the sale of common stock in our IPO, the sale of preferred stock and through an up-front payment from a collaboration partner. Since our inception in 2015, we have raised a total of approximately $288 million in net proceeds from our initial public offering in April 2018 and sales of our preferred stock. We received an up-front payment of $50.0 million from a collaboration partner, comprised of $35.0 million in cash and a $15.0 million equity investment, which is included in the proceeds from the sale of preferred stock. Cash Flows Our cash, cash equivalents and short-term investments totaled $214.7 million and $129.7 million as of December 31, 2018 and 2017, respectively. We had no indebtedness as of December 31, 2018 and 2017. The following table summarizes our sources and uses of cash for the period presented: Cash Flows for the year ended December 31, 2018 Operating Activities Net cash used in operating activities for the year ended December 31, 2018 was $42.6 million, primarily due to our net loss of $57.2 million as we incurred expenses associated with research activities on HMI-102 and research activities on other applications for our technology. The funding of our net loss was partially offset by net non-cash expenses of $2.5 million, an increase in long-term deferred rent of $10.0 million which was largely due to the receipt of cash lease incentives from our landlord during 2018 and an increase in working capital of $2.2 million. Investing Activities Net cash used in investing activities for the year ended December 31, 2018 was $121.8 million, attributable to $245.3 million in purchases of short-term investments and $24.9 million in purchases of property and equipment, partially offset by maturities of short-term investments of $148.5 million. Financing Activities Net cash provided by financing activities for the year ended December 31, 2018 was $151.0 million, primarily due to proceeds from the issuance of common stock in our initial public offering, net of discounts and issuance costs, of $150.8 million. Cash Flows for the year ended December 31, 2017 Operating Activities Net cash provided by operating activities for the year ended December 31, 2017 was $6.5 million, consisting of a $35.0 million up-front payment received from a collaboration partner recorded as deferred revenue, net of $1.7 million allocated to convertible preferred stock, and changes in our operating assets and liabilities of $1.3 million. This was partially offset by our net losses of $30.0 million as we incurred expenses associated with research activities on our lead gene therapy program for the treatment of PKU and research activities on other applications for our technology and incurred general and administrative expenses. In addition, we had non-cash charges totaling $1.8 million including the change in fair value of a convertible preferred stock tranche liability, depreciation and stock-based compensation expense offset by accretion on short-term investments. Net cash provided by changes in our operating assets and liabilities was due to increases of $33.4 million in deferred revenue, $1.7 million in accounts payable and $0.9 million in accrued expenses and other liabilities, partially offset by a decrease of $1.5 million in prepaid expenses and other current assets. Investing Activities Net cash used in investing activities for the year ended December 31, 2017 was $81.5 million, attributable to the purchases of short-term investments of $78.1 million, the purchases of property and equipment of $2.0 million, and the change in restricted cash of $1.5 million related to a new facility lease. Financing Activities Net cash provided by financing activities for the year ended December 31, 2017 was $115.2 million, consisting of the net proceeds from the second tranche of the Series A convertible preferred stock financing of $20.5 million and the net proceeds from the issuance of Series B convertible preferred stock of $94.8 million, net of issuance costs. Funding Requirements Our operating expenses increased substantially in 2018 and are expected to increase substantially in 2019 and future years in connection with our ongoing activities, particularly as we advance our preclinical activities including IND enabling studies, scale-up of manufacturing processes and engagement with CMOs and initiation of human clinical trials. In addition, we have incurred and expect to continue to incur additional costs associated with operating as a public company. In addition, we expect our capital expenditures to continue to increase as we expand our operations. Specifically, our expenses will increase as we: • pursue the preclinical and clinical development of HMI-102, HMI-103 and HMI-202; • pursue the preclinical and clinical development of other product candidates based on our gene editing and gene therapy technology; • further scale up our internal manufacturing processes and capabilities and contract with CMOs to support our preclinical studies and clinical trials of our product candidates; • further expand our manufacturing capacity potentially including commercial scale manufacturing; • operate our business in our new larger facility with expanded research and development labs and manufacturing suites and purchase additional equipment for our operations; • in-license or acquire the rights to other products, product candidates or technologies; • maintain, expand and protect our intellectual property portfolio; • hire additional personnel in research, manufacturing and regulatory and clinical development as well as management personnel; and • expand our operational, financial and management systems and increase personnel, including personnel to support our operations as a public company. We believe that our existing cash, cash equivalents and short-term investments will enable us to fund our operating expenses and capital expenditure requirements through the end of 2020. We have based these estimates on assumptions that may prove to be imprecise, and we could utilize our available capital resources sooner than we expect. Because of the numerous risks and uncertainties associated with research, development and commercialization of pharmaceutical drugs, it is difficult to estimate with certainty the amount of our working capital requirements. Our future funding requirements will depend on many factors, including: • the progress, costs and results of our preclinical development and initial clinical trials for HMI-102, HMI-103 and HMI-202; • the progress, costs and results of our additional research and preclinical development programs in gene editing and gene therapy; • the costs, scope and timing of internal process development and manufacturing scale-up activities and contract with CMOs associated with our lead product development programs and other programs we advance through preclinical and clinical development; • our ability to establish and maintain strategic collaborations, licensing or other agreements and the financial terms of such agreements; • the scope, progress, results and costs of any product candidates that we may derive from our platform technology or any other product candidates that we may develop; • the extent to which we in-license or acquire rights to other products, product candidates or technologies; and • the costs and timing of preparing, filing and prosecuting patent applications, maintaining and protecting our intellectual property rights and defending against any intellectual property-related claims. Until such time, if ever, that we can generate product revenue sufficient to achieve profitability, we expect to finance our cash needs through a combination of equity offerings, debt financings, collaboration agreements, other third-party funding, strategic alliances, licensing arrangements and marketing and distribution arrangements. 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 the rights of our shareholders as common stockholders. Debt financing and preferred 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 additional funds through other third-party funding, collaboration agreements, strategic alliances, licensing arrangements or marketing and distribution arrangements, 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. 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 products or product candidates that we would otherwise prefer to develop and market ourselves. Contractual Obligations The following is a summary of our significant contractual obligations as of December 31, 2018: (1) Represents future minimum lease payments under our operating leases for office and lab space in Bedford, Massachusetts that expire in October 2021 and February 2027. Future minimum lease payments are net of anticipated sublease payments of approximately $2.7 million for the period of 2019 to 2021. (2) Represents minimum annual license fees under our license agreements with Caltech and COH. These amounts do not include any potential contingent payments upon the achievement by us of specified clinical, regulatory and commercial events, as applicable, or patent prosecution or royalty payments we may be required to make under these license agreements. We have excluded these potential payments in the contractual obligations table because the timing and likelihood of these contingent payments are not currently known and would be difficult to predict or estimate. See “Business-Strategic Collaborations” for additional information about these license agreements, including with respect to potential payments thereunder. (3) Represents future minimum payments under our sponsored research agreement with COH. We enter into contracts in the normal course of business with CROs and CMOs for clinical trials, preclinical research studies and testing, manufacturing and other services and products for operating purposes. These contracts do not contain any minimum purchase commitments and are cancelable by us upon prior notice of 30 days and, as a result, are not included in the table of contractual obligations above. Off-Balance Sheet Arrangements We have not entered into any off-balance sheet arrangements and do not have any holdings in variable interest entities.
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-0.061982
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<s>[INST] Overview We are a genetic medicines company dedicated to transforming the lives of patients suffering from rare genetic diseases with significant unmet medical needs by curing the underlying cause of the disease. Our proprietary platform is designed to utilize our AAVHSCs to precisely and efficiently deliver single administration genetic medicines in vivo either through a gene therapy or nucleasefree gene editing modality across a broad range of genetic disorders. The unique properties of our proprietary suite of 15 novel AAVHSCs enable us to focus on a method of gene editing called gene correction, either through the replacement of an entire diseased gene in the genome with a whole functional copy or the precise repair of individual mutated nucleotides, by harnessing the naturally occurring DNA repair process of HR. We believe our HRdriven gene editing approach will allow us to efficiently perform gene correction at therapeutic levels without unwanted on and offtarget modifications, and to directly measure and confirm those modifications in an unbiased manner to ensure only the intended changes are made. By utilizing the body’s natural mechanism of correcting gene defects, we also avoid the need for exogenous nucleases, or bacteriaderived enzymes used in other gene editing approaches to cut DNA, that are known to significantly increase the risk of unwanted modifications. Our diverse set of AAVHSCs allows us to precisely target, via a single injection, a wide range of diseaserelevant tissues, including the liver, CNS, bone marrow, lung, muscle and eye, across both modalitiesgene editing and gene therapy. We believe these advantages will allow us to safely provide transformative cures using either modality. We have generated compelling preclinical data for our first and lead product candidate, HMI102, a gene therapy for the treatment of PKU, and expect to advance HMI102 into a Phase 1/2 clinical trial in adult PKU patients and report initial clinical data in 2019. We continue to advance our gene editing modality and have generated in vivo preclinical data demonstrating achievement of gene correction efficiencies in the liver that are significantly greater than both nucleasebased and other AAVbased approaches and are at a therapeutic level. We have nominated a lead gene editing product development candidate, HMI103, for the treatment of PKU in pediatric patients. We have also nominated a lead gene therapy CNS product development candidate, HMI202, for the treatment of MLD. We have initiated INDenabling studies for both programs. We will require additional capital in order to advance HMI102 and our other product candidates through clinical development and commercialization. Our management team has a successful track record of discovering, developing and commercializing therapeutics with a particular focus on rare diseases. Our genetic medicines platform is based on gene editing and gene therapy technologies resulting from the pioneering work conducted on AAVHSCs in the laboratory of COH. We have a robust intellectual property portfolio with issued composition of matter patents in the United States for our suite of 15 AAVHSCs and we believe the breadth and depth of our intellectual property is a strategic asset that has the potential to provide us with a significant competitive advantage. We continue to build on our intellectual property estate through our ongoing product and platform development efforts. We have internal process development and GMP manufacturing capabilities and recently completed the buildout of a cGMP manufacturing facility to support our clinical development programs in both gene therapy and gene editing expect to commence manufacturing in the first half of 2019. In November 2017, we entered into a collaboration with Novartis to develop new genetic medicines using our HRbased gene correction approach in ophthalmology, which leverages our platform technology into a new therapeutic area. On February 6, 2019, Novartis elected to discontinue our collaboration on the sickle cell disease program under our agreement effective in August 2019. Since our inception in 2015, we have raised approximately $288 million in net proceeds through our initial public offering in April 2018 and preferred stock financings. We believe that our compelling preclinical data, scientific expertise, product development strategy, manufacturing capabilities, and robust intellectual property position us as a leader in the development of genetic medicines. We were incorporated and commenced operations in 2015. Since our incorpor [/INST] Negative. </s>
2,019
8,229
1,661,998
Homology Medicines, Inc.
2020-03-12
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 our “Selected Consolidated Financial Data” and our consolidated financial statements, related notes and other financial information included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties such as our plans, objectives, expectations and intentions. As a result of many important factors, including those set forth in the section captioned “Risk Factors” and elsewhere in this Annual Report on Form 10-K, our actual results could differ materially from the results described in, or implied by, these forward-looking statements. A discussion of the year ended December 31, 2018 compared to the year ended December 31, 2017 has been reported previously in our Annual Report on Form 10-K for the year ended December 31, 2018, filed with the SEC on March 12, 2019, under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Overview We are a genetic medicines company dedicated to transforming the lives of patients suffering from rare genetic diseases with significant unmet medical needs by curing the underlying cause of the disease. Our proprietary platform is designed to utilize our AAVHSCs to precisely and efficiently deliver single administration genetic medicines in vivo either through gene therapy or nuclease-free gene editing across a broad range of genetic disorders. Our diverse set of AAVHSCs allows us to precisely target, via a single injection, a wide range of disease-relevant tissues, including the liver, CNS, PNS, bone marrow, muscle and eye. Our genetic medicines platform is designed to provide us the flexibility to choose the method we believe is best suited from either gene therapy or gene editing for each disease we pursue, based on such factors as the targeted disease biology, the biodistribution of our AAVHSCs to key tissues, and the rate of cell division the tissues exhibit. Our product development strategy is to continue to develop in parallel both gene therapy and gene editing, while initially leveraging the experience from our gene therapy product candidates to further advance our gene editing. We believe our dual technology platform will allow us to provide transformative cures using either modality. The unique properties of our proprietary suite of 15 novel AAVHSCs enable us to focus on a method of gene editing called gene integration, through the replacement of an entire diseased gene in the genome with a whole functional copy, by harnessing the naturally occurring DNA repair process of HR. We believe our HR-driven gene editing approach will allow us to efficiently perform gene editing at therapeutic levels without unwanted on- and off-target modifications, and to directly measure and confirm those modifications in an unbiased manner to ensure only the intended changes are made. By utilizing the body’s natural mechanism of correcting gene defects, we also avoid the need for exogenous nucleases, or bacteria-derived enzymes used in other gene editing approaches to cut DNA, that are known to significantly increase the risk of unwanted modifications. We are currently in the dose-escalation portion of our Phase 1/2 pheNIX clinical trial with our first and lead product candidate, HMI-102, a gene therapy for the treatment of PKU. Once a dose is chosen, we will initiate the randomized, concurrently controlled Part B of the trial, which has the potential to be converted to a registrational trial. In December 2019, in accordance with a corporate goal that we had established in early 2018, we reported encouraging initial clinical data from the pheNIX trial from Cohort 1 (low dose, n=2) and Cohort 2 (mid-dose, n=1) based on the data cutoff date of December 2, 2019. Preliminary safety data from three subjects in Cohorts 1 and 2 showed HMI-102 was well-tolerated with no treatment-emergent adverse events, or TEAEs, or serious TEAEs. Efficacy data from the first patient in Cohort 2 suggested a dose-response effect with an observed reduction in Phe levels from baseline and a corresponding increase in Tyr which translated to an overall reduction in the Phe/Tyr ratio, suggestive of increased enzymatic activity. Phe levels have been evaluated as a primary registrable endpoint in previous PKU clinical trials, Tyr is a product of Phe metabolism and a precursor to neurotransmitters, and the Phe/Tyr ratio is a clinically relevant diagnostic measurement for PKU. We are in IND-enabling studies with HMI-202, our lead gene therapy CNS product development candidate for the treatment of MLD. This represents our first CNS program as we are leveraging the ability of our AAVHSCs to cross the blood-brain-barrier as well as the blood-nerve-barrier. We are in IND-enabling studies with HMI-103, our lead gene editing product development candidate for the treatment of PKU in pediatric patients. We have generated in vivo preclinical data demonstrating achievement of gene integration efficiencies in the liver that correspond with Phe correction in a PKU murine model, are significantly greater than other AAV-based approaches and we believe are at a therapeutic level in the preclinical model. We have internal process development and GMP manufacturing capabilities, including a 25,000 square foot GMP manufacturing facility to support our clinical development programs in both gene therapy and gene editing. We have a commercial manufacturing process. We are currently operating three 500-liter bioreactors in our internal manufacturing facility and have successfully produced GMP material at the 500-liter scale for multiple pipeline candidates. Additionally, we have now executed our manufacturing platform at the 2,000-liter bioreactor scale. Our management team has a successful track record of discovering, developing and commercializing therapeutics with a particular focus on rare diseases. We have a robust intellectual property portfolio with issued composition of matter patents in the United States for our suite of 15 AAVHSCs and we believe the breadth and depth of our intellectual property is a strategic asset that has the potential to provide us with a significant competitive advantage. We continue to build on our intellectual property estate through our ongoing product and platform development efforts. Since our inception in 2015, we have raised approximately $444 million in aggregate net proceeds through our IPO in April 2018, a follow-on public offering of common stock in April 2019, proceeds from the sale of common stock under an “at-the-market” sales agreement and preferred stock financings. We received $50.0 million from Novartis, our collaboration partner, including an up-front payment of $35.0 million and a $15.0 million equity investment. We will require additional capital in order to advance HMI-102 and our other product candidates through clinical development and commercialization. We believe that our compelling preclinical data, encouraging initial clinical data, scientific expertise, product development strategy, manufacturing capabilities, and robust intellectual property position us as a leader in the development of genetic medicines. We were incorporated and commenced operations in 2015. Since our incorporation, we have devoted substantially all of our resources to organizing and staffing our company, business planning, raising capital, developing our technology platform, advancing our lead product candidate, HMI-102 for the treatment of PKU, through IND-enabling studies and into a Phase 1/2 clinical trial, advancing HMI-103 and HMI-202 into IND-enabling studies, researching and identifying additional product candidates, developing and implementing manufacturing processes and internal manufacturing capabilities, building out our manufacturing and research and development space, enhancing our intellectual property portfolio, and providing general and administrative support for these operations. To date, we have financed our operations primarily through the sale of common stock, through the sale of preferred stock, and through funding from our collaboration partner. To date, we have not generated any revenue from product sales and do not expect to generate any revenue from the sale of products in the foreseeable future, if at all. We recognized $1.7 million and $5.3 million (as revised) in collaboration revenue for the years ended December 31, 2019 and 2018, respectively. Since inception, we have incurred significant operating losses. Our net losses for the years ended December 31, 2019 and 2018 were $103.9 million and $55.6 million (as revised), respectively. As of December 31, 2019, we had an accumulated deficit of $199.7 million. Our total operating expenses were $111.6 million and $65.2 million for the years ended December 31, 2019 and 2018, respectively. We expect our operating expenses to continue to increase substantially in connection with our ongoing development activities related to our product candidates. Specifically, we anticipate that our expenses will increase substantially due to costs associated with our Phase 1/2 pheNIX clinical trial with HMI-102, development activities including IND-enabling studies associated with our other gene therapy and gene editing product candidates, including HMI-202, our gene therapy product candidate for MLD, and HMI-103, our gene editing product candidate for PKU, research activities in additional therapeutic areas to expand our pipeline, hiring additional personnel in manufacturing, research, clinical and regulatory, quality and other functional areas, increased expenses incurred with CMOs to supply us with product for our clinical studies, costs to manufacture product for preclinical and clinical studies in our internal manufacturing facility and other costs including the maintenance and expansion of our intellectual property portfolio. In addition, we expect to incur additional costs associated with operating as a public company. We have incurred significant capital expenditures for the buildout of a new facility we have leased, including research and development labs, office space and manufacturing suites and the procurement of equipment and furniture for this facility and in support of our product development candidates and research initiatives. We expect to incur additional capital expenditures in 2020 and beyond in support of our research and development activities and our manufacturing facility. Because of the numerous risks and uncertainties associated with the development of our current and any future product candidates and our platform and technology and because the extent to which we may enter into collaborations with third parties for development of any of our product candidates is unknown, we are unable to predict the timing and amount of increased operating expenses and capital expenditures associated with completing the research and development of our product candidates. Our future capital requirements will depend on many factors, including: • the costs, timing, and results of our ongoing research and development efforts, including clinical trials, on HMI-102; • the costs, timing, and results of our ongoing research and development efforts on HMI-103 and HMI-202, both of which are in IND-enabling studies; • the costs, timing, and results of our research and development efforts on current and future product candidates in our gene therapy and gene editing pipeline; • the costs and timing of process development and manufacturing scale-up activities, and the adequacy of supply of our product candidates for preclinical studies and clinical trials through CMOs and internal manufacturing; • the costs and timing of capital expenditures for potential additional manufacturing capacity and related equipment and furniture; • the costs and timing of preparing, filing, and prosecuting patent applications, maintaining and enforcing our intellectual property rights and defending any intellectual property-related claims, including any claims by third parties that we are infringing upon their intellectual property rights; • the effect of competitors and market developments; and • our ability to establish and maintain strategic collaborations, licensing or other agreements and the financial terms of such agreements for our product candidates. We believe that our existing cash, cash equivalents and short-term investments will enable us to fund our current projected operating expenses and capital expenditures into the fourth quarter of 2021. 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. If we raise additional funds through 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 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 programs or any future commercialization efforts or grant rights to develop and market product candidates that we would otherwise prefer to develop and market ourselves. Because of the numerous risks and uncertainties associated with drug development, we are unable to predict when or if we will be able to achieve or maintain profitability. Even if we are able to generate revenue from product sales, we may not become profitable. If we fail to become profitable or are unable to sustain profitability on a continuing basis, then we may be unable to continue our operations at planned levels and be forced to reduce or terminate our operations. Components of Our Results of Operations Revenue To date, we have not generated any revenue from product sales and do not expect to generate any revenue from the sale of products in the foreseeable future. We recorded $1.7 million in collaboration revenue for the year ended December 31, 2019 (see Note 15 to our Financial Statements for additional information regarding Novartis revenue recognition discussion). Operating Expenses Our operating expenses since inception have consisted solely of research and development costs and general and administrative costs. Research and Development Expenses Research and development expenses consist primarily of costs incurred for our research activities, including our discovery efforts, and the development of our product candidates, and include: • salaries, benefits and other related costs, including stock-based compensation expense, for personnel engaged in research and development functions; • expenses incurred under agreements with third parties, including CROs and other third parties that conduct research, preclinical activities and clinical trials on our behalf as well as CMOs and our internal technical operations team that manufacture our product candidates for use in our preclinical testing, our Phase 1/2 pheNIX clinical trial and additional potential future clinical trials; • costs of outside consultants, including their fees and related travel expenses; • the costs of laboratory supplies and acquiring, developing and manufacturing preclinical study and clinical trial materials; and • facility-related expenses, which include direct depreciation costs and allocated expenses for rent and maintenance of facilities and other operating costs. We expense research and development costs as incurred. We typically use our employee and infrastructure resources across our development programs. We track outsourced development costs by product candidate or development program, but we do not allocate personnel costs, license payments made under our licensing arrangements or other internal costs to specific development programs or product candidates. These costs are included in other research and development expenses in the table below. The following table summarizes our research and development expenses by product candidate or development program: Research and development activities are central to our business model. We expect that our research and development expenses will continue to increase substantially for the foreseeable future as we advance clinical trials of HMI-102, for the treatment of PKU, including our Phase 1/2 pheNIX clinical trial, continue to advance both HMI-103 and HMI-202 through IND-enabling studies and into clinical trials and continue to discover and develop additional product candidates. We cannot determine with certainty the duration and costs of future clinical trials of HMI-102 and IND-enabling studies and future clinical trials of our other product candidates in development or any other future product candidate we may develop or if, when, or to what extent we will generate revenue from the commercialization and sale of any product candidate for which we obtain marketing approval. We may never succeed in obtaining marketing approval for any product candidate. The duration, costs and timing of clinical trials and development of HMI-102, our other product candidates in development and any other future product candidate we may develop will depend on a variety of factors, including: • the scope, rate of progress, expense and results of clinical trials of HMI-102, HMI-103, HMI-202, as well as of any future clinical trials of other product candidates and other research and development activities that we may conduct; • uncertainties in clinical trial design and patient enrollment rates; • the actual probability of success for our product candidates, including the safety and efficacy results, early clinical data, competition, manufacturing capability and commercial viability; • significant and changing government regulation and regulatory guidance; • the timing and receipt of any marketing approvals; and • the expense of filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights. A change in the outcome of any of these variables with respect to the development of a product candidate could mean a significant change in the costs and timing associated with the development of that product candidate. For example, if the FDA or another regulatory authority were to require us to conduct clinical trials beyond those that we anticipate will be required for the completion of clinical development of a product candidate, or if we experience significant delays in our clinical trials due to patient enrollment or other reasons, we would be required to expend significant additional financial resources and time on the completion of clinical development. General and Administrative Expenses General and administrative expenses consist primarily of salaries and other related costs, including stock-based compensation, for personnel in our executive, finance, human resources, business development and administrative functions. General and administrative expenses also include legal fees relating to intellectual property and corporate matters; professional fees for accounting, auditing, tax and consulting services; insurance costs; travel expenses; and facility-related expenses, which include direct depreciation costs, rent expense, maintenance of facilities and other operating costs. We expect that our general and administrative expenses will increase in the future as we increase our personnel headcount to support increased research and development activities relating to HMI-102, HMI-103, HMI-202, and any other product candidate we may develop. We also have incurred and expect to continue to incur increased expenses associated with being a public company, including costs of accounting, audit, legal, regulatory and tax-related services associated with maintaining compliance with Nasdaq and SEC requirements; director and officer insurance costs; and investor and public relations costs. Interest Income Interest income consists of interest income earned on our cash, cash equivalents and short-term investments. Our interest income has increased due to higher investment balances and higher yields on invested funds in 2019 as compared to 2018. Income Taxes Since our inception in 2015, we have not recorded any U.S. federal or state income tax benefits for the net losses we have incurred in any year or for our earned research and development tax credits, due to our uncertainty of realizing a benefit from those items. As of December 31, 2019, we had federal and state net operating loss carryforwards of $150.7 million and $157.3 million, respectively, that expire at various dates through 2039. As of December 31, 2019, we also had federal and state research and development tax credit carryforwards of $21.2 million and $5.2 million, respectively, that expire at various dates through 2039. Included in the $21.2 million of federal research and development credit carryforwards is $17.3 million of orphan drug credit carryforwards. Critical Accounting Policies and Use of Estimates Our management’s discussion and analysis of financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States. The preparation of our consolidated financial statements and related disclosures requires us to make estimates, assumptions and judgements that affect the reported amount of assets, liabilities, revenue, costs and expenses, and related disclosures. We base our estimates on historical experience, known trends and events and various other factors that we believe are 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. We evaluate our estimates and assumptions on an ongoing basis. Our 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 at the end of 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 financial statements. Revenue Recognition-In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09, Revenue (Topic 606): Revenue from Contracts with Customers (“ASU 2014-09”), which amends the guidance for accounting for revenue from contracts with customers. ASU 2014-09 supersedes the revenue recognition requirements in FASB ASC Topic 605, Revenue Recognition (“ASC 605”), and creates a new Topic 606, Revenue from Contracts with Customers (“ASC 606”). On January 1, 2019, we adopted ASC 606 using the full retrospective transition method. Under ASC 606, an entity recognizes revenue when its customer obtains control of promised goods or services, in an amount that reflects the consideration which the entity expects to receive in exchange for those goods or services. To determine the appropriate amount of revenue to be recognized for arrangements determined to be within the scope of ASC 606, we perform the following five steps: (i) identification of the promised goods or services in the contract; (ii) determination of whether the promised goods or services are performance obligations including whether they are distinct in the context of the contract; (iii) measurement of the transaction price, including the constraint on variable consideration; (iv) allocation of the transaction price to the performance obligations; and (v) recognition of revenue when (or as) we satisfy each performance obligation. We only apply the five-step model to contracts when it is probable that we will collect consideration we are entitled to in exchange for the goods or services we transfer to the customer. We estimate the transaction price based on the amount expected to be received for transferring the promised goods or services in the contract. The consideration may include fixed consideration and variable consideration. At the inception of each arrangement that includes variable consideration, we evaluate the amount of consideration to which we expect to be entitled to. We utilize either the most likely amount method or expected value method to estimate the amount expected to be received based on which method best predicts the amount expected to be received. The amount of variable consideration that is included in the transaction price may be constrained and is included in the transaction price only to the extent that it is probable that a significant reversal in the amount of the cumulative revenue recognized will not occur in a future period. Our contracts may include development and regulatory milestone payments that are assessed under the most likely amount method and constrained until it is probable that a significant revenue reversal would not occur. Milestone payments that are not within our control, such as regulatory approvals, are not considered probable of being achieved until those approvals are received. At the end of each reporting period, we re-evaluate the probability of achievement of such development and clinical milestones and any related constraint, and if necessary, adjust our estimate of the overall transaction price. Any such adjustments are recorded on a cumulative catch-up basis, which would affect collaboration revenue in the period of adjustment. For arrangements that include sales-based royalties, including milestone payments based on the level of sales, and the license is deemed to be the predominant item to which the royalties relate, we recognize revenue at the later of (i) when the related sales occur, or (ii) when the performance obligation to which some or all of the royalty has been allocated has been satisfied (or partially satisfied). We allocate the transaction price based on the estimated standalone selling price of each performance obligation. We develop assumptions that require judgment to determine the stand-alone selling price for each performance obligation identified in the contract. We utilize key assumptions to determine the stand-alone selling price, which may include other comparable transactions, pricing considered in negotiating the transaction and the estimated costs. Variable consideration is allocated specifically to one or more performance obligations in a contract when the terms of the variable consideration relate to the satisfaction of the performance obligation and the resulting amounts allocated are consistent with the amounts we would expect to receive for the satisfaction of each performance obligation. The consideration allocated to each performance obligation is recognized as revenue when control is transferred for the related goods or services. For performance obligations which consist of licenses and other promises, we utilize judgment to assess the nature of the combined performance obligation to determine whether the combined performance obligation is satisfied over time or at a point in time and, if over time, the appropriate method of measuring progress. We evaluate the measure of progress for our over-time arrangements at each reporting period and, if necessary, adjust the measure of performance and related revenue recognition and, if necessary, update the measure or progress and revenue recognized. Under the full retrospective transition method, we revised our consolidated financial statements for prior period amounts as if ASC 606 had been effective for such periods. See Notes 2 and 15 to our consolidated financial statements for more information regarding our adoption of the new revenue recognition and rules under ASC 606. Accrued Research and Development Expenses-As part of the process of preparing our financial statements, we are required to estimate our accrued research and development expenses. This process involves reviewing open contract and purchase orders, communicating with our personnel and vendors to identify services that have been performed on our behalf and estimating the level of service performed and the associated costs incurred for the services when we have not yet been invoiced or otherwise notified of the actual costs. The majority of our service providers invoice us in arrears for services performed, on a pre-determined schedule or when contractual milestones are met; however, some require advanced payments. 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. Examples of estimated accrued research and development expenses include fees paid to: • CROs and other third parties in connection with performing research activities on our behalf and conducting preclinical studies and clinical trials on our behalf and CMOs in connection with producing product for our clinical studies; • vendors in connection with preclinical development activities; and • vendors related to product manufacturing and development and distribution of preclinical supplies. We base our expenses related to preclinical and clinical studies on our estimates of the services received and efforts expended pursuant to quotes and contracts with CROs that conduct and manage preclinical studies and clinical trials and CMOs that manufacture product for our research and development 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 expense. In accruing 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 amount of 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 may result in us reporting amounts that are too high or too low in any particular period. To date, we have not made any material adjustments to our prior estimates of accrued research and development expenses. Stock-Based Compensation-We account for stock-based compensation transactions using a grant-date fair-value-based method under FASB Codification Topic 718, Compensation-Stock Compensation. We measure stock options and other stock-based awards granted to employees, directors, consultants or advisors of the company or its affiliates based on their fair value on the date of the grant and recognize compensation expense of those awards, over the requisite service period, which is generally the vesting period of the respective award. We apply the straight-line method of expense recognition to all awards with only service-based vesting conditions and apply the graded-vesting method to all awards with performance-based vesting conditions or to awards with both service-based and performance-based vesting conditions. We estimate the fair value of each stock option grant on the date of 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. Emerging Growth Company Status The Jumpstart Our Business Startups Act of 2012, or the JOBS Act, permits an “emerging growth company,” which we are, 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 elected to take advantage of this extended transition period. Recent Accounting Pronouncements In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) (“ASU 2016-02”), which eliminates the current tests for lease classification under U.S. GAAP and requires lessees to recognize the right-to-use assets and related lease liabilities in the balance sheet. The new standard provides for a modified retrospective application. ASU 2016-02 was initially effective for us beginning January 1, 2020 with early application permitted. In October 2019, the FASB approved an update that would delay the effective date of this standard for us until the interim and annual period beginning after December 15, 2020, with early adoption permitted. We adopted this standard early on January 1, 2020. We expect to elect the package of practical expedients permitted under the transition guidance within the new standard, which, among other things, allows us to carry forward historical lease classification. We have substantially completed our evaluation of the impact of the adoption of ASU 2016-02 on our consolidated financial statements and upon adoption, expect to recognize a lease liability and related right-of-use asset on our consolidated balance sheet of approximately $17.0 million to $18.0 million and approximately $6.0 million to $7.0 million, respectively, and a reduction to deferred rent of approximately $10.0 million to $11.0 million to eliminate the deferred rent balance. We do not expect the standard to have a material impact on our results of operations or cash flows. In addition, we are currently implementing changes to processes and controls to support lease accounting and related disclosures under the new standard. In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”) to improve financial reporting by requiring more timely recording of credit losses on loans and other financial instruments held by financial institutions and other organizations. 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. ASU 2016-13 also requires enhanced disclosures to help investors and other financial statement users better understand significant estimates and judgments used in estimating credit losses, as well as the credit quality and underwriting standards of an organization’s portfolio. ASU 2016-13 is effective for us beginning January 1, 2023, with early application permitted. We are currently evaluating the impact the adoption of this standard will have on our consolidated financial statements. In December 2016, the FASB issued ASU No. 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash (a consensus of the FASB Emerging Issues Task Force) (“ASU 2016-18”), which requires that amounts described as restricted cash or cash equivalents must be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. We adopted ASU 2016-18 on January 1, 2019, and reclassified restricted cash in the consolidated statements of cash flows to be included in cash and cash equivalents. The reclassification was not material to the periods presented. In June 2018, the FASB issued ASU No. 2018-07, Compensation-Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting (“ASU 2018-07”), which changes certain aspects of the accounting for share-based payments granted to nonemployees. Under ASU 2018-07, most of the guidance on such payments to nonemployees would be aligned with the requirements for share-based payments granted to employees. ASU 2018-07 is effective for us beginning January 1, 2020. Early application of this standard is permitted. We do not expect the adoption of ASU 2018-07 to have a material impact on our consolidated financial statements and related disclosures. Results of Operations Comparison of Years Ended December 31, 2019 and 2018 The following table summarizes our results of operations for the years ended December 31, 2019 and 2018: Collaboration Revenue Collaboration revenue for the year ended December 31, 2019 was $1.7 million, compared to $5.3 million (as revised) for the year ended December 31, 2018. We recognize revenues consistent with the pattern of performance of our research and development activities under our collaboration agreement with Novartis, taking into consideration all upfront payments and research funding payments under this arrangement together as a single performance obligation. Collaboration revenue recognized in a given period is based on actual costs incurred during that period as a percentage of total estimated costs to complete the single performance obligation under the arrangement. We would not expect collaboration revenue to be consistent period to period as it will fluctuate as we perform the research, development and manufacturing services over the term of our collaboration agreement with Novartis. Research and Development Expenses Research and development expenses for the year ended December 31, 2019 were $89.4 million, compared to $47.9 million for the year ended December 31, 2018. The increase of $41.5 million was primarily due to an increase of $15.2 million in direct research expenses, including costs related to manufacturing preclinical study and clinical trial materials, as well as costs incurred with our CRO to conduct and manage our Phase 1/2 pheNIX clinical trial, a $12.6 million increase in direct research expenses related to HMI-202 and HMI-103 development costs as we advance through IND-enabling studies, which were initiated in 2019, and a $13.7 million increase in employee-related costs due to an increase in employee headcount to support our ongoing development programs, research initiatives, technology platform and manufacturing capabilities. General and Administrative Expenses General and administrative expenses were $22.2 million for the year ended December 31, 2019, compared to $17.3 million for the year ended December 31, 2018. The increase of $4.9 million was primarily due to a $3.5 million increase in employee-related costs, a $1.8 million increase in consulting costs, a $1.1 million increase in legal costs and a $0.8 million increase in insurance and other public company related expenses. These increases were partially offset by a $2.4 million decrease in facilities costs, primarily as a result of a larger portion of facilities costs allocated to research and development expense in the year ended December 31, 2019. Interest Income Interest income was $6.0 million for the year ended December 31, 2019 compared to approximately $4.3 million for the year ended December 31, 2018. The increase was the result of interest income generated on our higher average cash, cash equivalent and short-term investment balances and higher yields on invested funds for the year ended December 31, 2019 compared to the year ended December 31, 2018. Net Loss Net loss for the year ended December 31, 2019 was $103.9 million, compared to $55.6 million for the year ended December 31, 2018. The increase in net loss was primarily due to the increases in research and development and general and administrative expenses discussed above. Liquidity and Capital Resources Since our inception, we have incurred significant operating losses. We expect to incur significant expenses and operating losses for the foreseeable future as we advance the preclinical and clinical development of our product candidates. We expect that our research and development and general and administrative costs and our capital expenditures will increase in connection with conducting preclinical studies and clinical trials for our product candidates, contracting with CMOs producing material in our internal manufacturing facility to support preclinical studies and clinical trials, expanding our research and development laboratories and manufacturing facility, expanding our intellectual property portfolio, and providing general and administrative support for our operations. As a result, we will need additional capital to fund our operations, which we may obtain from additional equity or debt financings, collaborations, licensing arrangements, or other sources. We do not currently have any approved products and have never generated any revenue from product sales. To date, we have financed our operations primarily through the sale of common stock, the sale of preferred stock and through an up-front payment from a collaboration partner. Since our inception in 2015, we have raised a total of approximately $444 million in net proceeds through our initial public offering, or IPO, in April 2018, a follow-on public offering of common stock in April 2019, proceeds from the sale of common stock under an “at-the-market” sales agreement and preferred stock financings. We received an up-front payment of $50.0 million from a collaboration partner, comprised of $35.0 million in cash and a $15.0 million equity investment, which is included in the proceeds from the sale of preferred stock. In April 2019, we entered into a sales agreement, or the Sales Agreement, with Cowen and Company, LLC, as sales agent, pursuant to which we may, from time to time, issue and sell common stock with an aggregate value of up to $100 million in "at-the-market" offerings under our Registration Statement on Form S-3 (File No. 333-230664) filed with the SEC on April 1, 2019. Sales of common stock, if any, pursuant to the Sales Agreement, may be made in sales deemed to be an “at the market offering” as defined in Rule 415(a) of the Securities Act, including sales made directly through the Nasdaq Global Market or on any other existing trading market for our common stock. During the year ended December 31, 2019, we sold 1,105,000 shares of our common stock pursuant to the Sales Agreement for aggregate net proceeds of $22.5 million, after deducting commissions and other transaction costs. Also in April 2019, we completed a follow-on public offering of our common stock. We sold 5,555,556 shares of our common stock at a public offering price of $22.50 per share and received net proceeds of $116.9 million, after deducting underwriting discounts and commissions and offering expenses. In addition, in April and May 2019, in connection with the exercise in full of the underwriters’ option to purchase additional shares, we issued an aggregate of 833,333 shares of our common stock at a public offering price of $22.50 per share and received net proceeds of $17.6 million, after deducting underwriting discounts and commissions. Cash Flows Our cash, cash equivalents and short-term investments totaled $262.4 million and $214.7 million as of December 31, 2019 and 2018, respectively. We had no indebtedness as of December 31, 2019 and 2018. The following table summarizes our sources and uses of cash for the period presented: Cash Flows for the year ended December 31, 2019 Operating Activities Net cash used in operating activities for the year ended December 31, 2019 was $91.4 million, driven primarily by our net loss of $103.9 million as we incurred expenses associated with research and development activities on HMI-102, HMI-103 and HMI-202, including the Phase 1/2 pheNIX trial for our HMI-102 program, and research activities on other applications for our technology. The funding of our net loss was partially offset by net non-cash expenses of $12.1 million, including $7.6 million of stock compensation expense and $6.3 million of depreciation expense. Changes to working capital were mostly offsetting, with $4.5 million in decreased accounts payable and $0.6 million in decreased deferred revenue netting against $2.8 million in decreased prepaid expenses and other current assets and $2.3 million in increased accrued expenses and other liabilities. Investing Activities Net cash used in investing activities for the year ended December 31, 2019 was $51.8 million, attributable to $286.4 million in purchases of short-term investments and $21.8 million in purchases of property and equipment, partially offset by maturities of short-term investments of $256.4 million. Financing Activities Net cash provided by financing activities for the year ended December 31, 2019 was $158.2 million, primarily due to $134.5 million of net proceeds from the issuance of common stock in a public offering in April 2019 and $22.5 million of net proceeds from the issuance of common stock under an “at-the-market” sales agreement in December 2019. Cash Flows for the year ended December 31, 2018 Operating Activities Net cash used in operating activities for the year ended December 31, 2018 was $42.6 million, primarily due to our net loss of $55.6 million as we incurred expenses associated with research activities on HMI-102 and research activities on other applications for our technology. The funding of our net loss was partially offset by net non-cash expenses of $2.5 million, an increase in long-term deferred rent of $10.0 million which was largely due to the receipt of cash lease incentives from our landlord during 2018 and an increase in working capital of $0.5 million. Investing Activities Net cash used in investing activities for the year ended December 31, 2018 was $121.8 million, attributable to $245.3 million in purchases of short-term investments and $24.9 million in purchases of property and equipment, partially offset by maturities of short-term investments of $148.5 million. Financing Activities Net cash provided by financing activities for the year ended December 31, 2018 was $151.0 million, primarily due to proceeds from the issuance of common stock in our initial public offering, net of discounts and issuance costs, of $150.8 million. Funding Requirements Our operating expenses increased substantially in 2019 and are expected to increase substantially in 2020 and future years in connection with our ongoing activities, particularly as we advance our Phase 1/2 pheNIX clinical trial with HMI-102 and our preclinical activities including IND enabling studies, scale-up our manufacturing processes, engage with CMOs, manufacture materials for preclinical and clinical activities in our internal manufacturing facility and initiate additional human clinical trials. In addition, we have incurred and expect to continue to incur additional costs associated with operating as a public company. We also expect our capital expenditures to increase substantially as we expand our operations. Specifically, our expenses will increase as we: • pursue the preclinical and clinical development of HMI-102, including the ongoing pheNIX Phase 1/2 clinical trial, HMI-103 and HMI-202; • pursue the preclinical and clinical development of other product candidates based on our gene therapy and gene editing technology; • further scale up our internal manufacturing processes and capabilities, manufacture materials in our internal manufacturing facility and contract with CMOs to support our preclinical studies and clinical trials of our product candidates; • further expand our manufacturing capacity; • operate our business in our facility with expanded research and development labs and manufacturing suites and purchase additional equipment for our operations; • in-license or acquire the rights to other products, product candidates or technologies; • maintain, expand and protect our intellectual property portfolio; • hire additional personnel in research, manufacturing and regulatory and clinical development as well as management personnel; and • expand our operational, financial and management systems and increase personnel, including personnel to support our operations as a public company. We believe that our existing cash, cash equivalents and short-term investments will enable us to fund our operating expenses and capital expenditure requirements into the fourth quarter of 2021. We have based these estimates on assumptions that may prove to be imprecise, and we could utilize our available capital resources sooner than we expect. Because of the numerous risks and uncertainties associated with research, development and commercialization of pharmaceutical drugs, it is difficult to estimate with certainty the amount of our working capital requirements. Our future funding requirements will depend on many factors, including: • the progress, costs and results of our preclinical development and initial clinical trials for HMI-102, including the pheNIX Phase 1/2 clinical trial, HMI-103 and HMI-202; • the progress, costs and results of our additional research and preclinical development programs in gene therapy and gene editing; • the costs, scope and timing of internal process development and manufacturing scale-up activities, the production of materials in our internal manufacturing facility, and outsourcing activities with CMOs associated with our lead product development programs and other programs we advance through preclinical and clinical development; • our ability to establish and maintain strategic collaborations, licensing or other agreements and the financial terms of such agreements; • the scope, progress, results and costs of any product candidates that we may derive from our platform technology or any other product candidates that we may develop; • the extent to which we in-license or acquire rights to other products, product candidates or technologies; and • the costs and timing of preparing, filing and prosecuting patent applications, maintaining and protecting our intellectual property rights and defending against any intellectual property-related claims. Until such time, if ever, that we can generate product revenue sufficient to achieve profitability, we expect to finance our cash needs through a combination of equity offerings, debt financings, collaboration agreements, other third-party funding, strategic alliances, licensing arrangements and marketing and distribution arrangements. 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 the rights of our shareholders as common stockholders. Debt financing and preferred 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 additional funds through other third-party funding, collaboration agreements, strategic alliances, licensing arrangements or marketing and distribution arrangements, 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. 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 products or product candidates that we would otherwise prefer to develop and market ourselves. Contractual Obligations The following is a summary of our significant contractual obligations as of December 31, 2019: (1) Represents future minimum lease payments under our operating leases for office and lab space in Bedford, Massachusetts that expire in October 2021 and February 2027. Future minimum lease payments are net of anticipated sublease payments of approximately $1.8 million for the period of 2020 to 2021. (2) Represents minimum annual license fees under our license agreements with Caltech and COH. These amounts do not include any potential contingent payments upon the achievement by us of specified clinical, regulatory and commercial events, as applicable, or patent prosecution or royalty payments we may be required to make under these license agreements. We have excluded these potential payments in the contractual obligations table because the timing and likelihood of these contingent payments are not currently known and would be difficult to predict or estimate. See Item 1. “Business-Strategic Collaborations” for additional information about these license agreements, including with respect to potential payments thereunder. We enter into contracts in the normal course of business with CROs and CMOs for clinical trials, preclinical research studies and testing, manufacturing and other services and products for operating purposes. These contracts do not contain any minimum purchase commitments and are cancelable by us upon prior notice of 30 days and, as a result, are not included in the table of contractual obligations above. Off-Balance Sheet Arrangements We have not entered into any off-balance sheet arrangements and do not have any holdings in variable interest entities.
-0.144592
-0.144114
0
<s>[INST] Overview We are a genetic medicines company dedicated to transforming the lives of patients suffering from rare genetic diseases with significant unmet medical needs by curing the underlying cause of the disease. Our proprietary platform is designed to utilize our AAVHSCs to precisely and efficiently deliver single administration genetic medicines in vivo either through gene therapy or nucleasefree gene editing across a broad range of genetic disorders. Our diverse set of AAVHSCs allows us to precisely target, via a single injection, a wide range of diseaserelevant tissues, including the liver, CNS, PNS, bone marrow, muscle and eye. Our genetic medicines platform is designed to provide us the flexibility to choose the method we believe is best suited from either gene therapy or gene editing for each disease we pursue, based on such factors as the targeted disease biology, the biodistribution of our AAVHSCs to key tissues, and the rate of cell division the tissues exhibit. Our product development strategy is to continue to develop in parallel both gene therapy and gene editing, while initially leveraging the experience from our gene therapy product candidates to further advance our gene editing. We believe our dual technology platform will allow us to provide transformative cures using either modality. The unique properties of our proprietary suite of 15 novel AAVHSCs enable us to focus on a method of gene editing called gene integration, through the replacement of an entire diseased gene in the genome with a whole functional copy, by harnessing the naturally occurring DNA repair process of HR. We believe our HRdriven gene editing approach will allow us to efficiently perform gene editing at therapeutic levels without unwanted on and offtarget modifications, and to directly measure and confirm those modifications in an unbiased manner to ensure only the intended changes are made. By utilizing the body’s natural mechanism of correcting gene defects, we also avoid the need for exogenous nucleases, or bacteriaderived enzymes used in other gene editing approaches to cut DNA, that are known to significantly increase the risk of unwanted modifications. We are currently in the doseescalation portion of our Phase 1/2 pheNIX clinical trial with our first and lead product candidate, HMI102, a gene therapy for the treatment of PKU. Once a dose is chosen, we will initiate the randomized, concurrently controlled Part B of the trial, which has the potential to be converted to a registrational trial. In December 2019, in accordance with a corporate goal that we had established in early 2018, we reported encouraging initial clinical data from the pheNIX trial from Cohort 1 (low dose, n2) and Cohort 2 (middose, n1) based on the data cutoff date of December 2, 2019. Preliminary safety data from three subjects in Cohorts 1 and 2 showed HMI102 was welltolerated with no treatmentemergent adverse events, or TEAEs, or serious TEAEs. Efficacy data from the first patient in Cohort 2 suggested a doseresponse effect with an observed reduction in Phe levels from baseline and a corresponding increase in Tyr which translated to an overall reduction in the Phe/Tyr ratio, suggestive of increased enzymatic activity. Phe levels have been evaluated as a primary registrable endpoint in previous PKU clinical trials, Tyr is a product of Phe metabolism and a precursor to neurotransmitters, and the Phe/Tyr ratio is a clinically relevant diagnostic measurement for PKU. We are in INDenabling studies with HMI202, our lead gene therapy CNS product development candidate for the treatment of MLD. This represents our first CNS program as we are leveraging the ability of our AAVHSCs to cross the bloodbrainbarrier as well as the bloodnervebarrier. We are in INDenabling studies with HMI103, our lead gene editing product development candidate for the treatment of PKU in pediatric patients. We have generated in vivo preclinical data demonstrating achievement of gene integration efficiencies in the liver that correspond with Phe correction in a PKU murine model, are significantly greater than other AAVbased approaches and we believe are at a therapeutic level in the preclinical model. We have internal process development and GMP manufacturing capabilities, including a [/INST] Negative. </s>
2,020
8,146
1,702,780
Altice USA, Inc.
2018-03-06
2018-01-05
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations This Form 10-K contains statements that constitute forward-looking information within the meaning of the Private Securities Litigation Reform Act of 1995. In this Form 10-K there are statements concerning our future operating results and future financial performance. Words such as "expects", "anticipates", "believes", "estimates", "may", "will", "should", "could", "potential", "continue", "intends", "plans" and similar words and terms used in the discussion of future operating results, future financial performance and future events identify forward-looking statements. Investors are cautioned that such forward-looking statements are not guarantees of future performance, results or events and involve risks and uncertainties and that actual results or developments may differ materially from the forward-looking statements as a result of various factors. We operate in a highly competitive, consumer and technology driven and rapidly changing business that is affected by government regulation and economic, strategic, technological, political and social conditions. Various factors could adversely affect our operations, business or financial results in the future and cause our actual results to differ materially from those contained in the forward-looking statements. In addition, important factors that could cause our actual results to differ materially from those in our forward-looking statements include: • competition for broadband, pay television and telephony customers from existing competitors (such as broadband communications companies, DBS providers and Internet-based providers) and new competitors entering our footprint; • changes in consumer preferences, laws and regulations or technology that may cause us to change our operational strategies; • increased difficulty negotiating programming agreements on favorable terms, if at all, resulting in increased costs to us and/or the loss of popular programming; • increasing programming costs and delivery expenses related to our products and services; • our ability to achieve anticipated customer and revenue growth, to successfully introduce new products and services and to implement our growth strategy; • our ability to complete our capital investment plans on time and on budget, including our plan to build a FTTH network, and deploy Altice One, our new home communications hub; • our ability to develop and deploy mobile voice and data services pursuant to the agreement we entered into with Sprint in the fourth quarter of 2017; • the effects of economic conditions or other factors which may negatively affect our customers’ demand for our products and services; • the effects of industry conditions; • demand for advertising on our cable systems; • our substantial indebtedness and debt service obligations; • adverse changes in the credit market; • changes as a result of any tax reforms that may affect our business; • financial community and rating agency perceptions of our business, operations, financial condition and the industries in which we operate; • the restrictions contained in our financing agreements; • our ability to generate sufficient cash flow to meet our debt service obligations; • fluctuations in interest rates which may cause our interest expense to vary from quarter to quarter; • technical failures, equipment defects, physical or electronic break-ins to our services, computer viruses and similar problems; • the disruption or failure of our network, information systems or technologies as a result of computer hacking, computer viruses, “cyber-attacks,” misappropriation of data, outages, natural disasters and other material events; • our ability to obtain necessary hardware, software, communications equipment and services and other items from our vendors at reasonable costs; • our ability to effectively integrate acquisitions and to maximize expected operating efficiencies from our acquisitions or as a result of the transactions, if any; • significant unanticipated increases in the use of bandwidth-intensive Internet-based services; • the outcome of litigation, government investigations and other proceedings; • our ability to successfully operate our business following the completion of our separation from Altice N.V., and • other risks and uncertainties inherent in our cable and other broadband communications businesses and our other businesses, including those listed under the caption “Risk Factors” and "Management's Discussion and Analysis of Financial Condition and Results of Operations" contained herein. We disclaim any obligation to update or revise the forward-looking statements contained herein, except as otherwise required by applicable federal securities laws. Certain numerical figures included in this annual report have been subject to rounding adjustments. Accordingly, such numerical figures shown as totals in various tables may not be arithmetic aggregations of the figures that precede them. Overview All dollar amounts, except per customer and per share data, included in the following discussion, are presented in thousands. Our Business We deliver broadband, pay television, telephony services, Wi-Fi hotspot access, proprietary content and advertising services to approximately 4.9 million residential and business customers. Our footprint extends across 21 states through a fiber-rich broadband network with approximately 8.6 million homes passed as of December 31, 2017. We have two reportable segments: Cablevision and Cequel. Cablevision provides broadband, pay television and telephony services to residential and business customers in and around the New York metropolitan area. Cequel provides broadband, pay television and telephony services to residential and business customers in the south-central United States, with the majority of its customers located in the ten states of Texas, West Virginia, Louisiana, Arkansas, North Carolina, Oklahoma, Arizona, California, Missouri and Ohio. Key Factors Impacting Operating Results and Financial Condition Our future performance is dependent, to a large extent, on the impact of direct competition, general economic conditions (including capital and credit market conditions), our ability to manage our businesses effectively, and our relative strength and leverage in the marketplace, both with suppliers and customers. For more information see “Risk Factors” and “Business-Competition” included herein. We derive revenue principally through monthly charges to residential customers of our pay television, broadband, and telephony services. We also derive revenue from equipment rental, DVR, VOD, pay-per-view, installation and home shopping commissions. Our residential pay television, broadband, and telephony services accounted for approximately 45%, 27% and 9%, respectively, of our consolidated revenue for the year ended December 31, 2017. We also derive revenue from the sale of a wide and growing variety of products and services to both large enterprise and SMB customers, including broadband, telephony, networking and pay television services. For the year ended December 31, 2017, 14% of our consolidated revenue was derived from these business services. In addition, we derive revenues from the sale of advertising time available on the programming carried on our cable television systems, which accounted for approximately 4% of our consolidated revenue for the year ended December 31, 2017. Our other revenue for the year ended December 31, 2017 accounted for less than 1% of our consolidated revenue. Revenue increases are derived from rate increases, increases in the number of customers to our services, including additional services sold to our existing customers, programming package upgrades by our pay television customers, speed tier upgrades by our broadband customers, and acquisitions of cable systems that result in the addition of new customers. Our ability to increase the number of customers to our services is significantly related to our penetration rates. We operate in a highly competitive consumer-driven industry and we compete against a variety of broadband, pay television and telephony providers and delivery systems, including broadband communications companies, wireless data and telephony providers, satellite-delivered video signals, Internet-delivered video content and broadcast television signals available to residential and business customers in our service areas. Our competitors include AT&T and its DirecTV subsidiary, CenturyLink, DISH Network, Frontier and Verizon. Consumers’ selection of an alternate source of service, whether due to economic constraints, technological advances or preference, negatively impacts the demand for our services. For more information on our competitive landscape, see “Risk Factors” and “Business-Competition” included herein. Our programming costs, which are the most significant component of our operating expenses, have increased and are expected to continue to increase primarily as a result of contractual rate increases and new channel launches. See “-Results of Operations” below for more information regarding our key factors impacting our revenues and operating expenses. Historically, we have made substantial investments in our network and the development of new and innovative products and other service offerings for our customers as a way of differentiating ourselves from our competitors and may continue to do so in the future. We have commenced a five-year plan to build a FTTH network, which will enable us to deliver more than 10 Gbps broadband speeds across our entire Optimum footprint and part of our Suddenlink footprint. We may incur greater than anticipated capital expenditures in connection with this initiative, fail to realize anticipated benefits, experience delays and business disruptions or encounter other challenges to executing it as planned. See “-Liquidity and Capital Resources-Capital Expenditures” for additional information regarding our capital expenditures. Certain Transactions The following transactions occurred during the periods covered by this Management's Discussion and Analysis of Financial Condition and Results of Operations: On June 21, 2016, Altice USA acquired Cablevision for a total purchase price of approximately $9,958,323. The Altice USA operating results include the operating results of Cablevision from the date of acquisition. In July 2016, we completed the sale of a 75% interest in Newsday LLC and retained the remaining 25% ownership interest. Effective July 7, 2016, the operating results of Newsday are no longer consolidated with our results and our 25% interest in the operating results of Newsday is recorded on the equity basis. Non-GAAP Financial Measures We define Adjusted EBITDA, which is a non-GAAP financial measure, as net income (loss) excluding income taxes, income (loss) from discontinued operations, other non-operating income or expenses, loss on extinguishment of debt and write-off of deferred financing costs, gain (loss) on interest rate swap contracts, gain (loss) on derivative contracts, gain (loss) on investments, interest expense (including cash interest expense), interest income, depreciation and amortization (including impairments), share-based compensation expense or benefit, restructuring expense or credits and transaction expenses. We believe Adjusted EBITDA is an appropriate measure for evaluating the operating performance of the Company. Adjusted EBITDA and similar measures with similar titles are common performance measures used by investors, analysts and peers to compare performance in our industry. Internally, we use revenue and Adjusted EBITDA measures as important indicators of our business performance, and evaluate management’s effectiveness with specific reference to these indicators. We believe Adjusted EBITDA provides management and investors a useful measure for period-to-period comparisons of our core business and operating results by excluding items that are not comparable across reporting periods or that do not otherwise relate to the Company’s ongoing operating results. Adjusted EBITDA should be viewed as a supplement to and not a substitute for operating income (loss), net income (loss), and other measures of performance presented in accordance with GAAP. Since Adjusted EBITDA is not a measure of performance calculated in accordance with GAAP, this measure may not be comparable to similar measures with similar titles used by other companies. Results of Operations - Altice USA The following is a reconciliation of net income (loss) to Adjusted EBITDA: (a) Includes primarily dividends received on Comcast common stock owned by the Company. (b) Consists of unrealized and realized losses (gains) due to the change in the fair value of derivative contracts. The following table sets forth certain customer metrics by segment (unaudited): (a) Represents the estimated number of single residence homes, apartments and condominium units passed by the cable distribution network in areas serviceable without further extending the transmission lines. In addition, it includes commercial establishments that have connected to our cable distribution network. For Cequel, broadband services were not available to approximately 100 homes passed and telephony services were not available to approximately 500 homes passed. (b) Represents number of households/businesses that receive at least one of the Company's services. (c) Customers represent each customer account (set up and segregated by customer name and address), weighted equally and counted as one customer, regardless of size, revenue generated, or number of boxes, units, or outlets. In calculating the number of customers, we count all customers other than inactive/disconnected customers. Free accounts are included in the customer counts along with all active accounts, but they are limited to a prescribed group. Most of these accounts are also not entirely free, as they typically generate revenue through pay-per-view or other pay services and certain equipment fees. Free status is not granted to regular customers as a promotion. In counting bulk residential customers, such as an apartment building, we count each subscribing family unit within the building as one customer, but do not count the master account for the entire building as a customer. We count a bulk commercial customer, such as a hotel, as one customer, and do not count individual room units at that hotel. (d) Represents the number of customers that subscribe to three of our services divided by total residential customer relationships. (e) Represents the number of total customer relationships divided by homes passed. (f) Calculated by dividing the average monthly revenue for the respective quarter (fourth quarter for annual periods) derived from the sale of broadband, pay television and telephony services to residential customers for the respective quarter by the average number of total residential customers for the same period. Altice USA - Comparison of Results for the Year Ended December 31, 2017 compared to the Year Ended December 31, 2016 Pay Television Revenue Pay television revenue for the years ended December 31, 2017 and 2016 was $4,214,745 and $2,759,216, respectively, of which $3,113,238 and $1,638,691 was derived from the Cablevision segment and $1,101,507 and $1,120,525 relates to our Cequel segment, respectively. Pay television is derived principally through monthly charges to residential customers of our pay television services. Revenue increases are derived primarily from rate increases, increases in the number of customers, including additional services sold to our existing customers, and programming package upgrades. Pay television revenue for our Cablevision segment increased $1,474,547 for the year ended December 31, 2017 compared to the year ended December 31, 2016. The increase is primarily due to the consolidation of the Cablevision results as of June 21, 2016, the date of the Cablevision Acquisition. Our 2016 results do not include pay television revenue of $1,468,006 recognized by Cablevision for the period January 1, 2016 through June 20, 2016. Pay television revenue was also impacted by rate increases for certain video services implemented in the fourth quarter of 2016 and 2017, an increase in late fees and an increase in pay-per-view revenue. Partially offsetting these increases was a decrease in revenue as compared to the prior year due to a decline in pay television customers. Pay television revenue for our Cequel segment decreased $19,018 (2%) for the year ended December 31, 2017 compared to the year ended December 31, 2016. The decrease was due primarily to a decline in the number of pay television customers and a decrease in premium video services revenue, partially offset by certain rate increases, and an increase in late fees. We believe our pay television customer declines noted in the table above are largely attributable to competition, particularly from Verizon in our Cablevision footprint and DBS providers in our Cequel footprint, as well as competition from companies that deliver video content over the Internet directly to customers. These factors are expected to continue to impact our ability to maintain or increase our existing customers and revenue in the future. Broadband Revenue Broadband revenue for the years ended December 31, 2017 and 2016 was $2,563,772 and $1,617,029, respectively, of which $1,603,015 and $782,615 was derived from our Cablevision segment and $960,757 and $834,414 was derived from our Cequel segment. Broadband revenue is derived principally through monthly charges to residential customers of our broadband services. Revenue increases are derived primarily from rate increases, increases in the number of customers, including additional services sold to our existing customers, and speed tier upgrades. Broadband revenue for our Cablevision segment increased $820,400 for the year ended December 31, 2017 compared to the year ended December 31, 2016. The increase is primarily due to the consolidation of the Cablevision results as of June 21, 2016, the date of the Cablevision Acquisition. Our 2016 results do not include broadband revenue of $673,010 recognized by Cablevision for the period January 1, 2016 through June 20, 2016. Broadband revenue also increased $147,390 as a result of higher average recurring broadband revenue per broadband customer (driven by rate increases, the impact of service level changes, and an increase in late fees) and an increase in broadband customers. Broadband revenue for our Cequel segment increased $126,343 (15%) for the year ended December 31, 2017 compared to the same period in the prior year. The increase was due primarily to higher average recurring broadband revenue per broadband customer (driven by rate increases, the impact of service level changes, and an increase in late fees) and an increase in broadband customers. Telephony Revenue Telephony revenue for the years ended December 31, 2017 and 2016 was $823,981 and $529,973 of which $693,478 and $376,034 was derived from the Cablevision segment and $130,503 and $153,939 was derived from our Cequel segment. Telephony revenue is derived principally through monthly charges to residential customers of our telephony services. Revenue increases are derived primarily from rate increases, increases in the number of customers, and additional services sold to our existing customers. Telephony revenue for our Cablevision segment increased $317,444 for the year ended December 31, 2017 compared to the year ended December 31, 2016. The increase is primarily due to the consolidation of the Cablevision results as of June 21, 2016, the date of the Cablevision Acquisition. Our 2016 results do not include telephony revenue of $342,142 recognized by Cablevision for the period January 1, 2016 through June 20, 2016. Offsetting this increase was a net decrease of $24,698 due primarily to lower average revenue per telephony customer and a decline in international calling. Telephony revenue for our Cequel segment decreased $23,436 (15%) for the year ended December 31, 2017 compared to the year ended December 31, 2016. The decrease was due primarily to lower average revenue per telephony customer and a decline in telephony customers. Business Services and Wholesale Revenue Business services and wholesale revenue for the years ended December 31, 2017 and 2016 was $1,298,817 and $819,541, respectively of which $923,161 and $468,632 was derived from the Cablevision segment and $375,656 and $350,909 was derived from our Cequel segment. Business services and wholesale revenue is derived primarily from the sale of fiber based telecommunications services to the business market, and the sale of broadband, pay television and telephony services to SMB customers. Business services and wholesale revenue for our Cablevision segment increased $454,529 for the year ended December 31, 2017 compared to the year ended December 31, 2016. The increase is primarily due to the consolidation of the Cablevision results as of June 21, 2016, the date of the Cablevision Acquisition. Our 2016 results do not include revenue of $411,102 recognized by Cablevision for the period January 1, 2016 through June 20, 2016. Business services revenue also increased $43,427 primarily due to higher average recurring telephony and broadband revenue per SMB customer and an increase in Ethernet revenue resulting from a larger number of services installed, partially offset by reduced traditional voice and data services for commercial customers. Business services and wholesale revenue for our Cequel segment increased $24,747 (7%) for the year ended December 31, 2017 as compared to the year ended December 31, 2016. The increase was primarily due to higher commercial rates and customers for broadband services, an increase in certain pay television rates and increases in commercial carrier services. Advertising Revenue Advertising revenue for the years ended December 31, 2017 and 2016, net of inter-segment revenue, was $391,866 and $252,049, respectively, of which $321,149 and $163,678 was derived from our Cablevision segment and $73,509 and $88,371 was derived from our Cequel segment. Advertising revenue is primarily derived from the sale of advertising time available on the programming carried on our cable television systems. Advertising revenue for our Cablevision segment increased $157,471 for the year ended December 31, 2017 compared to the year ended December 31, 2016. The increase is primarily due to the consolidation of the Cablevision results as of June 21, 2016, the date of the Cablevision Acquisition. Our 2016 results do not include advertising revenue of $125,419 recognized by Cablevision for the period January 1, 2016 through June 20, 2016. The remaining increase in advertising revenue of $32,052 was due primarily to an increase in digital advertising revenue and an increase in data and analytics revenue, partially offset by a decrease in political advertising. Advertising revenue for our Cequel segment decreased $14,862 (17%) for the year ended December 31, 2017 as compared to the year ended December 31, 2016. The decrease is due to declines in political, auto, retail, and restaurant advertising. Other Revenue Other revenue for the years ended December 31, 2017 and 2016 was $33,389 and $39,404, respectively, of which $10,747 and $14,402 was derived from our Cablevision segment and $22,642 and $25,002 was derived from our Cequel segment. Other revenue includes other miscellaneous revenue streams. Programming and Other Direct Costs Programming and other direct costs, net of intersegment eliminations, for the years ended December 31, 2017 and 2016 amounted to $3,035,655 and $1,911,230, respectively, of which $2,280,062 and $1,164,925 relate to our Cablevision segment and $758,190 and $746,305 relate to our Cequel segment. Programming and other direct costs include cable programming costs, which are costs paid to programmers (net of amortization of any incentives received from programmers for carriage) for cable content (including costs of VOD and pay-per-view) and are generally paid on a per-customer basis. These costs typically rise due to increases in contractual rates and new channel launches and are also impacted by changes in the number of customers receiving certain programming services. These costs also include interconnection, call completion, circuit and transport fees paid to other telecommunication companies for the transport and termination of voice and data services, which typically vary based on rate changes and the level of usage by our customers. These costs also include franchise fees which are payable to the state governments and local municipalities where we operate and are primarily based on a percentage of certain categories of revenue derived from the provision of pay television service over our cable systems, which vary by state and municipality. These costs change in relation to changes in such categories of revenues or rate changes. The increase of $1,115,137 related to our Cablevision segment for the year ended December 31, 2017, as compared to the prior year is primarily due to the consolidation of the Cablevision results as of June 21, 2016, the date of the Cablevision Acquisition. Our 2016 results do not include $1,088,555 of programming and other direct costs recognized by Cablevision for the period January 1, 2016 through June 20, 2016. The remaining increase of $26,582 is attributable to the following: The increase of $11,885 related to our Cequel segment for the year ended December 31, 2017, as compared to the prior year period is attributable to the following: Programming costs Programming costs aggregated $2,533,244 and $1,567,688 for the years ended December 31, 2017 and 2016, respectively. The 2016 amount does not include programming costs of $883,792 recognized by Cablevision for the period January 1, 2016 through June 20, 2016. Our programming costs in 2018 will continue to be impacted by changes in programming rates, which we expect to increase by high single digits, and by changes in the number of pay television customers. Other Operating Expenses Other operating expenses for the years ended December 31, 2017 and 2016 amounted to $2,342,655 and $1,705,615, respectively, of which $1,675,665 and $1,028,447 relate to our Cablevision segment and $667,185 and $677,168 relate to our Cequel segment. Other operating expenses include staff costs and employee benefits including salaries of company employees and related taxes, benefits and other employee related expenses. Other operating expenses also include network management and field service costs, which represent costs associated with the maintenance of our broadband network, including costs of certain customer connections and other costs associated with providing and maintaining services to our customers. Customer installation and repair and maintenance costs may fluctuate as a result of changes in the level of activities and the utilization of contractors as compared to employees. Also, customer installation costs fluctuate as the portion of our expenses that we are able to capitalize changes. Costs associated with the initial deployment of new customer premise equipment necessary to provide broadband, pay television and telephony services are capitalized (asset-based). In circumstances where customer premise equipment tracking is not available, the Company estimates the amount of capitalized installation costs based on whether or not the business or residence had been previously connected to the network, (premise-based). Network repair and maintenance and utility costs also fluctuate as capitalizable network upgrade and enhancement activity changes. In connection with the execution of an agreement with ATS in the second quarter of 2017 (see Note 14 of our consolidated financial statements), the Cablevision segment's operating results reflect a reduction in employee related expenses due to certain employees becoming employed by ATS and an increase in contractor costs for services provided by ATS. See further details in the table below. A substantial portion of the Cequel segment technical workforce became employees of ATS in December 2017. In January 2018, the Company acquired 70% of the equity interests in ATS and the Company expects to become the owner of 100% of the equity interests in ATS prior to the Distribution (see Note 1 of our consolidated financial statements). Other operating expenses also include costs related to the operation and maintenance of our call center facilities that handle customer inquiries and billing and collection activities and sales and marketing costs, which include advertising production and placement costs associated with acquiring and retaining customers. These costs vary period to period and certain of these costs, such as sales and marketing, may increase with intense competition. Additionally, other operating expenses include various other administrative costs, including legal fees, and product development costs. The increase of $647,218 related to our Cablevision segment for the year ended December 31, 2017, net of inter-segment eliminations, as compared to the prior year is primarily due to the consolidation of the Cablevision results as of June 21, 2016, the date of the Cablevision Acquisition. Our 2016 results do not include $1,136,970 of other operating expenses recognized by Cablevision for the period January 1, 2016 through June 20, 2016. The remaining decrease of $489,752 is attributable to the following: The decrease of $9,983 related to our Cequel segment for the year ended December 31, 2017, net of inter-segment eliminations, as compared to the prior year period is attributable to the following: Restructuring and Other Expense Restructuring and other expense for the year ended December 31, 2017 of $152,401 ($112,384 for our Cablevision segment and $40,017 for our Cequel segment) as compared to $240,395 for the year ended December 31, 2016 ($212,150 for our Cablevision segment and $28,245 for our Cequel segment). These amounts primarily relate to severance and other employee related costs resulting from headcount reductions related to initiatives which commenced in 2016 that are intended to simplify the Company's organizational structure. We currently anticipate that additional restructuring expenses will be recognized as we continue to analyze our organizational structure. Depreciation and Amortization Depreciation and amortization for the years ended December 31, 2017 and 2016 amounted to $2,930,475 and $1,700,306, respectively, of which $2,251,614 and $963,665 relates to our Cablevision segment and $678,861 and $736,641 relates to our Cequel segment. The increase in depreciation and amortization related to our Cablevision segment of $1,287,949 is primarily due to the consolidation of the Cablevision results as of June 21, 2016, the date of the Cablevision Acquisition. Our 2016 results do not include $414,550 of depreciation and amortization recognized by Cablevision for the period January 1, 2016 through June 20, 2016. The remaining increase of $873,399 is primarily attributable to the acceleration of amortization of its trade name intangible assets in connection with the announcement, on May 23, 2017, of the adoption of a global brand to replace the Optimum brand in the future, as well as depreciation on new asset additions. In December 2017, the Company made a decision to postpone the adoption of a global brand that would have replaced the Optimum brand, increasing the useful life of the Optimum trade name intangible asset to 5 years, which will reduce the future annual amortization expense related to the Optimum trade name. The decrease in depreciation and amortization related to our Cequel segment of $57,780 (8%) is due primarily to lower amortization expense for certain intangible assets that are being amortized using an accelerated method, partially offset by an increase resulting from revisions made to the fair value of assets acquired resulting from the finalization in the fourth quarter of 2016 of the purchase price allocation in connection with the Cequel Acquisition. Adjusted EBITDA Adjusted EBITDA amounted to $4,005,690 and $2,414,735 for the years ended December 31, 2017 and 2016, of which $2,751,121 and $1,259,844 relates to our Cablevision segment and $1,254,569 and $1,154,891 relates to our Cequel segment. Adjusted EBITDA is a non-GAAP measure that is defined as net loss excluding income taxes, loss from discontinued operations, other non-operating income or expenses, loss on extinguishment of debt and write-off of deferred financing costs, gain (loss) on interest rate swap contracts, gain (loss) on derivative contracts, gain (loss) on investments, interest expense (including cash interest expense), interest income, depreciation and amortization (including impairments), share-based compensation expense, restructuring expense or credits and transaction expenses. See reconciliation of net loss to adjusted EBITDA above. The increase in adjusted EBITDA for the year ended December 31, 2017 as compare to the prior year was due to the consolidation of the Cablevision results as of June 21, 2016, the date of the Cablevision Acquisition and the increases in revenue and decreases in operating expenses (excluding depreciation and amortization, restructuring and other expense and share-based compensation), as discussed above. Interest Expense, net Interest expense, net was $1,601,211 and $1,442,730, for the years ended December 31, 2017 and 2016, respectively, and includes interest on debt issued to finance the Cablevision Acquisition and Cequel Acquisition, as well as interest on debt assumed in connection with these acquisitions. The increase of $158,481 for the year ended December 31, 2017 as compared to the prior year is attributable to the following: See "Liquidity and Capital Resources" discussion below for a detail of our borrower groups. Gain on Investments, net Gain on investments, net for the years ended December 31, 2017 and 2016, of $237,354 and $141,896 consists primarily of the increase in the fair value of Comcast common stock owned by the Company for the periods. For 2016, the gain is for the period June 21, 2016 through December 31, 2016. The effects of these gains are partially offset by the losses on the related equity derivative contracts, net described below. Loss on Derivative Contracts, net Loss on derivative contracts, net for the year ended December 31, 2017 amounted to $236,330 compared to $53,696 for the year ended December 31, 2016, and includes realized and unrealized losses due to the change in fair value of equity derivative contracts relating to the Comcast common stock owned by the Company. For 2016, the loss is for the period June 21, 2016 through December 31, 2016. The effects of these losses are offset by gains on investment securities pledged as collateral, which are included in gain on investments, net discussed above. The loss for the year ended December 31, 2017 also includes the realized loss on the settlement of certain put-call options of $97,410. Gain (loss) on interest rate swap contracts Gain (loss) on interest rate swap contracts was $5,482 and $(72,961) for the years ended December 31, 2017 and 2016. These amounts represent the increase or decrease in fair value of the fixed to floating interest rate swaps entered into by our Cequel segment in September 2016. The objective of these swaps is to adjust the proportion of total debt that is subject to fixed and variable interest rates. These swap contracts are not designated as hedges for accounting purposes. Loss on extinguishment of debt and write-off of deferred financing costs Loss on extinguishment of debt and write-off of deferred financing costs amounted to $600,240 and $127,649 for the year ended December 31, 2017 and 2016, respectively. The 2017 amount includes the premium of $513,723 related to the notes payable to affiliates and related parties that were converted into shares of the Company’s common stock, $18,976 related to the Cablevision Extension Amendment and the redemption of senior notes, $28,684 related to the Cequel Extension Amendment and the redemption of senior notes and $38,858 related to premiums paid upon the early repayment of certain senior notes outstanding. Loss on extinguishment of debt amounted to $127,649 for the year ended December 31, 2016 and includes primarily the write-off of unamortized deferred financing costs and the unamortized discount relating to the prepayment of $1,290,500 outstanding under the term credit facility at Cablevision. Income Tax Benefit The Company recorded income tax benefit of $2,852,967 for the year ended December 31, 2017. Pursuant to the enactment of Tax Reform on December 22, 2017, the Company recorded a noncash deferred tax benefit of $2,337,900 to remeasure the net deferred tax liability to adjust for the reduction in the corporate federal income tax rate from 35% to 21% which is effective on January 1, 2018. Nondeductible share-based compensation expense for the year ended December 31, 2017 reduced income tax benefit by $22,938. The Company recorded income tax benefit of $259,666 for the year ended December 31, 2016. Nondeductible share-based compensation expense for the year ended December 31, 2016 reduced income tax benefit by $5,747. On June 9, 2016 the common stock of Cequel was contributed to the Company. On June 21, 2016, the Company completed its acquisition of Cablevision. Accordingly, Cequel and Cablevision joined the federal consolidated and certain state combined income tax returns of the Company. As a result, the applicate tax rate used to measure deferred tax assets and liabilities increased, resulting in a non-cash deferred income tax charge of $153,660 in the second quarter of 2016. In addition, there was no state income tax benefit on the pre-merger accrued interest at Neptune Finco Corp. ("Finco"), an indirect wholly-owned subsidiary of Altice N.V. formed to complete the financing for the Cablevision Acquisition and the merger with CSC Holdings, resulting in additional deferred tax expense of $18,542 for the year ended December 31, 2016. Results of Operations - Cablevision Systems Corporation ___________________ (a) Certain reclassifications have been made to previously reported amounts by product to reflect the current presentation. (a) Includes primarily dividends received on Comcast common stock owned by the Company. (b) Consists of unrealized and realized losses (gains) due to the change in fair value of equity derivative contracts relating to the Comcast common stock owned by the Company. ____________________ (a) Represents the estimated number of single residence homes, apartments and condominium units passed by the cable distribution network in areas serviceable without further extending the transmission lines. In addition, it includes commercial establishments that have connected to our cable distribution network. (b) Represents number of households/businesses that receive at least one of the Company’s services. (c) Customers represent each customer account (set up and segregated by customer name and address), weighted equally and counted as one customer, regardless of size, revenue generated, or number of boxes, units, or outlets. In calculating the number of customers, we count all customers other than inactive/disconnected customers. Free accounts are included in the customer counts along with all active accounts, but they are limited to a prescribed group. Most of these accounts are also not entirely free, as they typically generate revenue through pay-per-view or other pay services and certain equipment fees. Free status is not granted to regular customers as a promotion. In counting bulk residential customers, such as an apartment building, we count each subscribing family unit within the building as one customer, but do not count the master account for the entire building as a customer. We count a bulk commercial customer, such as a hotel, as one customer, and do not count individual room units at that hotel. (d) Represents the number of customers that subscribe to three of our services divided by total residential customer relationships. (e) Represents the number of total customer relationships divided by homes passed. (f) Calculated by dividing the average monthly revenue for the respective quarter (fourth quarter for annual periods) presented derived from the sale of broadband, pay television and telephony services to residential customers for the respective quarter by the average number of total residential customers for the same period. Cablevision - Comparison of Results for the Periods June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016 to Results for the Year Ended December 31, 2015 Pay Television Revenue Pay television revenue amounted to $1,638,691 and $1,468,006 for the period June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016, respectively, compared to$3,142,991 for the year ended December 31, 2015. Pay television revenue for the Successor and Predecessor periods in 2016 was impacted by a decline in pay television customers, a decrease due to a pay-per-view boxing event that took place in 2015, partially offset by increases in revenue due primarily to rate increases for certain pay television services implemented during the first quarter of 2016 and an increase in fees charged to restore suspended services. We believe our pay television customer declines noted in the table above are largely attributable to intense competition, particularly from Verizon, as well as competition from companies that deliver video content over the Internet directly to customers. Also, the declines are attributable to our disciplined pricing and credit policies. These factors are expected to continue to impact our ability to maintain or increase our existing customers and revenue in the future. Broadband Revenue Broadband revenue amounted to $782,615 and $673,010 for the period June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016, respectively, compared to $1,303,918 for the year ended December 31, 2015. Broadband revenue for the Successor and Predecessor periods in 2016 was impacted by rate increases for certain broadband services implemented during the first quarter of 2016, an increase in broadband customers, and an increase in fees charged to restore suspended services. Telephony Revenue Telephony revenue amounted to $376,034 and $342,142 for the period June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016, respectively, compared to $748,181 for the year ended December 31, 2015. Telephony revenue for the Successor and Predecessor periods in 2016 was impacted by a decline in telephony customers and a decline in international calling. Business Services Revenue Business services and wholesale revenue amounted to $468,632 and $411,102 for the period June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016, respectively, compared to $834,154 for the year ended December 31, 2015. Business services and wholesale revenue for the Successor and Predecessor periods in 2016 was impacted by rate increases for certain broadband services implemented during the first quarter of 2016, an increase in broadband customers and an increase in Ethernet revenue from an increase in services installed, partially offset by reduced traditional voice and data services. Advertising Revenue Advertising revenue amounted to $163,678 and $125,419 for the period June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016, respectively, compared to $263,839 for the year ended December 31, 2015. Advertising revenue for the Successor and Predecessor periods in 2016 was impacted by an increase in advertising sales to the political sector. Other Revenue Other revenue amounted to $14,402 and $117,925 for the period June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016, respectively, compared to $252,462 for the year ended December 31, 2015. Other revenue for the Successor and Predecessor periods in 2016 includes revenue recognized by Newsday through July 7, 2016, affiliation fees paid by cable operators for carriage of our News 12 Networks and other revenue sources. On July 7, 2016, the Company sold a 75% interest in Newsday and as a result no longer consolidates its operating results. As of July 7, 2016, the Company’s 25% interest in the operating results of Newsday is recorded on the equity basis. Programming and Other Direct Costs Programming and other direct costs include cable programming costs, which are costs paid to programmers (net of amortization of any incentives received from programmers for carriage) for cable content (including costs of VOD and pay-per-view) and are generally paid on a per-customer basis. These costs typically rise due to increases in contractual rates and new channel launches and are also impacted by changes in the number of customers receiving certain programming services. These costs also include interconnection, call completion, circuit and transport fees paid to other telecommunication companies for the transport and termination of voice and data services, which typically vary based on rate changes and the level of usage by our customers. These costs also include franchise fees which are payable to the state governments and local municipalities where we operate and are primarily based on a percentage of certain categories of revenue derived from the provision of pay television service over our cable systems, which vary by state and municipality. These costs change in relation to changes in such categories of revenues or rate changes. These costs also included content, production and distribution costs of the Newsday business. Programming and other direct costs amounted to $1,164,925 and $1,088,555 for the period June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016, respectively, compared to $2,269,290 for the year ended December 31, 2015. Programming and other direct costs for the Successor and Predecessor periods in 2016 were impacted by an increase in programming costs due primarily to contractual rate increases, partially offset by lower video customers. These costs were also impacted by the lower costs related to Newsday (due to the sale of our 75% interest in Newsday in July 2016), lower call completion and transport costs primarily due to lower level of activity, lower cost of sales related to wireless handset inventory and higher franchise and other fees due primarily to increases in rates in certain areas, partially offset by lower pay television customers. Programming costs aggregated $978,120 and $883,792 for the period June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016, respectively, compared to $1,796,021 for the year ended December 31, 2015. Our programming costs increased 4% for the 2016 periods due primarily to an increase in contractual programming rates and a pay-per-view boxing event in 2015, partially offset by a decrease in telephony customers. Other Operating Expenses Other operating expenses include staff costs and employee benefits including salaries of company employees and related taxes, benefits and other employee-related expenses. Other operating expenses also include network management and field service costs, which represent costs associated with the maintenance of our broadband network, including costs of certain customer connections and other costs associated with providing and maintaining services to our customers which are impacted by general cost increases for contractors, insurance and other various expenses. Customer installation and repair and maintenance costs may fluctuate as a result of changes in the level of activities and the utilization of contractors as compared to employees. Also, customer installation costs fluctuate as the portion of our expenses that we are able to capitalize changes. Network repair and maintenance and utility costs also fluctuate as capitalizable network upgrade and enhancement activity changes. Other operating expenses also include costs related to the operation and maintenance of our call center facilities that handle customer inquiries and billing and collection activities and sales and marketing costs, which include advertising production and placement costs associated with acquiring and retaining customers. These costs vary period to period and certain costs, such as sales and marketing, may increase with intense competition. Additionally, other operating expenses include various other administrative costs, including legal fees, and product development costs. Other operating expenses amounted to $1,028,447 and $1,136,970 for the period June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016, respectively, compared to $2,546,319 for the year ended December 31, 2015. Other operating expenses for the Successor and Predecessor periods in 2016 were impacted by a decrease in employee-related costs related to the elimination of certain positions, lower benefits and an increase in capitalizable activity, partially offset by merit increases. These costs were also impacted by the lower costs related to Newsday (due to the sale of our 75% interest in Newsday in July 2016), a decrease in share based compensation, a decrease in long-term incentive plan awards, lower legal costs, lower sales and marketing costs, lower repair and maintenance expenses, lower contractor costs, a settlement of a class action legal matter in 2015, partially offset by an increase in the management fee to Altice N.V. Restructuring and Other Expense Restructuring and other expense amounted to $212,150 and $22,223 for the period June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016, respectively, compared to $16,213 for the year ended December 31, 2015. Restructuring and other expense for the Successor 2016 period is primarily related to severance and other employee related costs resulting from headcount reductions related to initiatives which commenced in the Successor period that are intended to simplify the Company’s organizational structure. The restructuring and other expense for the Predecessor 2016 period is primarily related to transaction costs of $19,924 incurred in connection with the Cablevision Acquisition and adjustments related to prior restructuring plans of $2,299. Restructuring and other expense for 2015 includes transaction costs incurred in connection with the Cablevision Acquisition of $17,862, net of adjustments related to prior restructuring plans of $1,649. Depreciation and Amortization Depreciation and amortization (including impairments) amounted to $963,665 and $414,550 for the period June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016, respectively, compared to $865,252 for the year ended December 31, 2015. Depreciation and amortization for the Successor period in 2016 was impacted by an increase in related to the step-up in the carrying value of property, plant and equipment and amortizable intangible assets recorded in connection with the Cablevision Acquisition on June 21, 2016, partially offset by certain assets being retired or becoming fully depreciated. Adjusted EBITDA Adjusted EBITDA amounted to $1,259,844 and $937,310 for the periods June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016, respectively, compared to $1,795,222 for the year ended December 31, 2015. Adjusted EBITDA for the 2016 periods was impacted by an increase in revenue, and a decrease in operating expenses (excluding depreciation and amortization, restructuring and other expense and share-based compensation), as discussed above. Interest Expense, net Interest expense amounted to $606,347 and $285,508 for the period June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016, respectively, compared to $584,839 for the year ended December 31, 2015. Interest expense for the Successor 2016 period includes additional interest related to the debt incurred to finance the Cablevision Acquisition. Gain (Loss) on Investments, net Gain (loss) on investments, net amounted to $141,896 and $129,990 for the period June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016, respectively, and $(30,208) for the year ended December 31, 2015 and reflect the increase or decrease in the fair value of Comcast common stock owned by the Company. The effects of these gains (losses) are partially offset by the (losses) gains on the related equity derivative contracts, net described below. Gain (Loss) on Equity Derivative Contracts, net Gain (loss) on equity derivative contracts, net amounted to $(53,696) and $(36,283) for the periods June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016, respectively, and $104,927 for the year ended December 31, 2015. Gain (loss) on equity derivative contracts, net consists of unrealized and realized gains (losses) due to the change in fair value of the Company’s equity derivative contracts relating to the Comcast common stock owned by the Company. The effects of these gains (losses) are offset by the (losses) gains on investment securities pledged as collateral, which are included in gain (loss) on investments, net discussed above. Loss on Extinguishment of Debt and Write-off of Deferred Financing Costs Loss on extinguishment of debt and write-off of deferred financing costs amounted to $102,894 for the period June 21, 2016 through December 31, 2016 and $1,735 for the year ended December 31, 2015. The Successor 2016 amount includes the write-off of unamortized deferred financing costs and the unamortized discount related to the prepayment of $1,290,500 outstanding under the CSC Holdings, a wholly-owned subsidiary of Cablevision, term credit facility. The 2015 amount includes the write-off of unamortized deferred financing costs and the unamortized discount related to the $200,000 repayment of CSC Holdings term B loan facility. Income Tax Expense Income tax benefit (expense) amounted to $213,065 for the periods from June 21, 2016 through December 31, 2016 and $(124,848) for the period from January 1, 2016 through June 20, 2016. In the Successor period, excluding the impact of the nondeductible share-based compensation of $3,208, the effective tax rate would have been 40%. In the Predecessor period, certain acquisition-related costs were determined to be nondeductible, resulting in additional deferred tax expense of $9,392. Absent this item, the effective tax rate would have been 40%. Income tax expense of $154,872 for the year ended December 31, 2015, reflected an effective tax rate of 45%. In April 2015, corporate income tax changes were enacted for both New York State and the City of New York. Those changes included a provision whereby investment income will be subject to higher taxes. Accordingly, in the second quarter of 2015, Cablevision recorded deferred tax expense of $16,334 to remeasure the deferred tax liability for the investment in Comcast common stock and associated derivative securities. Also in 2015, Cablevision recorded tax benefit of $2,630 related to research credits. Absent these items, the effective tax rate for the year ended December 31, 2015 would have been 41%. Loss From Discontinued Operations Loss from discontinued operations for the year ended December 31, 2015 amounted to $12,541, net of income taxes, and primarily reflects an expense related to the settlement of a legal matter relating to Rainbow Media Holdings LLC, a business whose operations were previously discontinued. LIQUIDITY AND CAPITAL RESOURCES Altice USA has no operations independent of its subsidiaries, Cablevision and Cequel. Funding for our subsidiaries has generally been provided by cash flow from their respective operations, cash on hand and borrowings under their revolving credit facilities and the proceeds from the issuance of securities and borrowings under syndicated term loans in the capital markets. Our decision as to the use of cash generated from operating activities, cash on hand, borrowings under the revolving credit facilities or accessing the capital markets has been based upon an ongoing review of the funding needs of the business, the optimal allocation of cash resources, the timing of cash flow generation and the cost of borrowing under the revolving credit facilities, debt securities and syndicated term loans. We manage our business to a long-term net leverage ratio target of 4.5x to 5.0x. We calculate our consolidated net leverage ratio as net debt to L2QA EBITDA (Adjusted EBITDA for the two most recent consecutive fiscal quarters multiplied by 2.0). We expect to utilize free cash flow and availability under the revolving credit facilities, as well as future refinancing transactions, to further extend the maturities of, or reduce the principal on, our debt obligations. The timing and terms of any refinancing transactions will be subject to, among other factors, market conditions. Additionally, we may, from time to time, depending on market conditions and other factors, use cash on hand and the proceeds from other borrowings to repay the outstanding debt securities through open market purchases, privately negotiated purchases, tender offers, or redemptions. We believe existing cash balances, operating cash flows and availability under our revolving credit facilities will provide adequate funds to support our current operating plan, make planned capital expenditures and fulfill our debt service requirements for the next twelve months. However, our ability to fund our operations, make planned capital expenditures, make scheduled payments on our indebtedness and repay our indebtedness depends on our future operating performance and cash flows and our ability to access the capital markets, which, in turn, are subject to prevailing economic conditions and to financial, business and other factors, some of which are beyond our control. Our collateralized debt maturing in the next 12 months will be settled with proceeds from monetization contracts entered into pursuant to the Synthetic Monetization Closeout discussed below. However, competition, market disruptions or a deterioration in economic conditions could lead to lower demand for our products, as well as lower levels of advertising, and increased incidence of customers' inability to pay for the services we provide. These events would adversely impact our results of operations, cash flows and financial position. Although we currently believe that amounts available under the revolving credit facilities will be available when, and if, needed, we can provide no assurance that access to such funds will not be impacted by adverse conditions in the financial markets or other conditions. The obligations of the financial institutions under the revolving credit facilities are several and not joint and, as a result, a funding default by one or more institutions does not need to be made up by the others. In the longer term, we do not expect to be able to generate sufficient cash from operations to fund anticipated capital expenditures, meet all existing future contractual payment obligations and repay our debt at maturity. As a result, we will be dependent upon our continued access to the capital and credit markets to issue additional debt or equity or refinance existing debt obligations. We will need to raise significant amounts of funding over the next several years to fund capital expenditures, repay existing obligations and meet other obligations, and the failure to do so successfully could adversely affect our business. If we are unable to do so, we will need to take other actions including deferring capital expenditures, selling assets, seeking strategic investments from third parties or reducing or eliminating discretionary uses of cash. Initial Public Offering In June 2017, the Company completed its IPO of 71,724,139 shares of its Class A common stock (12,068,966 shares sold by the Company and 59,655,173 shares sold by existing stockholders) at a price to the public of $30.00 per share, including the underwriters full exercise of their option to purchase 7,781,110 shares to cover overallotments. The Company’s Class A common stock began trading on June 22, 2017, on the New York Stock Exchange under the symbol “ATUS”. In connection with the sale of its Class A common stock, the Company received proceeds of approximately $362,069, before deducting the underwriting discount and expenses directly related to the issuance of the securities of $12,998. The Company did not receive any proceeds from the sale of shares by the selling stockholders. In July 2017, the Company used approximately $350,120 of the proceeds to fund the redemption of $315,779 principal amount of 10.875% senior notes that mature in 2025 issued by CSC Holdings, an indirect wholly-owned subsidiary of the Company, and the related call premium of approximately $34,341. Debt Outstanding The following tables summarize the carrying value of our outstanding debt, net of deferred financing costs, discounts and premiums (excluding accrued interest), as well as interest expense. (a) This indebtedness is collateralized by shares of Comcast common stock. We intend to settle this debt by (i) delivering shares of Comcast common stock and the related equity contracts, (ii) delivering cash from the net proceeds on new monetization contracts, or (iii) delivering cash from the proceeds of monetization contracts entered into pursuant to the Synthetic Monetization Closeout discussed below. The following table provides details of our outstanding credit facility debt as of December 31, 2017: (a) Carrying amounts are net of unamortized discounts and deferred financing costs. (b) At December 31, 2017, $115,973 of the revolving credit facility was restricted for certain letters of credit issued on behalf of the Company and $1,734,027 of the facility was undrawn and available, subject to covenant limitations. (c) At December 31, 2017, $13,500 of the revolving credit facility was restricted for certain letters of credit issued on behalf of the Company and $336,500 of the facility was undrawn and available, subject to covenant limitations. Payment Obligations Related to Debt As of December 31, 2017, total amounts payable by us in connection with our outstanding obligations, including related interest, as well as capital lease obligations, notes payable, and the value deliverable at maturity under monetization contracts are as follows: (a) Includes $1,575,136 related to the Company's collateralized indebtedness (including related interest). This indebtedness is collateralized by shares of Comcast common stock. We intend to settle this debt by (i) delivering shares of Comcast common stock and the related equity contracts, (ii) delivering cash from the net proceeds on new monetization contracts, or (iii) delivering cash from the proceeds of monetization contracts entered into pursuant to the Synthetic Monetization Closeout discussed below. The amounts in the table above do not include the effects of the debt transactions discussed in Note 20. CSC Holdings Restricted Group CSC Holdings and those of its subsidiaries which conduct our broadband, pay television and telephony services operations, as well as Lightpath, which provides Ethernet-based data, Internet, voice and video transport and managed services to the business market, comprise the "Restricted Group" as they are subject to the covenants and restrictions of the credit facility and indentures governing the notes and debentures issued by CSC Holdings. In addition, the Restricted Group is also subject to the covenants of the debt issued by Cablevision. Sources of cash for the Restricted Group include primarily cash flow from the operations of the businesses in the Restricted Group, borrowings under its credit facility and issuance of securities in the capital markets, contributions from its parent, and, from time to time, distributions or loans from its subsidiaries. The Restricted Group's principal uses of cash include: capital spending, in particular, the capital requirements associated with the upgrade of its digital broadband, pay television and telephony services, including costs to build a FTTH network and enhancements to its service offerings such as Wi-Fi; debt service, including distributions made to Cablevision to service interest expense and principal repayments on its debt securities; other corporate expenses and changes in working capital; and investments that it may fund from time to time. Cablevision Credit Facilities On October 9, 2015, Finco, which merged with and into CSC Holdings on June 21, 2016, entered into a senior secured credit facility, which currently provides U.S. dollar term loans currently in an aggregate principal amount of $3,000,000 ($2,985,000 outstanding at December 31, 2017) (the “CVC Term Loan Facility”, and the term loans extended under the CVC Term Loan Facility, the “CVC Term Loans”) and U.S. dollar revolving loan commitments in an aggregate principal amount of $2,300,000 (the “CVC Revolving Credit Facility” and, together with the CVC Term Loan Facility, the “CVC Credit Facilities”), which are governed by a credit facilities agreement entered into by, inter alios, CSC Holdings certain lenders party thereto and JPMorgan Chase Bank, N.A. as administrative agent and security agent (as amended, restated, supplemented or otherwise modified on June 20, 2016, June 21, 2016, July 21, 2016, September 9, 2016, December 9, 2016 and March 15, 2017, respectively, and as further amended, restated, supplemented or otherwise modified from time to time, the “CVC Credit Facilities Agreement”). During the year ended December 31, 2017, CSC Holdings borrowed $1,350,000 under its revolving credit facility ($500,000 was used to make cash distributions to its stockholders) and made voluntary repayments aggregating $1,075,256 with cash on hand. In January 2018, CSC Holdings borrowed $150,000 under its revolving credit facility and entered into a new $1,500,000 incremental term loan facility (the "Incremental Term Loan") under its existing CVC Credit Facilities Agreement. The Incremental Term Loan was priced at 99.50% and will mature on January 25, 2026. The Incremental Term Loan is comprised of eurodollar borrowings or alternate base rate borrowings, and bears interest at a rate per annum equal to the adjusted LIBO rate or the alternate base rate, as applicable, plus the applicable margin, where the applicable margin is (i) with respect to any alternate base rate loan, 1.50% per annum and (ii) with respect to any eurodollar loan, 2.50% per annum. See discussion below regarding use of proceeds from the Incremental Term Loan. The Company was in compliance with all of its financial covenants under the CVC Credit Facilities Agreement as of December 31, 2017. See Note 9 to our consolidated financial statements for further information regarding the CVC Credit Facilities Agreement. Cequel Credit Facilities On June 12, 2015, Altice US Finance I Corporation, a wholly-owned subsidiary of Cequel, entered into a senior secured credit facility which currently provides U.S. dollar term loans in an aggregate principal amount of $1,265,000 ($1,258,675 outstanding at December 31, 2017) (the “Cequel Term Loan Facility” and the term loans extended under the Cequel Term Loan Facility, the “Cequel Term Loans”) and U.S. dollar revolving loan commitments in an aggregate principal amount of $350,000 which are governed by a credit facilities agreement entered into by, inter alios, Altice US Finance I Corporation, certain lenders party thereto and JPMorgan Chase Bank, N.A. as administrative agent and security agent (as amended, restated, supplemented or otherwise modified on October 25, 2016, December 9, 2016 and March 15, 2017, and as further amended, restated, supplemented or modified from time to time, the “Cequel Credit Facilities Agreement”). The Company was in compliance with all of its financial covenants under the Cequel Credit Facilities Agreement as of December 31, 2017. See Note 9 to our consolidated financial statements for further information regarding the Cequel Credit Facilities Agreement. Senior Notes Cablevision Notes On September 23, 2009, Cablevision issued $900,000 aggregate principal amount of its 8 5/8% Senior Notes due 2017 and 8 5/8% Series B Senior Notes due 2017 (together, the "Cablevision 2017 Senior Notes"). In April 2017, Cablevision redeemed $500,000 aggregate principal amount of its Cablevision 2017 Senior Notes with certain of the proceeds of the term loans incurred under the CVC Credit Facilities Agreement, and in September 2017, Cablevision repaid the remaining $400,000 from borrowings under its revolving credit facility. On April 15, 2010, Cablevision issued $750,000 aggregate principal amount of its 7 3/4% Senior Notes due 2018 and $500,000 aggregate principal amount of its 8% Senior Notes due 2020. On September 27, 2012, Cablevision issued $750,000 aggregate principal amount of its 5 7/8% Senior Notes due 2022 ($649,024 outstanding at December 31, 2017). As of December 31, 2017, Cablevision was in compliance with all of its financial covenants under the indentures under which the Cablevision Notes were issued. CSC Holdings Notes CSC Holdings Senior Guaranteed Notes On October 9, 2015, Finco issued $1,000,000 aggregate principal amount of its 6 5/8% Senior Guaranteed Notes due 2025 (the "CSC 2025 Senior Guaranteed Notes"). CSC Holdings assumed the obligations as issuer of the CSC 2025 Senior Guaranteed Notes upon the merger of Finco and CSC Holdings on June 21, 2016. On September 23, 2016, CSC Holdings issued $1,310,000 aggregate principal amount of its 5 1/2% Senior Guaranteed Notes due 2027. In January 2018, CSC Holdings issued $1,000,000 aggregate principal amount of 5 3/8% senior guaranteed notes due February 1, 2028 (the "2028 Guaranteed Notes"). The 2028 Guaranteed Notes are senior unsecured obligations and rank pari passu in right of payment with all of the existing and future senior indebtedness, including the existing senior notes and the Credit Facilities and rank senior in right of payment to all of existing and future subordinated indebtedness. The proceeds from the 2028 Guaranteed Notes, together with proceeds from the Incremental Term Loan, borrowings under CSC Holdings' revolving credit facility and cash on hand, were used in February 2018 to repay certain senior notes ($300,000 principal amount of CSC Holdings' senior notes due in February 2018 and $750,000 principal amount of Cablevision senior notes due in April 2018) and will be used to fund a dividend of $1,500,000 to the Company's stockholders immediately prior to and in connection with the Distribution. As of December 31, 2017, CSC Holdings was in compliance with all of its financial covenants under the indentures under which the CSC Holdings senior guaranteed notes were issued. CSC Holdings Senior Notes On February 6, 1998, CSC Holdings issued $300,000 aggregate principal amount of its 7 7/8% Senior Debentures which matured and were repaid on February 15, 2018. On July 21, 1998, CSC Holdings issued $500,000 aggregate principal amount of its 7 5/8% Senior Debentures due 2018. On February 12, 2009, CSC Holdings issued $526,000 aggregate principal amount of its 8 5/8% Senior Notes due 2019 and 8 5/8% Series B Senior Notes due 2019. On November 15, 2011, CSC Holdings issued $1,000,000 aggregate principal amount of its 6 3/4% Senior Notes due 2021 and 6 3/4% Series B Senior Notes due 2021. On May 23, 2014, CSC Holdings issued $750,000 aggregate principal amount of its 5 1/4% Senior Notes due 2024 and 5 1/4% Series B Senior Notes due 2024. On October 9, 2015, Finco issued $1,800,000 aggregate principal amount of its 10 1/8% Senior Notes due 2023 (the "CSC 2023 Senior Notes") and $2,000,000 10 7/8% Senior Notes due 2025 (the "CSC 2025 Senior Notes). CSC Holdings assumed the obligations as issuer of the CSC 2023 Senior Notes and the CSC 2025 Senior Notes upon the merger of Finco and CSC Holdings on June 21, 2016. In July 2017, the Company used approximately $350,120 of the proceeds from the Company's IPO discussed above to fund the redemption of $315,779 principal amount of the CSC 2025 Senior Notes and the related call premium of approximately $34,341. See Note 9 of our consolidated financial statements for further details. As of December 31, 2017, CSC Holdings was in compliance with all of its financial covenants under the indentures under which the CSC Holdings senior notes were issued. Cequel Notes Cequel Senior Secured Notes On June 12, 2015, Altice US Finance I Corporation issued $1,100,000 aggregate principal amount of its 5 3/8% Senior Secured Notes due 2023. On April 26, 2016, Altice US Finance I Corporation issued $1,500,000 aggregate principal amount of its 5 1/2% Senior Secured Notes due 2026. As of December 31, 2017, Cequel was in compliance with all of its financial covenants under the indentures under which the Cequel senior secured notes were issued. Cequel Senior Notes On October 25, 2012, Cequel Capital Corporation and Cequel Communications Holdings I, LLC (collectively, the "Cequel Senior Notes Co-Issuers") issued $500,000 aggregate principal amount of their 6 3/8% Senior Notes due 2020 (the "Cequel 2020 Senior Notes"). On December 28, 2012, the Cequel Senior Notes Issuers issued an additional $1,000,000 aggregate principal amount of their Cequel 2020 Senior Notes. In April 2017, the Company redeemed $450,000 of the Cequel 2020 Senior Notes from proceeds of the Cequel Term Loan pursuant to the March 15, 2017 amendment. On May 16, 2013, the Cequel Senior Notes Co-Issuers issued $750,000 aggregate principal amount of their 5 1/8% Senior Notes due 2021. On September 9, 2014, the Cequel Senior Notes Co-Issuers issued $500,000 aggregate principal amount of their 5 1/8% Senior Notes due 2021. On June 12, 2015, Altice US Finance II Corporation issued $300,000 aggregate principal amount of its 7 3/4% Senior Notes due 2025 (the "Cequel 2025 Senior Notes"). Following the Cequel Acquisition, Altice US Finance II Corporation was merged into Cequel and the Cequel 2025 Senior Notes became the obligation of the Cequel Senior Notes Co-Issuers. Also on June 12, 2015, Altice US Finance S.A., an indirect subsidiary of Altice, issued $320,000 principal amount of 7 3/4% Senior Notes due 2025 (the "Cequel Holdco Notes"), the proceeds from which were placed in escrow, to finance a portion of the purchase price for the Cequel Acquisition. The Cequel Holdco Notes were automatically exchanged into an equal aggregate principal amount of Cequel 2025 Senior Notes during the second quarter of 2016. As of December 31, 2017, Cequel was in compliance with all of its financial covenants under the indentures under which the Cequel senior notes were issued. Capital Expenditures (a) The Cablevision 2017 amount excludes advance payments aggregating $16,363 made to ATS for the FTTH project. Customer premise equipment includes expenditures for set-top boxes, cable modems and other equipment that is placed in a customer's home, as well as equipment installation costs. Network infrastructure includes: (i) scalable infrastructure, such as headend equipment, (ii) line extensions, such as fiber/coaxial cable, amplifiers, electronic equipment, make-ready and design engineering, and (iii) upgrade and rebuild, including costs to modify or replace existing fiber/coaxial cable networks, including enhancements. Support and other capital expenditures includes costs associated with the replacement or enhancement of non-network assets, such as office equipment, buildings and vehicles. Business services capital expenditures include primarily equipment, installation, support, and other costs related to our fiber based telecommunications business. Cash Flow Discussion Operating Activities Net cash provided by operating activities amounted to $2,001,743 for the year ended December 31, 2017 compared to $1,184,455 for the year ended December 31, 2016. The 2017 cash provided by operating activities resulted from $2,354,709 of income before depreciation and amortization and non-cash items and an increase in deferred revenue of $12,310, partially offset by a decrease in accounts payable and accrued expenses of $195,943, a net increase in current and other assets of $135,442, a net decrease in amounts due to affiliates of $32,970, and a decrease in liabilities related to interest rate swap contracts of $921. The 2016 cash provided by operating activities resulted from $746,341 of income before depreciation and amortization and non-cash items, $310,892 as a result of an increase in accounts payable, deferred revenue and other liabilities, $78,823 resulting from an increase in liabilities related to interest rate swap contracts and $48,399 resulting from a net decrease in current and other assets. Investing Activities Net cash used in investing activities for the year ended December 31, 2017 was $1,132,214 compared to $9,599,319 for the year ended December 31, 2016. The 2017 investing activities consisted primarily of capital expenditures of $991,364, payments of $97,410 related to the settlement of put-call options, and payments for acquisitions, net of cash acquired of $46,703, partially offset by $3,263 in other net cash proceeds. The 2016 investing activities consisted primarily of $8,988,774 payment for the Cablevision Acquisition, net of cash acquired, $625,541 of capital expenditures, net payments related to other investments of $4,608, and additions to other intangible assets of $106, partially offset by other net cash receipts of $19,710, including $13,825 from the sale of an affiliate interest. Financing Activities Net cash used in financing activities amounted to $1,099,041 for the year ended December 31, 2017 compared to net cash provided by financing activities of $131,421 for the year ended December 31, 2016. In 2017, the Company's financing activities consisted primarily of the repayment of senior notes, including premiums and fees, of $1,729,400, cash distributions paid to stockholders of $919,317, principal payments on capital lease obligations of $15,157, additions to deferred financing costs of $8,600 and distributions to noncontrolling interests of $335, partially offset by net proceeds from credit facility debt of $1,182,094, net proceeds from collateralized indebtedness and related derivative contracts of $7,735, net proceeds from the Company's IPO of $349,071, proceeds from notes payable of $33,733, and contributions from stockholders of $1,135. In 2016, the Company's financing activities consisted of proceeds of $1,750,000 from the issuance of notes to affiliates and related parties, $1,310,000 from the issuance of senior notes, contribution from stockholders of $1,246,499, net proceeds from collateralized indebtedness of $36,286, and an excess tax benefit related to share-based awards of $31. Partially offsetting these increases were net repayments of credit facility debt of $3,623,287, distributions to stockholders of $365,559, payments of deferred financing costs of $203,712, and principal payments on capital lease obligations of $18,837. Settlements of Collateralized Indebtedness The following table summarizes the settlement of the Company's collateralized indebtedness relating to Comcast shares that was settled by delivering cash equal to the collateralized loan value, net of the value of the related equity derivative contracts during the year ended December 31, 2017: ______________________ (a) Share amounts are adjusted for the 2 for 1 stock split in February 2017. The cash to settle the collateralized indebtedness was obtained from the proceeds of new monetization contracts covering an equivalent number of Comcast shares. The terms of the new contracts allow the Company to retain upside participation in Comcast shares up to each respective contract's upside appreciation limit with downside exposure limited to the respective hedge price. In April 2017, the Company entered into new monetization contracts related to 32,153,118 shares of Comcast common stock held by Cablevision, which synthetically reversed the existing contracts related to these shares (the "Synthetic Monetization Closeout"). As the existing collateralized debt matures, the Company will settle the contracts with proceeds received from the new monetization contracts. The new monetization contracts mature on April 28, 2021. The new monetization contracts provide the Company with downside protection below the hedge price of $35.47 and upside benefit of stock price appreciation up to $44.72 per share. In connection with the execution of these contracts, the Company recorded (i) the fair value of the equity derivative contracts of $53,316 (in a net asset position), (ii) notes payable of $111,657, representing the fair value of the existing equity derivative contracts, in a liability position, and (iii) a discount on debt of $58,341. Contractual Obligations and Off Balance Sheet Commitments Our contractual obligations to affiliates and non-affiliates as of December 31, 2017, which consist primarily of our debt obligations and the effect such obligations are expected to have on our liquidity and cash flow in future periods, are summarized in the following table: (a) Purchase obligations primarily include contractual commitments with various programming vendors to provide video services to our customers and minimum purchase obligations to purchase goods or services. Future fees payable under contracts with programming vendors are based on numerous factors, including the number of customers receiving the programming. Amounts reflected above related to programming agreements are based on the number of customers receiving the programming as of December 31, 2017 multiplied by the per customer rates or the stated annual fee, as applicable, contained in the executed agreements in effect as of December 31, 2017. See Note 15 to our consolidated financial statements for a discussion of our program rights obligations. (b) Operating lease obligations represent primarily future minimum payment commitments on various long-term, noncancelable leases, at rates now in force, for office, production and storage space, and rental space on utility poles. See Note 7 to our consolidated financial statements for a discussion of our operating leases. (c) Includes franchise and performance surety bonds primarily for our cable television systems. Also includes outstanding guarantees primarily by CSC Holdings in favor of certain financial institutions in respect of ongoing interest expense obligations in connection with the monetization of our holdings of shares of Comcast common stock. Payments due by period for these arrangements represent the year in which the commitment expires. (d) Consists primarily of letters of credit obtained by CSC Holdings and Cequel in favor of insurance providers and certain governmental authorities. Payments due by period for these arrangements represent the year in which the commitment expires. (e) Includes interest and principal payments due on our (i) credit facility debt, (ii) senior guaranteed notes, senior secured notes, and senior notes and debentures, (iii) notes payable and (iv) collateralized indebtedness. See Notes 9 and 10 to our consolidated financial statements for a discussion of our long-term debt. These amounts do not include the effects of the debt transactions discussed in Note 20. (f) Reflects the principal amount of capital lease obligations, including related interest. (g) Represents tax liabilities, including accrued interest, relating to uncertain tax positions. See Note 12 to our consolidated financial statements for a discussion of our income taxes. The table above does not include obligations for payments required to be made under multi-year franchise agreements based on a percentage of revenues generated from pay television services per year. For the years ended December 31, 2017 and 2016, the amount of franchise fees and certain other taxes and fees included as a component of revenue aggregated $259,075 and $154,732, respectively. Dividends and Distributions In the second quarter of 2017, prior to the Company's IPO, the Company declared and paid cash distributions aggregating $839,700, $500,000 of which were funded with proceeds from borrowings under CSC Holdings' revolving credit facility. In 2016, the Company declared cash distributions of $445,176, of which $365,559 were paid in 2016 and $79,617 were paid in the first quarter of 2017. Managing our Interest Rate and Equity Price Risk Interest Rate Risk Interest rate risk is primarily a result of exposures to changes in the level, slope and curvature of the yield curve, the volatility of interest rates and credit spreads. Our exposure to interest rate risk results from changes in short-term interest rates. Interest rate risk exists primarily with respect to our credit facility debt, which bears interest at variable rates. The carrying value of our outstanding credit facility debt at December 31, 2017 amounted to $4,643,523. To manage interest rate risk, we have from time to time entered into interest rate swap contracts to adjust the proportion of total debt that is subject to variable and fixed interest rates. Such contracts effectively fix the borrowing rates on floating rate debt to provide an economic hedge against the risk of rising rates and/or effectively convert fixed rate borrowings to variable rates to permit the Company to realize lower interest expense in a declining interest rate environment. We monitor the financial institutions that are counterparties to our interest rate swap contracts and we only enter into interest rate swap contracts with financial institutions that are rated investment grade. All such contracts are carried at their fair market values on our consolidated balance sheet, with changes in fair value reflected in the consolidated statement of operations. In June 2016, a subsidiary of Cequel entered into two fixed to floating interest rate swaps. One fixed to floating interest rate swap is converting $750,000 from a fixed rate of 1.6655% to six-month LIBOR and a second tranche of $750,000 from a fixed rate of 1.68% to six-month LIBOR. The objective of these swaps is to adjust the proportion of total debt that is subject to fixed and variable interest rates. These swap contracts are not designated as hedges for accounting purposes. Accordingly, the changes in the fair value of these interest rate swap contracts are recorded through the statement of operations. For the year ended December 31, 2017, the Company recorded a gain on interest rate swap contracts of $5,482. As of December 31, 2017, our outstanding interest rate swap contracts had an aggregate fair value and carrying value of $77,902 reflected in ‘‘liabilities under derivative contracts’’ in our consolidated balance sheet. We do not hold or issue derivative instruments for trading or speculative purposes. See discussion above for further details of our credit facility debt and See "
0.014172
0.014294
0
<s>[INST] We operate in a highly competitive, consumer and technology driven and rapidly changing business that is affected by government regulation and economic, strategic, technological, political and social conditions. Various factors could adversely affect our operations, business or financial results in the future and cause our actual results to differ materially from those contained in the forwardlooking statements. In addition, important factors that could cause our actual results to differ materially from those in our forwardlooking statements include: competition for broadband, pay television and telephony customers from existing competitors (such as broadband communications companies, DBS providers and Internetbased providers) and new competitors entering our footprint; changes in consumer preferences, laws and regulations or technology that may cause us to change our operational strategies; increased difficulty negotiating programming agreements on favorable terms, if at all, resulting in increased costs to us and/or the loss of popular programming; increasing programming costs and delivery expenses related to our products and services; our ability to achieve anticipated customer and revenue growth, to successfully introduce new products and services and to implement our growth strategy; our ability to complete our capital investment plans on time and on budget, including our plan to build a FTTH network, and deploy Altice One, our new home communications hub; our ability to develop and deploy mobile voice and data services pursuant to the agreement we entered into with Sprint in the fourth quarter of 2017; the effects of economic conditions or other factors which may negatively affect our customers’ demand for our products and services; the effects of industry conditions; demand for advertising on our cable systems; our substantial indebtedness and debt service obligations; adverse changes in the credit market; changes as a result of any tax reforms that may affect our business; financial community and rating agency perceptions of our business, operations, financial condition and the industries in which we operate; the restrictions contained in our financing agreements; our ability to generate sufficient cash flow to meet our debt service obligations; fluctuations in interest rates which may cause our interest expense to vary from quarter to quarter; technical failures, equipment defects, physical or electronic breakins to our services, computer viruses and similar problems; the disruption or failure of our network, information systems or technologies as a result of computer hacking, computer viruses, “cyberattacks,” misappropriation of data, outages, natural disasters and other material events; our ability to obtain necessary hardware, software, communications equipment and services and other items from our vendors at reasonable costs; our ability to effectively integrate acquisitions and to maximize expected operating efficiencies from our acquisitions or as a result of the transactions, if any; significant unanticipated increases in the use of bandwidthintensive Internetbased services; the outcome of litigation, government investigations and other proceedings; our ability to successfully operate our business following the completion of our separation from Altice N.V., and other risks and uncertainties inherent in our cable and other broadband communications businesses and our other businesses, including those listed under the caption “Risk Factors” and "Management's Discussion and Analysis of Financial Condition and Results of Operations" contained herein. We disclaim any obligation to update or revise the forwardlooking statements contained herein, except as otherwise required by applicable federal securities laws. Certain numerical figures included in this annual report have been subject to rounding adjustments. Accordingly, such numerical figures shown as totals in various tables may not be arithmetic aggregations of the figures that precede them. Overview All dollar amounts, except per customer and per share data, included in the following discussion, are presented in thousands. Our Business We deliver broadband, pay television, telephony services, WiFi hotspot access, proprietary content and advertising services to approximately 4.9 million residential and business customers. Our footprint extends across 21 states through a fiberrich broadband network with approximately 8.6 million homes passed as of December 31, 2017. We have two reportable segments: Cablevision and Cequel. Cablevision provides broadband, pay television and telephony services to residential and business customers in and around the New York metropolitan area. Cequel provides broadband, pay television and telephony services to residential and business customers in the southcentral United States, with the majority of its customers [/INST] Positive. </s>
2,018
13,279
1,702,780
Altice USA, Inc.
2019-03-01
2018-12-31
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations This Form 10-K contains statements that constitute forward-looking information within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act and Section 21E of the Securities Act of 1934, as amended. In this Form 10-K there are statements concerning our future operating results and future financial performance. Words such as "expects", "anticipates", "believes", "estimates", "may", "will", "should", "could", "potential", "continue", "intends", "plans" and similar words and terms used in the discussion of future operating results, future financial performance and future events identify forward-looking statements. Investors are cautioned that such forward-looking statements are not guarantees of future performance, results or events and involve risks and uncertainties and that actual results or developments may differ materially from the forward-looking statements as a result of various factors. We operate in a highly competitive, consumer and technology driven and rapidly changing business that is affected by government regulation and economic, strategic, technological, political and social conditions. Various factors could adversely affect our operations, business or financial results in the future and cause our actual results to differ materially from those contained in the forward-looking statements. In addition, important factors that could cause our actual results to differ materially from those in our forward-looking statements include: • competition for broadband, pay television and telephony customers from existing competitors (such as broadband communications companies, DBS providers and Internet-based providers) and new competitors entering our footprint; • changes in consumer preferences, laws and regulations or technology that may cause us to change our operational strategies; • increased difficulty negotiating programming agreements on favorable terms, if at all, resulting in increased costs to us and/or the loss of popular programming; • increasing programming costs and delivery expenses related to our products and services; • our ability to achieve anticipated customer and revenue growth, to successfully introduce new products and services and to implement our growth strategy; • our ability to complete our capital investment plans on time and on budget, including our plan to build a FTTH network, and deploy Altice One, our home communications hub; • our ability to develop and deploy mobile voice and data services pursuant to the agreement we entered into with Sprint in the fourth quarter of 2017, and our ability to attract customers to these services; • the effects of economic conditions or other factors which may negatively affect our customers’ demand for our current and future products and services; • the effects of industry conditions; • demand for digital and linear advertising products and services; • our substantial indebtedness and debt service obligations; • adverse changes in the credit market; • changes as a result of any tax reforms that may affect our business; • financial community and rating agency perceptions of our business, operations, financial condition and the industries in which we operate; • the restrictions contained in our financing agreements; • our ability to generate sufficient cash flow to meet our debt service obligations; • fluctuations in interest rates which may cause our interest expense to vary from quarter to quarter; • technical failures, equipment defects, physical or electronic break-ins to our services, computer viruses and similar problems; • the disruption or failure of our network, information systems or technologies as a result of computer hacking, computer viruses, “cyber-attacks,” misappropriation of data, outages, natural disasters and other material events; • our ability to obtain necessary hardware, software, communications equipment and services and other items from our vendors at reasonable costs; • our ability to effectively integrate acquisitions and to maximize expected operating efficiencies from our acquisitions or as a result of the transactions, if any; • significant unanticipated increases in the use of bandwidth-intensive Internet-based services; • the outcome of litigation, government investigations and other proceedings; • our ability to successfully operate our business following the completion of our separation from Altice Europe; and • other risks and uncertainties inherent in our cable and other broadband communications businesses and our other businesses, including those listed under the caption "Risk Factors" and "Management's Discussion and Analysis of Financial Condition and Results of Operations" contained herein. These factors are not necessarily all of the important factors that could cause our actual results to differ materially from those expressed in any of our forward-looking statements. Other unknown or unpredictable factors could cause our actual results to differ materially from those expressed in any of our forward-looking statements. Given these uncertainties, you are cautioned not to place undue reliance on such forward-looking statements. The forward-looking statements are made only as of the date of this Annual Report. Except to the extent required by law, we do not undertake, and specifically decline any obligation, to update any forward-looking statements or to publicly announce the results of any revisions to any of such statements to reflect future events or developments. Comparisons of results for current and any prior periods are not intended to express any future trends or indications of future performance, unless expressed as such, and should only be viewed as historical data. You should read this Annual Report with the understanding that our actual future results, levels of activity, performance and events and circumstances may be materially different from what we expect. We qualify all forward-looking statements by these cautionary statements. Certain numerical figures included in this Annual Report have been subject to rounding adjustments. Accordingly, such numerical figures shown as totals in various tables may not be arithmetic aggregations of the figures that precede them. Overview All dollar amounts, except per customer and per share data, included in the following discussion, are presented in thousands. Our Business We deliver broadband, pay television, telephony services, proprietary content and advertising services to approximately 4.9 million residential and business customers in and around the New York metropolitan area and in the south-central United States, with the majority of our customers located in the ten states of Texas, West Virginia, Louisiana, Arkansas, North Carolina, Oklahoma, Arizona, California, Missouri and Ohio. Our footprint extends across 21 states through a fiber-rich broadband network with approximately 8.7 million homes passed as of December 31, 2018. Key Factors Impacting Operating Results and Financial Condition Our future performance is dependent, to a large extent, on the impact of direct competition, general economic conditions (including capital and credit market conditions), our ability to manage our businesses effectively, and our relative strength and leverage in the marketplace, both with suppliers and customers. For more information see “Risk Factors” and “Business-Competition” included herein. We derive revenue principally through monthly charges to residential customers of our pay television, broadband, and telephony services. We also derive revenue from DVR, VOD, pay-per-view, installation and home shopping commissions. Our residential pay television, broadband, and telephony services accounted for approximately 43%, 30% and 7%, respectively, of our consolidated revenue for the year ended December 31, 2018. We also derive revenue from the sale of a wide and growing variety of products and services to both large enterprise and SMB customers, including broadband, telephony, networking and pay television services. For the year ended December 31, 2018, 14% of our consolidated revenue was derived from these business services. In addition, we derive revenues from the sale of advertising time available on the programming carried on our cable television systems, digital advertising and data analytics revenue, which accounted for approximately 5% of our consolidated revenue for the year ended December 31, 2018. Our other revenue for the year ended December 31, 2018 accounted for less than 1% of our consolidated revenue. Revenue is impacted by rate increases, changes in the number of customers to our services, including additional services sold to our existing customers, programming package changes by our pay television customers, speed tier changes by our broadband customers, and acquisitions of cable systems that result in the addition of new customers. Our ability to increase the number of customers to our services is significantly related to our penetration rates. We operate in a highly competitive consumer-driven industry and we compete against a variety of broadband, pay television and telephony providers and delivery systems, including broadband communications companies, wireless data and telephony providers, satellite-delivered video signals, Internet-delivered video content and broadcast television signals available to residential and business customers in our service areas. Our competitors include AT&T and its DirecTV subsidiary, CenturyLink, DISH, Frontier and Verizon. Consumers’ selection of an alternate source of service, whether due to economic constraints, technological advances or preference, negatively impacts the demand for our services. For more information on our competitive landscape, see "Risk Factors" and "Business-Competition" included herein. Our programming costs, which are the most significant component of our operating expenses, have increased and are expected to continue to increase primarily as a result of contractual rate increases and new channel launches. See “-Results of Operations” below for more information regarding our key factors impacting our revenues and operating expenses. Historically, we have made substantial investments in our network and the development of new and innovative products and other service offerings for our customers as a way of differentiating ourselves from our competitors and may continue to do so in the future. We are constructing a FTTH network, which will enable us to deliver more than 10 Gbps broadband speeds across our entire Optimum footprint and part of our Suddenlink footprint. In addition, in 2019 we will begin offering full service mobile voice and data services to our customers. We may incur greater than anticipated capital expenditures in connection with these initiatives, fail to realize anticipated benefits, experience delays and business disruptions or encounter other challenges to executing them as planned. See “-Liquidity and Capital Resources-Capital Expenditures” for additional information regarding our capital expenditures. Certain Transactions The following transactions occurred during the periods covered by this Management's Discussion and Analysis of Financial Condition and Results of Operations: As discussed in Note 1 of the Company's consolidated financial statements, the Company completed the ATS Acquisition in January 2018. ATS was previously owned by Altice Europe and a member of ATS's management through a holding company. As the acquisition is a combination of businesses under common control, the Company combined the results of operations and related assets and liabilities of ATS for all periods since the formation of ATS. In April 2018, Altice Europe transferred its ownership of i24NEWS, a 24/7 international news and current affairs channels, to the Company for minimal consideration. As the acquisition was a combination of businesses under common control, the Company combined the results of operations and related assets and liabilities of i24NEWS as of April 1, 2018. Operating results for periods prior to April 1, 2018 and the balance sheet as of December 31, 2017 have not been revised to reflect the combination of i24NEWS as the impact was deemed immaterial. On June 21, 2016, Altice USA acquired Cablevision for a total purchase price of approximately $9,958,323. The Altice USA operating results include the operating results of Cablevision from the date of acquisition. In July 2016, we completed the sale of a 75% interest in Newsday LLC and retained the remaining 25% ownership interest. Effective July 7, 2016, the operating results of Newsday are no longer consolidated with our results and our 25% interest in the operating results of Newsday is recorded on the equity basis. In April 2018, the Company redeemed a 24% interest in Newsday. Non-GAAP Financial Measures We define Adjusted EBITDA, which is a non-GAAP financial measure, as net income (loss) excluding income taxes, income (loss) from discontinued operations, non-operating income or expenses, loss on extinguishment of debt and write-off of deferred financing costs, gain (loss) on interest rate swap contracts, gain (loss) on derivative contracts, gain (loss) on investments and sale of affiliate interests, net, interest expense (including cash interest expense), interest income, depreciation and amortization (including impairments), share-based compensation expense or benefit, restructuring expense or credits and transaction expenses. We believe Adjusted EBITDA is an appropriate measure for evaluating the operating performance of the Company. Adjusted EBITDA and similar measures with similar titles are common performance measures used by investors, analysts and peers to compare performance in our industry. Internally, we use revenue and Adjusted EBITDA measures as important indicators of our business performance, and evaluate management’s effectiveness with specific reference to these indicators. We believe Adjusted EBITDA provides management and investors a useful measure for period-to-period comparisons of our core business and operating results by excluding items that are not comparable across reporting periods or that do not otherwise relate to the Company’s ongoing operating results. Adjusted EBITDA should be viewed as a supplement to and not a substitute for operating income (loss), net income (loss), and other measures of performance presented in accordance with GAAP. Since Adjusted EBITDA is not a measure of performance calculated in accordance with GAAP, this measure may not be comparable to similar measures with similar titles used by other companies. Results of Operations - Altice USA The following is a reconciliation of net income (loss) to Adjusted EBITDA: (a) Includes the non-service cost components of the Company's pension expense, net of dividends received on Comcast common stock owned by the Company. (b) Consists of unrealized and realized losses (gains) due to the change in the fair value of derivative contracts. The following table sets forth certain customer metrics for the Company (unaudited): (a) Represents the estimated number of single residence homes, apartments and condominium units passed by the cable distribution network in areas serviceable without further extending the transmission lines. In addition, it includes commercial establishments that have connected to our cable distribution network. For Cequel, broadband services were not available to approximately 100 homes passed and telephony services were not available to approximately 500 homes passed. (b) Represents number of households/businesses that receive at least one of the Company's services. (c) Customers represent each customer account (set up and segregated by customer name and address), weighted equally and counted as one customer, regardless of size, revenue generated, or number of boxes, units, or outlets. In calculating the number of customers, we count all customers other than inactive/disconnected customers. Free accounts are included in the customer counts along with all active accounts, but they are limited to a prescribed group. Most of these accounts are also not entirely free, as they typically generate revenue through pay-per-view or other pay services and certain equipment fees. Free status is not granted to regular customers as a promotion. In counting bulk residential customers, such as an apartment building, we count each subscribing family unit within the building as one customer, but do not count the master account for the entire building as a customer. We count a bulk commercial customer, such as a hotel, as one customer, and do not count individual room units at that hotel. (d) Represents the number of customers that subscribe to three of our services divided by total residential customer relationships. (e) Represents the number of total customer relationships divided by homes passed. (f) Calculated by dividing the average monthly revenue for the respective quarter (fourth quarter for annual periods) derived from the sale of broadband, pay television and telephony services to residential customers for the respective quarter by the average number of total residential customers for the same period. Altice USA - Comparison of Results for the Year Ended December 31, 2018 compared to the Year Ended December 31, 2017 and for the Year Ended December 31, 2017 compared to the Year Ended December 31, 2016 Pay Television Revenue Pay television revenue for the years ended December 31, 2018, 2017 and 2016 was $4,156,428, $4,274,122 and $2,788,873, respectively. Pay television revenue is derived principally through monthly charges to residential customers of our pay television services. Revenue is impacted by rate increases, changes in the number of customers, including additional services sold to our existing customers, and changes in programming packages. Pay television revenue decreased $117,694 (3%) for the year ended December 31, 2018 compared to the year ended December 31, 2017. The decrease was due primarily to a decline in pay television customers, partially offset by higher average revenue per pay television customer primarily due to rate increases. Pay television revenue increased $1,485,249 for the year ended December 31, 2017 compared to the year ended December 31, 2016. The increase is primarily due to the consolidation of the Cablevision results as of June 21, 2016, the date of the Cablevision Acquisition. Our 2016 results do not include pay television revenue of $1,494,186 recognized by Cablevision for the period from January 1, 2016 through June 20, 2016. Pay television revenue declined $8,937 as compared to the prior year due to a decline in pay television customers, net of increases resulting from rate increases for certain video services implemented in 2016 and 2017, an increase in late fees and an increase in pay-per-view revenue. We believe our pay television customer declines noted in the table above are largely attributable to competition, particularly from Verizon in our Optimum footprint and DBS providers in our Suddenlink footprint, as well as competition from companies that deliver video content over the Internet directly to customers. These factors are expected to continue to impact our ability to maintain or increase our existing customers and revenue in the future. Broadband Revenue Broadband revenue for the years ended December 31, 2018, 2017 and 2016 was $2,887,455, $2,608,595 and $1,651,574, respectively. Broadband revenue is derived principally through monthly charges to residential subscribers of our broadband services. Revenue is impacted by rate increases, changes in the number of customers, including additional services sold to our existing subscribers, and changes in speed tiers. Broadband revenue increased $278,860 (11%) for the year ended December 31, 2018 compared to the year ended December 31, 2017. The increases were due primarily to higher average recurring broadband revenue per broadband customer, primarily driven by certain rate increases and service level changes, and an increase in broadband customers. Broadband revenue increased $957,021 for the year ended December 31, 2017 compared to the year ended December 31, 2016. The increase is primarily due to the consolidation of the Cablevision results as of June 21, 2016, the date of the Cablevision Acquisition. Our 2016 results do not include broadband revenue of $702,811 recognized by Cablevision for the period January 1, 2016 through June 20, 2016. Broadband revenue also increased $254,210 as a result of higher average recurring broadband revenue per broadband customer (driven by rate increases, the impact of service level changes, and an increase in late fees) and an increase in broadband customers. Telephony Revenue Telephony revenue for the years ended December 31, 2018, 2017 and 2016 was $652,895, $700,765 and $465,771, respectively. Telephony revenue is derived principally through monthly charges to residential customers of our telephony services. Revenue is impacted by changes in rates for services, changes in the number of customers, and additional services sold to our existing customers. Telephony revenue decreased $47,870 (7%) for the year ended December 31, 2018 compared to the year ended December 31, 2017. The decrease is due to lower average revenue per telephony customer and a decline in telephony customers. Telephony revenue increased $234,994 for the year ended December 31, 2017 compared to the year ended December 31, 2016. The increase is primarily due to the consolidation of the Cablevision results as of June 21, 2016, the date of the Cablevision Acquisition. Our 2016 results do not include telephony revenue of $286,161 recognized by Cablevision for the period January 1, 2016 through June 20, 2016. Partially offsetting this increase was a net decrease of $51,167 due primarily to lower average revenue per telephony customer, a decline in international calling and a decline in telephony customers. Business Services and Wholesale Revenue Business services and wholesale revenue for the years ended December 31, 2018, 2017 and 2016 was $1,362,758, $1,298,213, $819,541, respectively. Business services and wholesale revenue is derived primarily from the sale of fiber based telecommunications services to the business market, and the sale of broadband, pay television and telephony services to SMB customers. Business services and wholesale revenue increased $64,545 (5%) for the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase was primarily due to higher average recurring broadband revenue per SMB customer, higher Ethernet and managed services revenue and an increase in the number of customers, partially offset by reduced traditional voice and data services for commercial customers. Business services and wholesale revenue increased $478,672 for the year ended December 31, 2017 compared to the year ended December 31, 2016. The increase is primarily due to the consolidation of the Cablevision results as of June 21, 2016, the date of the Cablevision Acquisition. Our 2016 results do not include revenue of $411,102 recognized by Cablevision for the period January 1, 2016 through June 20, 2016. Business services revenue also increased $67,570 primarily due to higher average recurring telephony and broadband revenue per SMB customer and an increase in Ethernet revenue resulting from a larger number of services installed, and increases in commercial carrier services, partially offset by reduced traditional voice and data services for commercial customers. Advertising Revenue Advertising revenue for the years ended December 31, 2018, 2017 and 2016, net of inter-segment revenue, was $482,649, $391,866 and $252,049, respectively. Advertising revenue is primarily derived from the sale of advertising time available on the programming carried on our cable television systems, digital advertising and data analytics revenue. Advertising revenue increased $90,783 (23%) for the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase was primarily due to an increase in digital advertising, higher political spending, and an increase in data analytics revenue. Advertising revenue for increased $139,817 for the year ended December 31, 2017 as compared to the year ended December 31, 2016. The increase is primarily due to the consolidation of the Cablevision results as of June 21, 2016, the date of the Cablevision Acquisition. Our 2016 results do not include advertising revenue of $125,419 recognized by Cablevision for the period January 1, 2016 through June 20, 2016. The remaining increase in advertising revenue of $14,398 was due primarily to an increase in digital advertising revenue and an increase in data and analytics revenue, partially offset by a decrease in political, auto, retail, and restaurant advertising. Other Revenue Other revenue for the years ended December 31, 2018, 2017 and 2016 was $24,423, $33,389 and $39,404, respectively. Other revenue includes other miscellaneous revenue streams. Programming and Other Direct Costs Programming and other direct costs for the years ended December 31, 2018, 2017 and 2016 amounted to $3,173,076, $3,035,655 and $1,911,230, respectively. Programming and other direct costs include cable programming costs, which are costs paid to programmers (net of amortization of any incentives received from programmers for carriage) for cable content (including costs of VOD and pay-per-view) and are generally paid on a per-customer basis. These costs typically rise due to increases in contractual rates and new channel launches and are also impacted by changes in the number of customers receiving certain programming services. These costs also include interconnection, call completion, circuit and transport fees paid to other telecommunication companies for the transport and termination of voice and data services, which typically vary based on rate changes and the level of usage by our customers. These costs also include franchise fees which are payable to the state governments and local municipalities where we operate and are primarily based on a percentage of certain categories of revenue derived from the provision of pay television service over our cable systems, which vary by state and municipality. These costs change in relation to changes in such categories of revenues or rate changes. The increase of $137,421 (5%) for the year ended December 31, 2018, as compared to the prior year is primarily attributable to the following: The increase of $1,124,425 for the year ended December 31, 2017 as compared to the prior year is primarily due to the consolidation of the Cablevision results as of June 21, 2016, the date of the Cablevision Acquisition. Our 2016 results do not include $1,088,555 of programming and other direct costs recognized by Cablevision for the period January 1, 2016 through June 20, 2016. The remaining increase of $35,870 is attributable to the following: Programming costs Programming costs aggregated $2,620,585, $2,533,244 and $1,567,688 for the years ended December 31, 2018, 2017 and 2016, respectively. The 2016 amount does not include programming costs of $883,792 recognized by Cablevision for the period January 1, 2016 through June 20, 2016. Our programming costs in 2019 will continue to be impacted by changes in programming rates, which we expect to increase by high single digits, and by changes in the number of pay television customers. Other Operating Expenses Other operating expenses for the years ended December 31, 2018, 2017 and 2016 amounted to $2,290,266, $2,347,315 and $1,702,472, respectively. Other operating expenses include staff costs and employee benefits including salaries of company employees and related taxes, benefits and other employee related expenses, as well as third-party labor costs. Other operating expenses also include network management and field service costs, which represent costs associated with the maintenance of our broadband network, including costs of certain customer connections and other costs associated with providing and maintaining services to our customers. Customer installation and repair and maintenance costs may fluctuate as a result of changes in the level of activities and the utilization of contractors as compared to employees. Also, customer installation costs fluctuate as the portion of our expenses that we are able to capitalize changes. Costs associated with the initial deployment of new customer premise equipment necessary to provide broadband, pay television and telephony services are capitalized (asset-based). The redeployment of customer premise equipment is expensed as incurred. Network repair and maintenance and utility costs also fluctuate as capitalizable network upgrade and enhancement activity changes. Other operating expenses also include costs related to the operation and maintenance of our call center facilities that handle customer inquiries and billing and collection activities and sales and marketing costs, which include advertising production and placement costs associated with acquiring and retaining customers. These costs vary period to period and certain of these costs, such as sales and marketing, may increase with intense competition. Additionally, other operating expenses include various other administrative costs, including legal fees, and product development costs. The decrease in other operating expenses of $57,049 (2%) for the year ended December 31, 2018 as compared to the prior year is attributable to the following: The increase in other operating expenses of $644,843 for the year ended December 31, 2017 as compared to the prior year is primarily due to the consolidation of the Cablevision results as of June 21, 2016, the date of the Cablevision Acquisition. Our 2016 results do not include $1,133,339 of other operating expenses recognized by Cablevision for the period January 1, 2016 through June 20, 2016. The remaining decrease of $488,496 is attributable to the following: Restructuring and Other Expense Restructuring and other expense for the year ended December 31, 2018 amounted to $38,548 as compared to $152,401 for the year ended December 31, 2017 and $240,395 for the year ended December 31, 2016. These amounts primarily relate to severance and other employee related costs resulting from headcount reductions related to initiatives which commenced in 2016 that are intended to simplify the Company's organizational structure. We currently anticipate that additional restructuring expenses will be recognized as we continue to analyze our organizational structure. Depreciation and Amortization Depreciation and amortization for the years ended December 31, 2018, 2017 and 2016 amounted to $2,382,339, $2,930,571 and $1,700,306, respectively. The decrease in depreciation and amortization of $548,232 (19%) in 2018 as compared to the prior year is due primarily to certain fixed assets and intangible assets becoming fully depreciated or amortized. These decreases were partially offset by depreciation of new asset additions. The increase in depreciation and amortization of $1,230,265 in 2017 as compared to the prior year is primarily due to the consolidation of the Cablevision results as of June 21, 2016, the date of the Cablevision Acquisition. Our 2016 results do not include $414,550 of depreciation and amortization recognized by Cablevision for the period January 1, 2016 through June 20, 2016. The remaining increase of $815,715 is primarily attributable to the acceleration of amortization of its trade name intangible assets in connection with the announcement, on May 23, 2017, of the adoption of a global brand to replace the Optimum brand in the future, as well as depreciation on new asset additions. In December 2017, the Company made a decision to postpone the adoption of a global brand that would have replaced the Optimum brand, increasing the useful life of the Optimum trade name intangible asset to 5 years. Adjusted EBITDA Adjusted EBITDA amounted to $4,163,078, $3,981,410 and $2,417,878 for the years ended December 31, 2018, 2017 and 2016, respectively. Adjusted EBITDA is a non-GAAP measure that is defined as net income (loss) excluding income taxes, income (loss) from discontinued operations, non-operating income or expenses, loss on extinguishment of debt and write-off of deferred financing costs, gain (loss) on interest rate swap contracts, gain (loss) on derivative contracts, gain (loss) on investments and sale of affiliate interests, net, interest expense (including cash interest expense), interest income, depreciation and amortization (including impairments), share-based compensation expense or benefit, restructuring expense or credits and transaction expenses. See reconciliation of net income (loss) to adjusted EBITDA above. The increase in adjusted EBITDA for the year ended December 31, 2018 as compared to the prior year was due to the increases in revenue and decreases in operating expenses (excluding depreciation and amortization, restructuring and other expense and share-based compensation), as discussed above. The increase in adjusted EBITDA for the year ended December 31, 2017 as compared to the prior year was due to the consolidation of the Cablevision results as of June 21, 2016, the date of the Cablevision Acquisition and the increases in revenue and decreases in operating expenses (excluding depreciation and amortization, restructuring and other expense and share-based compensation), as discussed above. Interest Expense, net Interest expense, net was $1,545,426, $1,601,211 and $1,442,730, for the years ended December 31, 2018, 2017 and 2016, respectively, and includes interest on debt issued to finance the Cablevision Acquisition and Cequel Acquisition, as well as interest on debt assumed in connection with these acquisitions. The decrease of $55,785 for the year ended December 31, 2018 and increase of $158,481 for the year ended December 31, 2017 as compared to the prior year are attributable to the following: Gain (Loss) on Investments and Sale of Affiliate Interests, net Gain (loss) on investments, net for the years ended December 31, 2018, 2017 and 2016, of $(250,877), $237,354 and $142,102 consists primarily of the increase (decrease) in the fair value of Comcast common stock owned by the Company for the periods. For 2016, the gain is for the period June 21, 2016 through December 31, 2016. The effects of these gains (losses) are partially offset by the losses (gains) on the related equity derivative contracts, net described below. Gain (Loss) on Derivative Contracts, net Gain (loss) on derivative contracts, net for the year ended December 31, 2018 amounted to $218,848 compared to $(236,330) for the year ended December 31, 2017 and $(53,696) for the year ended December 31, 2016, and includes realized and unrealized gains or losses due to the change in fair value of equity derivative contracts relating to the Comcast common stock owned by the Company. For 2016, the loss is for the period June 21, 2016 through December 31, 2016. The effects of these gains (losses) are offset by losses (gains) on investment securities pledged as collateral, which are included in gain (loss) on investments, net discussed above. The loss for the year ended December 31, 2017 also includes the realized loss on the settlement of certain put-call options of $97,410. Gain (loss) on Interest Rate Swap Contracts Gain (loss) on interest rate swap contracts was $(61,697), $5,482 and $(72,961) for the years ended December 31, 2018, 2017 and 2016, respectively. These amounts represent the increase or decrease in fair value of interest rate swaps. These swap contracts are not designated as hedges for accounting purposes. Loss on Extinguishment of Debt and Write-off of Deferred Financing Costs Loss on extinguishment of debt and write-off of deferred financing costs amounted to $48,804, $600,240 and $127,649 for the years ended December 31, 2018, 2017 and 2016, respectively. The 2018 amount primarily includes the write-off of unamortized discount and deferred financing costs and the premium paid in connection with early redemption of the Cequel 2020 Notes in the second quarter of 2018, the write-off of unamortized premium and deferred financing costs and the premium paid in connection with early redemption of the $750,000 7.75% Cablevision senior notes due in April 2018 in the first quarter of 2018, and write-off of unamortized deferred financing costs on the early repayment of the Cequel credit facility in November 2018. The 2017 amount includes the premium of $513,723 related to the notes payable to affiliates and related parties that were converted into shares of the Company’s common stock, $18,976 related to the Cablevision Extension Amendment and the redemption of senior notes, $28,684 related to the Cequel Extension Amendment and the redemption of senior notes and $38,858 related to premiums paid upon the early repayment of certain senior notes outstanding. The 2016 amount includes primarily the write-off of unamortized deferred financing costs and the unamortized discount relating to the prepayment of $1,290,500 outstanding under the term credit facility at Cablevision. Other Income (Expense), Net Other income (loss), net amounted to $(12,484), $(13,651) and $980, for the years ended December 31, 2018, 2017 and 2016, respectively. These amounts include the non-service cost components of the Company's pension expense of $9,529, $11,863 and $3,143, net of dividends received on Comcast common stock owned by the Company. Income Tax Benefit The Company recorded income tax benefit of $38,655 for the year ended December 31, 2018. During 2018, the Company determined that it met the definition of a Qualified Technology Company for New York State tax purposes and thereby was eligible for the reduced tax rate. Additionally, during 2018, the state of New Jersey enacted significant tax law changes imposing a 2.5% surtax for tax years beginning January 1, 2018 and mandating combined return filing requirements for unitary corporations for tax years beginning January 1, 2019. Accordingly, the Company recorded a net non-cash deferred tax benefit of $52,915 based on a remeasurement of the net deferred tax liability. The Company recorded income tax benefit of $2,862,352 for the year ended December 31, 2017. Pursuant to the enactment of Tax Cuts and Jobs Act on December 22, 2017, the Company recorded a non-cash deferred tax benefit of $2,332,677 to remeasure the net deferred tax liability to adjust for the reduction in the corporate federal income tax rate from 35% to 21% which is effective on January 1, 2018. Nondeductible share-based compensation expense for the year ended December 31, 2017 reduced income tax benefit by $22,938. The Company recorded income tax benefit of $259,666 for the year ended December 31, 2016. Nondeductible share-based compensation expense for the year ended December 31, 2016 reduced income tax benefit by $5,747. On June 9, 2016 the common stock of Cequel was contributed to the Company. On June 21, 2016, the Company completed its acquisition of Cablevision. Accordingly, Cequel and Cablevision joined the federal consolidated and certain state combined income tax returns of the Company. As a result, the applicate tax rate used to measure deferred tax assets and liabilities increased, resulting in a non-cash deferred income tax charge of $153,660 in the second quarter of 2016. In addition, there was no state income tax benefit on the pre-merger accrued interest at an indirect wholly-owned subsidiary of Altice Europe formed to complete the financing for the Cablevision Acquisition and the merger with CSC Holdings, resulting in additional deferred tax expense of $18,542 for the year ended December 31, 2016. Results of Operations - Cablevision Systems Corporation (a) Reflects certain reclassifications to conform to the Altice USA presentation as a result of the adoption of ASC ASU No. 2014-09, Revenue from Contracts with Customers and ASU No. 2017-07 Compensation-Retirement Benefits (Topic 715). (a) Includes primarily dividends received on Comcast common stock owned by the Company. (b) Consists of unrealized and realized losses (gains) due to the change in fair value of equity derivative contracts relating to the Comcast common stock owned by the Company. ____________________ (a) Represents the estimated number of single residence homes, apartments and condominium units passed by the cable distribution network in areas serviceable without further extending the transmission lines. In addition, it includes commercial establishments that have connected to our cable distribution network. (b) Represents number of households/businesses that receive at least one of the Company’s services. (c) Customers represent each customer account (set up and segregated by customer name and address), weighted equally and counted as one customer, regardless of size, revenue generated, or number of boxes, units, or outlets. In calculating the number of customers, we count all customers other than inactive/disconnected customers. Free accounts are included in the customer counts along with all active accounts, but they are limited to a prescribed group. Most of these accounts are also not entirely free, as they typically generate revenue through pay-per-view or other pay services and certain equipment fees. Free status is not granted to regular customers as a promotion. In counting bulk residential customers, such as an apartment building, we count each subscribing family unit within the building as one customer, but do not count the master account for the entire building as a customer. We count a bulk commercial customer, such as a hotel, as one customer, and do not count individual room units at that hotel. (d) Represents the number of customers that subscribe to three of our services divided by total residential customer relationships. (e) Represents the number of total customer relationships divided by homes passed. (f) Calculated by dividing the average monthly revenue for the respective quarter (fourth quarter for annual periods) presented derived from the sale of broadband, pay television and telephony services to residential customers for the respective quarter by the average number of total residential customers for the same period. Cablevision - Comparison of Results for the Periods June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016 to Results for the Year Ended December 31, 2015 Pay Television Revenue Pay television revenue amounted to $1,668,348 and $1,494,186 for the period June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016, respectively, compared to $3,174,059 for the year ended December 31, 2015. Pay television revenue for the Successor and Predecessor periods in 2016 was impacted by a decline in pay television customers, a decrease due to a pay-per-view boxing event that took place in 2015, partially offset by increases in revenue due primarily to rate increases for certain pay television services implemented during the first quarter of 2016 and an increase in fees charged to restore suspended services. We believe our pay television customer declines noted in the table above are largely attributable to intense competition, particularly from Verizon, as well as competition from companies that deliver video content over the Internet directly to customers. Also, the declines are attributable to our disciplined pricing and credit policies. These factors are expected to continue to impact our ability to maintain or increase our existing customers and revenue in the future. Broadband Revenue Broadband revenue amounted to $817,160 and $702,811 for the period June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016, respectively, compared to $1,389,447 for the year ended December 31, 2015. Broadband revenue for the Successor and Predecessor periods in 2016 was impacted by rate increases for certain broadband services implemented during the first quarter of 2016, an increase in broadband customers, and an increase in fees charged to restore suspended services. Telephony Revenue Telephony revenue amounted to $311,832 and $286,161 for the period June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016, respectively, compared to $631,584 for the year ended December 31, 2015. Telephony revenue for the Successor and Predecessor periods in 2016 was impacted by a decline in telephony customers and a decline in international calling. Business Services Revenue Business services and wholesale revenue amounted to $468,632 and $411,102 for the period June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016, respectively, compared to $834,154 for the year ended December 31, 2015. Business services and wholesale revenue for the Successor and Predecessor periods in 2016 was impacted by rate increases for certain broadband services implemented during the first quarter of 2016, an increase in broadband customers and an increase in Ethernet revenue from an increase in services installed, partially offset by reduced traditional voice and data services. Advertising Revenue Advertising revenue amounted to $163,678 and $125,419 for the period June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016, respectively, compared to $263,839 for the year ended December 31, 2015. Advertising revenue for the Successor and Predecessor periods in 2016 was impacted by an increase in advertising sales to the political sector. Other Revenue Other revenue amounted to $14,402 and $117,925 for the period June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016, respectively, compared to $252,462 for the year ended December 31, 2015. Other revenue for the Successor and Predecessor periods in 2016 includes revenue recognized by Newsday through July 7, 2016, affiliation fees paid by cable operators for carriage of our News 12 Networks and other revenue sources. On July 7, 2016, the Company sold a 75% interest in Newsday and as a result no longer consolidates its operating results. As of July 7, 2016, the Company’s 25% interest in the operating results of Newsday is recorded on the equity basis. Programming and Other Direct Costs Programming and other direct costs include cable programming costs, which are costs paid to programmers (net of amortization of any incentives received from programmers for carriage) for cable content (including costs of VOD and pay-per-view) and are generally paid on a per-customer basis. These costs typically rise due to increases in contractual rates and new channel launches and are also impacted by changes in the number of customers receiving certain programming services. These costs also include interconnection, call completion, circuit and transport fees paid to other telecommunication companies for the transport and termination of voice and data services, which typically vary based on rate changes and the level of usage by our customers. These costs also include franchise fees which are payable to the state governments and local municipalities where we operate and are primarily based on a percentage of certain categories of revenue derived from the provision of pay television service over our cable systems, which vary by state and municipality. These costs change in relation to changes in such categories of revenues or rate changes. These costs also included content, production and distribution costs of the Newsday business. Programming and other direct costs amounted to $1,164,925 and $1,088,555 for the period June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016, respectively, compared to $2,269,290 for the year ended December 31, 2015. Programming and other direct costs for the Successor and Predecessor periods in 2016 were impacted by an increase in programming costs due primarily to contractual rate increases, partially offset by lower video customers. These costs were also impacted by the lower costs related to Newsday (due to the sale of our 75% interest in Newsday in July 2016), lower call completion and transport costs primarily due to lower level of activity, lower cost of sales related to wireless handset inventory and higher franchise and other fees due primarily to increases in rates in certain areas, partially offset by lower pay television customers. Programming costs aggregated $978,120 and $883,792 for the period June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016, respectively, compared to $1,796,021 for the year ended December 31, 2015. Our programming costs increased 4% for the 2016 periods due primarily to an increase in contractual programming rates and a pay-per-view boxing event in 2015, partially offset by a decrease in telephony customers. Other Operating Expenses Other operating expenses include staff costs and employee benefits including salaries of company employees and related taxes, benefits and other employee-related expenses. Other operating expenses also include network management and field service costs, which represent costs associated with the maintenance of our broadband network, including costs of certain customer connections and other costs associated with providing and maintaining services to our customers which are impacted by general cost increases for contractors, insurance and other various expenses. Customer installation and repair and maintenance costs may fluctuate as a result of changes in the level of activities and the utilization of contractors as compared to employees. Also, customer installation costs fluctuate as the portion of our expenses that we are able to capitalize changes. Network repair and maintenance and utility costs also fluctuate as capitalizable network upgrade and enhancement activity changes. Other operating expenses also include costs related to the operation and maintenance of our call center facilities that handle customer inquiries and billing and collection activities and sales and marketing costs, which include advertising production and placement costs associated with acquiring and retaining customers. These costs vary period to period and certain costs, such as sales and marketing, may increase with intense competition. Additionally, other operating expenses include various other administrative costs, including legal fees, and product development costs. Other operating expenses amounted to $1,025,304 and $1,133,339 for the period June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016, respectively, compared to $2,533,958 for the year ended December 31, 2015. Other operating expenses for the Successor and Predecessor periods in 2016 were impacted by a decrease in employee-related costs related to the elimination of certain positions, lower benefits and an increase in capitalizable activity, partially offset by merit increases. These costs were also impacted by the lower costs related to Newsday (due to the sale of our 75% interest in Newsday in July 2016), a decrease in share-based compensation, a decrease in long-term incentive plan awards, lower legal costs, lower sales and marketing costs, lower repair and maintenance expenses, lower contractor costs, a settlement of a class action legal matter in 2015, partially offset by an increase in the management fee to Altice Europe Restructuring and Other Expense Restructuring and other expense amounted to $212,150 and $22,223 for the period June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016, respectively, compared to $16,213 for the year ended December 31, 2015. Restructuring and other expense for the Successor 2016 period is primarily related to severance and other employee related costs resulting from headcount reductions related to initiatives which commenced in the Successor period that are intended to simplify the Company’s organizational structure. The restructuring and other expense for the Predecessor 2016 period is primarily related to transaction costs of $19,924 incurred in connection with the Cablevision Acquisition and adjustments related to prior restructuring plans of $2,299. Restructuring and other expense for 2015 includes transaction costs incurred in connection with the Cablevision Acquisition of $17,862, net of adjustments related to prior restructuring plans of $1,649. Depreciation and Amortization Depreciation and amortization (including impairments) amounted to $963,665 and $414,550 for the period June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016, respectively, compared to $865,252 for the year ended December 31, 2015. Depreciation and amortization for the Successor period in 2016 was impacted by an increase in related to the step-up in the carrying value of property, plant and equipment and amortizable intangible assets recorded in connection with the Cablevision Acquisition on June 21, 2016, partially offset by certain assets being retired or becoming fully depreciated. Adjusted EBITDA Adjusted EBITDA amounted to $1,262,987 and $940,941 for the periods June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016, respectively, compared to $1,807,583 for the year ended December 31, 2015. Adjusted EBITDA for the 2016 periods was impacted by an increase in revenue, and a decrease in operating expenses (excluding depreciation and amortization, restructuring and other expense and share-based compensation), as discussed above. Interest Expense, net Interest expense amounted to $606,347 and $285,508 for the period June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016, respectively, compared to $584,839 for the year ended December 31, 2015. Interest expense for the Successor 2016 period includes additional interest related to the debt incurred to finance the Cablevision Acquisition. Gain (Loss) on Investments, net Gain (loss) on investments, net amounted to $141,896 and $129,990 for the period June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016, respectively, and $(30,208) for the year ended December 31, 2015 and reflect the increase or decrease in the fair value of Comcast common stock owned by the Company. The effects of these gains (losses) are partially offset by the (losses) gains on the related equity derivative contracts, net described below. Gain (Loss) on Equity Derivative Contracts, net Gain (loss) on equity derivative contracts, net amounted to $(53,696) and $(36,283) for the periods June 21, 2016 through December 31, 2016 and January 1, 2016 through June 20, 2016, respectively, and $104,927 for the year ended December 31, 2015. Gain (loss) on equity derivative contracts, net consists of unrealized and realized gains (losses) due to the change in fair value of the Company’s equity derivative contracts relating to the Comcast common stock owned by the Company. The effects of these gains (losses) are offset by the (losses) gains on investment securities pledged as collateral, which are included in gain (loss) on investments, net discussed above. Loss on Extinguishment of Debt and Write-off of Deferred Financing Costs Loss on extinguishment of debt and write-off of deferred financing costs amounted to $102,894 for the period June 21, 2016 through December 31, 2016 and $1,735 for the year ended December 31, 2015. The Successor 2016 amount includes the write-off of unamortized deferred financing costs and the unamortized discount related to the prepayment of $1,290,500 outstanding under the CSC Holdings, a wholly-owned subsidiary of Cablevision, term credit facility. The 2015 amount includes the write-off of unamortized deferred financing costs and the unamortized discount related to the $200,000 repayment of CSC Holdings term B loan facility. Income Tax Expense Income tax benefit (expense) amounted to $213,065 for the periods from June 21, 2016 through December 31, 2016 and $(124,848) for the period from January 1, 2016 through June 20, 2016. In the Successor period, excluding the impact of the nondeductible share-based compensation of $3,208, the effective tax rate would have been 40%. In the Predecessor period, certain acquisition-related costs were determined to be nondeductible, resulting in additional deferred tax expense of $9,392. Absent this item, the effective tax rate would have been 40%. Income tax expense of $154,872 for the year ended December 31, 2015, reflected an effective tax rate of 45%. In April 2015, corporate income tax changes were enacted for both New York State and the City of New York. Those changes included a provision whereby investment income will be subject to higher taxes. Accordingly, in the second quarter of 2015, Cablevision recorded deferred tax expense of $16,334 to remeasure the deferred tax liability for the investment in Comcast common stock and associated derivative securities. Also in 2015, Cablevision recorded tax benefit of $2,630 related to research credits. Absent these items, the effective tax rate for the year ended December 31, 2015 would have been 41%. Loss From Discontinued Operations Loss from discontinued operations for the year ended December 31, 2015 amounted to $12,541, net of income taxes, and primarily reflects an expense related to the settlement of a legal matter relating to Rainbow Media Holdings LLC, a business whose operations were previously discontinued. LIQUIDITY AND CAPITAL RESOURCES Altice USA has no operations independent of its subsidiaries. Funding for our subsidiaries has generally been provided by cash flow from their respective operations, cash on hand and borrowings under their revolving credit facilities and the proceeds from the issuance of securities and borrowings under syndicated term loans in the capital markets. Our decision as to the use of cash generated from operating activities, cash on hand, borrowings under the revolving credit facility or accessing the capital markets has been based upon an ongoing review of the funding needs of the business, the optimal allocation of cash resources, the timing of cash flow generation and the cost of borrowing under the revolving credit facility, debt securities and syndicated term loans. We manage our business to a year-end leverage target of 4.5x to 5.0x. We calculate our consolidated net leverage ratio as net debt to L2QA EBITDA (Adjusted EBITDA for the two most recent consecutive fiscal quarters multiplied by 2.0). We expect to utilize free cash flow and availability under the revolving credit facility, as well as future refinancing transactions, to further extend the maturities of, or reduce the principal on, our debt obligations. The timing and terms of any refinancing transactions will be subject to, among other factors, market conditions. Additionally, we may, from time to time, depending on market conditions and other factors, use cash on hand and the proceeds from other borrowings to repay the outstanding debt securities through open market purchases, privately negotiated purchases, tender offers, or redemptions. We believe existing cash balances, operating cash flows and availability under our revolving credit facility will provide adequate funds to support our current operating plan, make planned capital expenditures and fulfill our debt service requirements for the next twelve months. However, our ability to fund our operations, make planned capital expenditures, make scheduled payments on our indebtedness and repay our indebtedness depends on our future operating performance and cash flows and our ability to access the capital markets, which, in turn, are subject to prevailing economic conditions and to financial, business and other factors, some of which are beyond our control. However, competition, market disruptions or a deterioration in economic conditions could lead to lower demand for our products, as well as lower levels of advertising, and increased incidence of customers' inability to pay for the services we provide. These events would adversely impact our results of operations, cash flows and financial position. Although we currently believe that amounts available under the revolving credit facility will be available when, and if, needed, we can provide no assurance that access to such funds will not be impacted by adverse conditions in the financial markets or other conditions. The obligations of the financial institutions under the revolving credit facility are several and not joint and, as a result, a funding default by one or more institutions does not need to be made up by the others. In the longer term, we may not be able to generate sufficient cash from operations to fund anticipated capital expenditures, meet all existing future contractual payment obligations and repay our debt at maturity. As a result, we could be dependent upon our continued access to the capital and credit markets to issue additional debt or equity or refinance existing debt obligations. We intend to raise significant amounts of funding over the next several years to fund capital expenditures, repay existing obligations and meet other obligations, and the failure to do so successfully could adversely affect our business. If we are unable to do so, we will need to take other actions including deferring capital expenditures, selling assets, seeking strategic investments from third parties or reducing or eliminating stock repurchases and discretionary uses of cash. Credit Silo Combination In October 2018, the Company combined its Suddenlink and Optimum businesses under a single credit silo (the “Combination”). The integration of the Suddenlink and Optimum businesses was aimed at aligning Altice USA’s debt capital structure and to simplify Altice USA’s financing strategy and financial reporting requirements. The Combination was effected mainly by the following transactions: • In October 2018, Altice US Finance, Cequel Capital Corporation and Cequel Communications Holdings I, LLC (“CCHI”) commenced an offer to exchange (the "Exchange Offer") any and all outstanding senior notes and senior secured notes issued by them (the "Original Cequel Notes") for up to $5,520,000 aggregate principal amount of new notes (the "New Cequel Notes") and, in the case of the 5.375% senior secured notes due 2023 and 5.500% senior secured notes due 2026, and cash of $6,500. The Exchange Offer was accompanied by a consent solicitation to amend the terms of each series of the notes subject to the Exchange Offer (except the 5.125% senior notes due 2021) and the indentures governing such notes. Approximately $5,500,050 of the outstanding notes subject to the Exchange Offer were exchanged into corresponding series of New Cequel Notes. The proposed amendments in the consent solicitation, which have become operative effective November 27, 2018 (the “Combination Date”), eliminated or waived substantially all of the restrictive covenants, eliminated certain events of default, and modified or eliminated certain other provisions governing the Original Cequel Notes (except the 5.125% senior notes due 2021) to the extent that they remain outstanding. • In October 2018, CSC Holdings entered into a Sixth Amendment to the CSC Credit Facilities Agreement (the “Combination Incremental Term Loan Agreement”). The Combination Incremental Term Loan Agreement provided for, among other things, new incremental term loan commitments in an aggregate principal amount of $1,275,000. On or following the Combination Date the following transactions were completed: • The Company redeemed $5,206 principal amount of the Original Cequel Notes that were outstanding after the consummation of the Exchange Offer. • New Cequel Notes with an aggregate principal balance of $5,500,050 were converted into $5,499,156 principal amount of CSC Holdings senior notes (see detail below). • Pursuant to the Combination Incremental Term Loan Agreement, on the Combination Date, CSC Holdings entered into a $1,275,000 7-year incremental term loan maturing January 2026 (the “Incremental Term Loan B-3”). The proceeds from the Incremental Term Loan B-3 were used to repay the entire principal amount of loans under Cequel’s existing Term Loan Facility and other transaction costs related to the Combination. The Incremental Term Loan B-3 has a margin of 2.25% over LIBOR and was issued with an original issue discount of 25 basis points. The Company is required to make scheduled quarterly payments equal to 0.25% (or $3,188) of the principal amount of the Incremental Term Loan B-3, beginning with the fiscal quarter ended June 30, 2019, with the remaining balance scheduled to be paid on January 15, 2026. • The Combination was implemented by a series of corporate transactions, including: (i) CCHI merging into Cablevision, with Cablevision as the surviving entity (the “Holdco Merger”), and (ii) Cequel Communications Holdings II, LLC (the direct parent of Cequel) merging into CSC Holdings, with CSC Holdings as the surviving entity. In connection with the Holdco Merger, Cablevision assumed all of the obligations of CCHI that remained outstanding after giving effect to the Combination Exchange under the indentures governing the outstanding Original Cequel Notes. The following is a summary of the results of the Exchange Offer: Debt Outstanding The following tables summarize the carrying value of our outstanding debt, net of unamortized deferred financing costs, discounts and premiums (excluding accrued interest), as well as interest expense. (a) This indebtedness is collateralized by shares of Comcast common stock. We intend to settle this debt by (i) delivering shares of Comcast common stock and the related equity contracts, or (ii) delivering cash from the net proceeds on new monetization contracts. The following table provides details of our outstanding credit facility debt, net of unamortized discounts and deferred financing costs as of December 31, 2018: (a) At December 31, 2018, $147,564 of the revolving credit facility was restricted for certain letters of credit issued on behalf of the Company and $1,902,436 of the facility was undrawn and available, subject to covenant limitations. (b) Proceeds from the CSC Holdings term loan were used to repay the outstanding amount under the Cequel Term loan in November 2018 in connection with the Combination. See discussion above. Payment Obligations Related to Debt As of December 31, 2018, total amounts payable by us in connection with our outstanding obligations, including related interest, as well as capital lease obligations, notes payable, and the value deliverable at maturity under monetization contracts are as follows: (a) Includes $1,542,266 related to the Company's collateralized indebtedness (including related interest). This indebtedness is collateralized by shares of Comcast common stock. We intend to settle this debt by (i) delivering shares of Comcast common stock and the related equity contracts or (ii) delivering cash from the net proceeds on new monetization contracts. The amounts in the table above do not include the effects of the debt transactions discussed in Note 21. CSC Holdings Restricted Group CSC Holdings and those of its subsidiaries which conduct our broadband, pay television and telephony services operations, as well as Lightpath, which provides Ethernet-based data, Internet, voice and video transport and managed services to the business market, comprise the "Restricted Group" as they are subject to the covenants and restrictions of the credit facility and indentures governing the notes and debentures issued by CSC Holdings. In addition, the Restricted Group is also subject to the covenants of the debt issued by Cablevision. Sources of cash for the Restricted Group include primarily cash flow from the operations of the businesses in the Restricted Group, borrowings under its credit facility and issuance of securities in the capital markets, contributions from its parent, and, from time to time, distributions or loans from its subsidiaries. The Restricted Group's principal uses of cash include: capital spending, in particular, the capital requirements associated with the upgrade of its digital broadband, pay television and telephony services, including costs to build a FTTH network and enhancements to its service offerings such as Wi-Fi; debt service, including distributions made to Cablevision to service interest expense and principal repayments on its debt securities; other corporate expenses and changes in working capital; and investments that it may fund from time to time. CSC Holdings Credit Facility On October 9, 2015, Finco, which merged with and into CSC Holdings on June 21, 2016, entered into a senior secured credit facility, which currently provides U.S. dollar term loans currently in an aggregate principal amount of $3,000,000 ($2,955,000 outstanding at December 31, 2018) (the “CSC Term Loan Facility”, and the term loans extended under the CSC Term Loan Facility, the “CSC Term Loans”) and U.S. dollar revolving loan commitments in an aggregate principal amount of $2,300,000 (the “CSC Revolving Credit Facility” and, together with the CSC Term Loan Facility, the “CSC Credit Facilities”), which are governed by a credit facilities agreement entered into by, inter alios, CSC Holdings certain lenders party thereto and JPMorgan Chase Bank, N.A. as administrative agent and security agent (as amended, restated, supplemented or otherwise modified on June 20, 2016, June 21, 2016, July 21, 2016, September 9, 2016, December 9, 2016, March 15, 2017, January 12, 2018, and October 15, 2018, respectively, and as further amended, restated, supplemented or otherwise modified from time to time, the “CSC Credit Facilities Agreement”). In January 2018, CSC Holdings entered into a new $1,500,000 incremental term loan facility (the "Incremental Term Loan B-2") under its existing credit facilities agreement. The Incremental Term Loan B-2 was priced at 99.5% and will mature on January 25, 2026. The Incremental Term Loan B-2 is comprised of eurodollar borrowings or alternate base rate borrowings, and bears interest at a rate per annum equal to the adjusted LIBOR or the alternate base rate, as applicable, plus the applicable margin, where the applicable margin is (i) with respect to any alternate base rate loan, 1.50% per annum and (ii) with respect to any eurodollar loan, 2.50% per annum. The Company is required to make scheduled quarterly payments equal to 0.25% (or $3,750) of the principal amount of the Incremental Term Loan B-2, beginning with the fiscal quarter ended September 30, 2018, with the remaining balance scheduled to be paid on January 26, 2026. See discussion above under "Credit Silo Combination" regarding the Sixth Amendment to the CSC Credit Facilities Agreement, which provided for, among other things, new incremental term loan commitments in an aggregate principal amount of $1,275,000. In January 2019, CSC Holdings obtained commitments to refinance its existing revolving credit facility, subject to customary closing conditions. After the refinancing, the total size of the new revolving credit facility is $2,562,500, including $2,170,000 extended to January 2024 and priced at LIBOR plus 2.25%. The remaining $392,500 matures in November 2021. Also in January 2019, CSC Holdings borrowed $200,000 under its revolving credit facility and in February 2019, repaid $250,000 of amounts outstanding under the revolving credit facility from the proceeds of the issuance of an additional $250,000 principal amount of CSC Holdings 2029 Guaranteed Notes discussed below. In February 2019, CSC Holdings entered into a $1,000,000 senior secured Term Loan B ("Incremental Term Loan B-4") maturing on April 15, 2027, the proceeds of which were used to redeem $894,700 in aggregate principal amount of CSC Holdings’ 10.125% senior notes due 2023, representing the entire aggregate principal amount outstanding, and paying related fees, costs and expenses. The Incremental Term Loan B-4 bears interest at a rate per annum equal to LIBOR plus 3.0% and was issued with an original issue discount of 1.0%. During the year ended December 31, 2018, CSC Holdings borrowed $725,000 under its revolving credit facility (and used a portion of the proceeds to repay the $500,000 principal amount of senior notes due July 15, 2018) and made voluntary repayments aggregating $925,000 with cash on hand. The Company was in compliance with all of its financial covenants under the CSC Credit Facilities Agreement as of December 31, 2018. See Note 11 to our consolidated financial statements for further information regarding the CSC Credit Facilities Agreement. Cequel Credit Facilities In October 2018, in connection with the Combination described above, amounts outstanding pursuant to the Cequel credit facilities aggregating $1,249,188 were repaid from the proceeds of the CSC Holdings Senior Secured Term Loan B-3 and all commitments pursuant to the Cequel Credit Facilities were cancelled. Senior Guaranteed Notes and Senior Notes In January 2018, CSC Holdings issued $1,000,000 aggregate principal amount of 5 3/8% senior guaranteed notes due February 1, 2028 (the "2028 Guaranteed Notes"). The 2028 Guaranteed Notes are senior unsecured obligations and rank pari passu in right of payment with all of the existing and future senior indebtedness, including the existing senior notes and the Credit Facilities and rank senior in right of payment to all of existing and future subordinated indebtedness. The proceeds from the 2028 Guaranteed Notes, together with proceeds from the Incremental Term Loan (discussed above), borrowings under the CVC revolving credit facility and cash on hand, were used in February 2018 to repay $300,000 principal amount of CSC Holdings' senior notes due in February 2018 and $750,000 principal amount of Cablevision senior notes due in April 2018 and a portion was used to fund the dividend of $1,499,935 to the Company's stockholders on June 6, 2018. In July 2018, CSC Holdings repaid $500,000 aggregate principal amount of its 7 5/8% Senior Debentures upon maturity with borrowings under CSC Holdings’ revolving credit facility agreement. See Note 11 of our consolidated financial statements for further details of the Company’s outstanding senior guaranteed notes and senior notes. As of December 31, 2018, the Company was in compliance with all of its financial covenants under the indentures under which these notes were issued. In January 2019, CSC Holdings issued $1,500,000 in aggregate principal amount of senior guaranteed notes due 2029 ("CSC Holdings 2029 Guaranteed Notes"). The notes bear interest at a rate of 6.5% and will mature on February 1, 2029. The net proceeds from the sale of the notes was used to repay certain indebtedness, including to repay at maturity $526,000 aggregate principal amount of CSC Holdings' 8.625% senior notes due February 2019, redeem approximately $905,300 of the aggregate outstanding amount of CSC Holdings' 10.125% senior notes due 2023 at a redemption price of 107.594% plus accrued interest, and paid fees and expenses associated with the transactions. In February 2019, CSC Holdings issued an additional $250,000 CSC Holdings 2029 Guaranteed Notes at a price of 101.75% of the principal value. The proceeds of these notes were to repay the outstanding balance on the CSC Revolving Credit Facility. Capital Expenditures Customer premise equipment includes expenditures for set-top boxes, cable modems, routers and other equipment that is placed in a customer's home, as well as installation costs for placing assets into service. Network infrastructure includes: (i) scalable infrastructure, such as headend equipment, (ii) line extensions, such as fiber/coaxial cable, amplifiers, electronic equipment, make-ready and design engineering, and (iii) upgrade and rebuild, including costs to modify or replace existing fiber/coaxial cable networks, including enhancements. Support and other capital expenditures includes costs associated with the replacement or enhancement of non-network assets, such as office equipment, buildings and vehicles. Business services capital expenditures include primarily equipment, installation, support, and other costs related to our fiber based telecommunications business. Cash Flow Discussion Operating Activities Net cash provided by operating activities amounted to $2,508,317, $2,018,247 and $1,184,455 for the years ended December 31, 2018, 2017 and 2016, respectively. The 2018 cash provided by operating activities resulted from $2,644,639 of income before depreciation and amortization and non-cash items, an increase in deferred revenue of $72,426, an increase in liabilities related to interest rate swap contracts of $53,101, and a net increase in amounts due to affiliates of $11,049, partially offset by an increase in accounts receivable of $144,079, a decrease in accounts payable and accrued expenses of $118,176, and an increase in current and other assets of $10,643. The 2017 cash provided by operating activities resulted from $2,318,941 of income before depreciation and amortization and non-cash items and an increase in deferred revenue of $12,310, partially offset by a decrease in accounts payable and accrued expenses of $167,813, a net increase in current and other assets of $109,944, a net decrease in amounts due to affiliates of $34,326, and a decrease in liabilities related to interest rate swap contracts of $921. The 2016 cash provided by operating activities resulted from $746,341 of income before depreciation and amortization and non-cash items, $310,892 as a result of an increase in accounts payable, deferred revenue and other liabilities, $78,823 resulting from an increase in liabilities related to interest rate swap contracts and $48,399 resulting from a net decrease in current and other assets. Investing Activities Net cash used in investing activities for the years ended December 31, 2018, 2017 and 2016 was $1,148,357, $1,092,199 and $9,599,319, respectively. The 2018 investing activities consisted primarily of capital expenditures of $1,153,589, partially offset by other net cash receipts of $5,232. The 2017 investing activities consisted primarily of capital expenditures of $951,349, payments of $97,410 related to the settlement of put-call options, and payments for acquisitions, net of cash acquired of $46,703, partially offset by $3,263 in other net cash proceeds. The 2016 investing activities consisted primarily of $8,988,774 payment for the Cablevision Acquisition, net of cash acquired, $625,541 of capital expenditures, partially offset by cash receipt of $13,825 from the sale of an affiliate interest and other net cash receipts of $1,171. Financing Activities Net cash used in financing activities amounted to $1,390,996 and $1,099,041 for the years ended December 31, 2018 and December 31, 2017 compared to net cash provided by financing activities of $131,421 for the year ended December 31, 2016. In 2018, the Company's financing activities consisted primarily of the redemption and repurchase of senior notes, including premiums and fees of $2,628,962, dividends to stockholders of $1,499,935, the purchase of common stock pursuant to a share repurchase program of $500,000, payments of collateralized indebtedness and related derivatives of $516,513, contingent payment for acquisition of $30,000, additions to deferred financing costs of $28,468, net repayment of notes payable of $16,677, and other net cash payments of $11,087, partially offset by net proceeds from credit facility debt of $1,268,138, proceeds from the issuance of senior notes of $2,050,000, proceeds from collateralized indebtedness of $516,513, and contributions from noncontrolling interests of $5,995. In 2017, the Company's financing activities consisted primarily of the repayment of senior notes, including premiums and fees, of $1,729,400, cash distributions paid to stockholders of $919,317, principal payments on capital lease obligations of $15,157, and additions to deferred financing costs of $8,600, partially offset by net proceeds from credit facility debt of $1,182,094, net proceeds from collateralized indebtedness and related derivative contracts of $7,735, net proceeds from the Company's IPO of $349,071, proceeds from notes payable of $33,733, and other net cash receipt of $800. In 2016, the Company's financing activities consisted of proceeds of $1,750,000 from the issuance of notes to affiliates and related parties, $1,310,000 from the issuance of senior notes, contribution from stockholders of $1,246,499, net proceeds from collateralized indebtedness of $36,286, and an excess tax benefit related to share-based awards of $31. Partially offsetting these increases were net repayments of credit facility debt of $3,623,287, distributions to stockholders of $365,559, payments of deferred financing costs of $203,712, and principal payments on capital lease obligations of $18,837. Settlements of Collateralized Indebtedness The following table summarizes the settlement of the Company's collateralized indebtedness relating to Comcast shares that were settled by delivering cash equal to the collateralized loan value, net of the value of the related equity derivative contracts during the year ended December 31, 2018: The cash to settle the collateralized indebtedness was obtained from the proceeds of new monetization contracts covering an equivalent number of Comcast shares. The terms of the new contracts allow the Company to retain upside participation in Comcast shares up to each respective contract's upside appreciation limit with downside exposure limited to the respective hedge price. In April 2017, the Company entered into new monetization contracts related to 32,153,118 shares of Comcast common stock held by us, which synthetically reversed the then existing contracts related to these shares (the "Synthetic Monetization Closeout"). As the then existing collateralized debt matured, the Company settled the contracts with proceeds received from the new monetization contracts. The new monetization contracts mature on April 28, 2021. The new monetization contracts provide the Company with downside protection below the hedge price of $35.47 and upside benefit of stock price appreciation up to $44.72 per share. Contractual Obligations and Off Balance Sheet Commitments Our contractual obligations to affiliates and non-affiliates as of December 31, 2018, which consist primarily of our debt obligations and the effect such obligations are expected to have on our liquidity and cash flow in future periods, are summarized in the following table: (a) Purchase obligations primarily include contractual commitments with various programming vendors to provide video services to our customers and minimum purchase obligations to purchase goods or services, including contracts to acquire handsets and other equipment. Future fees payable under contracts with programming vendors are based on numerous factors, including the number of customers receiving the programming. Amounts reflected above related to programming agreements are based on the number of customers receiving the programming as of December 31, 2018 multiplied by the per customer rates or the stated annual fee, as applicable, contained in the executed agreements in effect as of December 31, 2018. See Note 17 to our consolidated financial statements for a discussion of our program rights obligations. (b) Operating lease obligations represent primarily future minimum payment commitments on various long-term, noncancelable leases, at rates now in force, for office, production and storage space. Operating lease obligations presented in the table above do not include rent related to utility poles used in our operations. The Company's pole rental agreements are for varying terms, and management anticipates renewals as they expire. Rent expense incurred for pole rental attachments for the years ended December 31, 2018, 2017 and 2016 was $33,082, $31,308, and $22,432, respectively. See Note 9 to our consolidated financial statements for a discussion of our operating leases. (c) Includes franchise and performance surety bonds primarily for our cable television systems. Also includes outstanding guarantees primarily by CSC Holdings in favor of certain financial institutions in respect of ongoing interest expense obligations in connection with the monetization of our holdings of shares of Comcast common stock. Payments due by period for these arrangements represent the year in which the commitment expires. (d) Consists primarily of letters of credit obtained by CSC Holdings and Cequel in favor of insurance providers and certain governmental authorities. Payments due by period for these arrangements represent the year in which the commitment expires. (e) Includes interest and principal payments due on our (i) credit facility debt, (ii) senior guaranteed notes, senior secured notes, and senior notes and debentures, (iii) notes payable and (iv) collateralized indebtedness. See Notes 11 and 12 to our consolidated financial statements for a discussion of our long-term debt. These amounts do not include the effects of the debt transactions discussed in Note 21. (f) Reflects the principal amount of capital lease obligations, including related interest. (g) Represents tax liabilities, including accrued interest, relating to uncertain tax positions. See Note 14 to our consolidated financial statements for a discussion of our income taxes. The table above does not include obligations for payments required to be made under multi-year franchise agreements based on a percentage of revenues generated from pay television services per year. For the years ended December 31, 2018, 2017 and 2016, the amount of franchise fees and certain other taxes and fees included as a component of revenue aggregated $257,467, $259,075 and $154,732, respectively. Dividends and Distributions In the second quarter of 2017, prior to the Company's IPO, the Company declared and paid cash distributions aggregating $839,700, $500,000 of which were funded with proceeds from borrowings under CSC Holdings' revolving credit facility. In 2016, the Company declared cash distributions of $445,176, of which $365,559 were paid in 2016 and $79,617 were paid in the first quarter of 2017. Prior to Altice Europe's announcement of the Distribution, the Board of Directors of Altice USA, acting through its independent directors, approved the payment of a $2.035 dividend to all shareholders of record on May 22, 2018. The payment of the dividend, aggregating $1,499,935, was made on June 6, 2018, and was funded with cash at CSC Holdings from financings completed in January 2018, and cash generated from operations at Cequel. Share Repurchase Program The Board of Directors of Altice USA also authorized a share repurchase program of $2.0 billion, effective June 8, 2018. Under the repurchase program, shares of Altice USA Class A common stock may be purchased from time to time in the open market and may include trading plans entered into with one or more brokerage firms in accordance with Rule 10b5-1 under the Securities Exchange Act of 1934. Size and timing of these purchases will be determined based on market conditions and other factors. From inception through December 31, 2018, the Company repurchased an aggregate of 28,028,680 shares for a total purchase price of approximately $500,000. These acquired shares were retired and the cost for these shares was recorded in paid in capital in the Company's consolidated balance sheet. As of December 31, 2018, the Company had approximately $1,500,000 of availability remaining under its stock repurchase program and had 709,040,286 combined Class A and Class B shares outstanding. Managing our Interest Rate and Equity Price Risk Interest Rate Risk Interest rate risk is primarily a result of exposures to changes in the level, slope and curvature of the yield curve, the volatility of interest rates and credit spreads. Our exposure to interest rate risk results from changes in short-term interest rates. Interest rate risk exists primarily with respect to our credit facility debt, which bears interest at variable rate To manage interest rate risk, we have from time to time entered into interest rate swap contracts to adjust the proportion of total debt that is subject to variable and fixed interest rates. Such contracts effectively fix the borrowing rates on floating rate debt to provide an economic hedge against the risk of rising rates and/or effectively convert fixed rate borrowings to variable rates to permit the Company to realize lower interest expense in a declining interest rate environment. We monitor the financial institutions that are counterparties to our interest rate swap contracts and we only enter into interest rate swap contracts with financial institutions that are rated investment grade. All such contracts are carried at their fair market values on our consolidated balance sheet, with changes in fair value reflected in the consolidated statement of operations. See "
0.003002
0.00314
0
<s>[INST] We operate in a highly competitive, consumer and technology driven and rapidly changing business that is affected by government regulation and economic, strategic, technological, political and social conditions. Various factors could adversely affect our operations, business or financial results in the future and cause our actual results to differ materially from those contained in the forwardlooking statements. In addition, important factors that could cause our actual results to differ materially from those in our forwardlooking statements include: competition for broadband, pay television and telephony customers from existing competitors (such as broadband communications companies, DBS providers and Internetbased providers) and new competitors entering our footprint; changes in consumer preferences, laws and regulations or technology that may cause us to change our operational strategies; increased difficulty negotiating programming agreements on favorable terms, if at all, resulting in increased costs to us and/or the loss of popular programming; increasing programming costs and delivery expenses related to our products and services; our ability to achieve anticipated customer and revenue growth, to successfully introduce new products and services and to implement our growth strategy; our ability to complete our capital investment plans on time and on budget, including our plan to build a FTTH network, and deploy Altice One, our home communications hub; our ability to develop and deploy mobile voice and data services pursuant to the agreement we entered into with Sprint in the fourth quarter of 2017, and our ability to attract customers to these services; the effects of economic conditions or other factors which may negatively affect our customers’ demand for our current and future products and services; the effects of industry conditions; demand for digital and linear advertising products and services; our substantial indebtedness and debt service obligations; adverse changes in the credit market; changes as a result of any tax reforms that may affect our business; financial community and rating agency perceptions of our business, operations, financial condition and the industries in which we operate; the restrictions contained in our financing agreements; our ability to generate sufficient cash flow to meet our debt service obligations; fluctuations in interest rates which may cause our interest expense to vary from quarter to quarter; technical failures, equipment defects, physical or electronic breakins to our services, computer viruses and similar problems; the disruption or failure of our network, information systems or technologies as a result of computer hacking, computer viruses, “cyberattacks,” misappropriation of data, outages, natural disasters and other material events; our ability to obtain necessary hardware, software, communications equipment and services and other items from our vendors at reasonable costs; our ability to effectively integrate acquisitions and to maximize expected operating efficiencies from our acquisitions or as a result of the transactions, if any; significant unanticipated increases in the use of bandwidthintensive Internetbased services; the outcome of litigation, government investigations and other proceedings; our ability to successfully operate our business following the completion of our separation from Altice Europe; and other risks and uncertainties inherent in our cable and other broadband communications businesses and our other businesses, including those listed under the caption "Risk Factors" and "Management's Discussion and Analysis of Financial Condition and Results of Operations" contained herein. These factors are not necessarily all of the important factors that could cause our actual results to differ materially from those expressed in any of our forwardlooking statements. Other unknown or unpredictable factors could cause our actual results to differ materially from those expressed in any of our forwardlooking statements. Given these uncertainties, you are cautioned not to place undue reliance on such forwardlooking statements. The forwardlooking statements are made only as of the date of this Annual Report. Except to the extent required by law, we do not undertake, and specifically decline any obligation, to update any forwardlooking statements or to publicly announce the results of any revisions to any of such statements to reflect future events or developments. Comparisons of results for current and any prior periods are not intended to express any future trends or indications of future performance, unless expressed as such, and should only be viewed as historical data. You should read this Annual Report with the understanding that our actual future results, levels of activity, performance and events and circumstances may be materially different from what we expect. We qualify all forwardlooking statements by these cautionary statements. Certain numerical [/INST] Positive. </s>
2,019
13,514
1,702,780
Altice USA, Inc.
2020-02-14
2019-12-31
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations This Form 10-K contains statements that constitute forward-looking information within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act and Section 21E of the Securities Act of 1934, as amended. In this Form 10-K there are statements concerning our future operating results and future financial performance. Words such as "expects", "anticipates", "believes", "estimates", "may", "will", "should", "could", "potential", "continue", "intends", "plans" and similar words and terms used in the discussion of future operating results, future financial performance and future events identify forward-looking statements. Investors are cautioned that such forward-looking statements are not guarantees of future performance, results or events and involve risks and uncertainties and that actual results or developments may differ materially from the forward-looking statements as a result of various factors. We operate in a highly competitive, consumer and technology driven and rapidly changing business that is affected by government regulation and economic, strategic, technological, political and social conditions. Various factors could adversely affect our operations, business or financial results in the future and cause our actual results to differ materially from those contained in the forward-looking statements. In addition, important factors that could cause our actual results to differ materially from those in our forward-looking statements include: •competition for broadband, video and telephony customers from existing competitors (such as broadband communications companies, DBS providers and Internet-based providers) and new competitors entering our footprint; •changes in consumer preferences, laws and regulations or technology that may cause us to change our operational strategies; •increased difficulty negotiating programming agreements on favorable terms, if at all, resulting in increased costs to us and/or the loss of popular programming; •increasing programming costs and delivery expenses related to our products and services; •our ability to achieve anticipated customer and revenue growth, to successfully introduce new products and services and to implement our growth strategy; •our ability to complete our capital investment plans on time and on budget, including our plan to build a FTTH network, and deploy Altice One, our home communications hub; •our ability to develop mobile voice and data services and our ability to attract customers to these services; •the effects of economic conditions or other factors which may negatively affect our customers’ demand for our current and future products and services; •the effects of industry conditions; •demand for digital and linear advertising products and services; •our substantial indebtedness and debt service obligations; •adverse changes in the credit market; •changes as a result of any tax reforms that may affect our business; •financial community and rating agency perceptions of our business, operations, financial condition and the industries in which we operate; •the restrictions contained in our financing agreements; •our ability to generate sufficient cash flow to meet our debt service obligations; •fluctuations in interest rates which may cause our interest expense to vary from quarter to quarter; •technical failures, equipment defects, physical or electronic break-ins to our services, computer viruses and similar problems; •the disruption or failure of our network, information systems or technologies as a result of computer hacking, computer viruses, "cyber-attacks," misappropriation of data, outages, natural disasters and other material events; •our ability to obtain necessary hardware, software, communications equipment and services and other items from our vendors at reasonable costs; •our ability to effectively integrate acquisitions and to maximize expected operating efficiencies from our acquisitions or as a result of the transactions, if any; •significant unanticipated increases in the use of bandwidth-intensive Internet-based services; •the outcome of litigation, government investigations and other proceedings; •our ability to successfully operate our business following the completion of our separation from Altice Europe; and •other risks and uncertainties inherent in our cable and other broadband communications businesses and our other businesses, including those listed under the caption "Risk Factors" and "Management's Discussion and Analysis of Financial Condition and Results of Operations" contained herein. These factors are not necessarily all of the important factors that could cause our actual results to differ materially from those expressed in any of our forward-looking statements. Other unknown or unpredictable factors could cause our actual results to differ materially from those expressed in any of our forward-looking statements. Given these uncertainties, you are cautioned not to place undue reliance on such forward-looking statements. The forward-looking statements are made only as of the date of this Annual Report. Except to the extent required by law, we do not undertake, and specifically decline any obligation, to update any forward-looking statements or to publicly announce the results of any revisions to any of such statements to reflect future events or developments. Comparisons of results for current and any prior periods are not intended to express any future trends or indications of future performance, unless expressed as such, and should only be viewed as historical data. You should read this Annual Report with the understanding that our actual future results, levels of activity, performance and events and circumstances may be materially different from what we expect. We qualify all forward-looking statements by these cautionary statements. Certain numerical figures included in this Annual Report have been subject to rounding adjustments. Accordingly, such numerical figures shown as totals in various tables may not be arithmetic aggregations of the figures that precede them. Overview All dollar amounts, except per customer and per share data, included in the following discussion, are presented in thousands. Our Business We principally provide broadband communications and video services in the United States and market our services primarily under two brands: Optimum, in the New York metropolitan area, and Suddenlink, principally in markets in the south-central United States. We deliver broadband, video, and telephony services to approximately 4.9 million residential and business customers. Our footprint extends across 21 states through a fiber-rich broadband network with more than 8.8 million homes passed as of December 31, 2019. Additionally, we offer news programming and content, and advertising services. In September 2019, the Company launched Altice Mobile, a full service mobile offering, to consumers across its footprint. Key Factors Impacting Operating Results and Financial Condition Our future performance is dependent, to a large extent, on the impact of direct competition, general economic conditions (including capital and credit market conditions), our ability to manage our businesses effectively, and our relative strength and leverage in the marketplace, both with suppliers and customers. For more information, see "Risk Factors" and "Business-Competition" included herein. We derive revenue principally through monthly charges to residential customers of our broadband, video, and telephony services. We also derive revenue from DVR, VOD, pay-per-view, installation and home shopping commissions. Our residential broadband, video, and telephony services accounted for approximately 33%, 41%, and 6%, respectively, of our consolidated revenue for the year ended December 31, 2019. We also derive revenue from the sale of a wide and growing variety of products and services to both large enterprise and SMB customers, including broadband, telephony, networking and video services. For the year ended December 31, 2019, 15% of our consolidated revenue was derived from these business services. In addition, we derive revenues from the sale of advertising time available on the programming carried on our cable television systems, digital advertising and data analytics, and affiliation fees for news programming, which accounted for approximately 5% of our consolidated revenue for the year ended December 31, 2019. Our mobile and other revenue for the year ended December 31, 2019 accounted for less than 1% of our consolidated revenue. Revenue is impacted by rate increases, changes in the number of customers to our services, including additional services sold to our existing customers, programming package changes by our video customers, speed tier changes by our broadband customers, and acquisitions and construction of cable systems that result in the addition of new customers. Our ability to increase the number of customers to our services is significantly related to our penetration rates. We operate in a highly competitive consumer-driven industry and we compete against a variety of broadband, video and telephony providers and delivery systems, including broadband communications companies, wireless data and telephony providers, satellite-delivered video signals, Internet-delivered video content and broadcast television signals available to residential and business customers in our service areas. Our competitors include AT&T and its DirecTV subsidiary, CenturyLink, DISH, Frontier and Verizon. Consumers' selection of an alternate source of service, whether due to economic constraints, technological advances or preference, negatively impacts the demand for our services. For more information on our competitive landscape, see "Risk Factors" and "Business-Competition" included herein. Our programming costs, which are the most significant component of our operating expenses, have increased and are expected to continue to increase primarily as a result of contractual rate increases and new channel launches. See "Results of Operations" below for more information regarding our key factors impacting our revenues and operating expenses. Historically, we have made substantial investments in our network and the development of new and innovative products and other service offerings for our customers as a way of differentiating ourselves from our competitors and may continue to do so in the future. We are constructing a FTTH network, which will enable us to deliver more than 10 Gbps broadband speeds across our entire Optimum footprint and part of our Suddenlink footprint. In addition, we launched Altice Mobile to consumers across our footprint in September 2019. We may incur greater than anticipated capital expenditures in connection with these initiatives, fail to realize anticipated benefits, experience delays and business disruptions or encounter other challenges to executing them as planned. See "Liquidity and Capital Resources-Capital Expenditures" for additional information regarding our capital expenditures. Certain Transactions The following transactions occurred during the periods covered by this Management's Discussion and Analysis of Financial Condition and Results of Operations: In June 2019, the Company completed the acquisition of Cheddar Inc., a digital-first news company and the operating results of Cheddar were consolidated as of June 1, 2019. See Note 10 to the consolidated financial statements for further details. As discussed in Note 1 of the Company's consolidated financial statements, the Company completed the ATS Acquisition in January 2018. ATS was previously owned by Altice Europe and a member of ATS's management through a holding company. As the acquisition is a combination of businesses under common control, the Company combined the results of operations and related assets and liabilities of ATS for all periods since the formation of ATS. In April 2018, Altice Europe transferred its ownership of i24NEWS, a 24/7 international news and current affairs channels, to the Company for minimal consideration. As the acquisition was a combination of businesses under common control, the Company combined the results of operations and related assets and liabilities of i24NEWS as of April 1, 2018. Operating results for periods prior to April 1, 2018 and the balance sheet as of December 31, 2017 have not been revised to reflect the combination of i24NEWS as the impact was deemed immaterial. In April 2018, the Company redeemed a 24% interest in Newsday. Non-GAAP Financial Measures We define Adjusted EBITDA, which is a non-GAAP financial measure, as net income (loss) excluding income taxes, income (loss) from discontinued operations, non-operating income or expenses, loss on extinguishment of debt and write-off of deferred financing costs, gain (loss) on interest rate swap contracts, gain (loss) on derivative contracts, gain (loss) on investments and sale of affiliate interests, net, interest expense (including cash interest expense), interest income, depreciation and amortization (including impairments), share-based compensation expense or benefit, restructuring expense or credits and transaction expenses. We believe Adjusted EBITDA is an appropriate measure for evaluating the operating performance of the Company. Adjusted EBITDA and similar measures with similar titles are common performance measures used by investors, analysts and peers to compare performance in our industry. Internally, we use revenue and Adjusted EBITDA measures as important indicators of our business performance, and evaluate management’s effectiveness with specific reference to these indicators. We believe Adjusted EBITDA provides management and investors a useful measure for period-to-period comparisons of our core business and operating results by excluding items that are not comparable across reporting periods or that do not otherwise relate to the Company’s ongoing operating results. Adjusted EBITDA should be viewed as a supplement to and not a substitute for operating income (loss), net income (loss), and other measures of performance presented in accordance with GAAP. Since Adjusted EBITDA is not a measure of performance calculated in accordance with GAAP, this measure may not be comparable to similar measures with similar titles used by other companies. We also use Operating Free Cash Flow (defined as Adjusted EBITDA less cash capital expenditures), and Free Cash Flow (defined as net cash flows from operating activities less cash capital expenditures) as indicators of the Company’s financial performance. We believe these measures are one of several benchmarks used by investors, analysts and peers for comparison of performance in the Company’s industry, although they may not be directly comparable to similar measures reported by other companies. Results of Operations - Altice USA The following is a reconciliation of net income to Adjusted EBITDA: (a)Includes the non-service cost components of the Company's pension expense, net of dividends received on Comcast common stock owned by the Company. The following table sets forth certain customer metrics for the Company (unaudited): (a)Represents the estimated number of single residence homes, apartments and condominium units passed by the broadband network in areas serviceable without further extending the transmission lines. In addition, it includes commercial establishments that have connected to our broadband network. Broadband services were not available to approximately 30 homes passed and telephony services were not available to approximately 500 homes passed. (b)Represents number of households/businesses that receive at least one of the Company's fixed-line services. (c)Customers represent each customer account (set up and segregated by customer name and address), weighted equally and counted as one customer, regardless of size, revenue generated, or number of boxes, units, or outlets. In calculating the number of customers, we count all customers other than inactive/disconnected customers. Free accounts are included in the customer counts along with all active accounts, but they are limited to a prescribed group. Most of these accounts are also not entirely free, as they typically generate revenue through pay-per-view or other pay services and certain equipment fees. Free status is not granted to regular customers as a promotion. In counting bulk residential customers, such as an apartment building, we count each subscribing family unit within the building as one customer, but do not count the master account for the entire building as a customer. We count a bulk commercial customer, such as a hotel, as one customer, and do not count individual room units at that hotel. (d)Represents the number of customers that subscribe to three of our services divided by total residential customer relationships. (e)Represents the number of total customer relationships divided by homes passed. (f)Calculated by dividing the average monthly revenue for the respective quarter (fourth quarter for annual periods) derived from the sale of broadband, video and telephony services to residential customers for the respective quarter by the average number of total residential customers for the same period. (g)Customer metrics for prior periods have been adjusted to conform definitions between Suddenlink and Optimum in connection with the migration of Suddenlink customers to the Optimum billing system in 2019. The following table summarizes the adjustments made to previously reported amounts. (h)Customer metrics do not include Altice Mobile customers. Comparison of Results for the Year Ended December 31, 2019 compared to the Year Ended December 31, 2018 and for the Year Ended December 31, 2018 compared to the Year Ended December 31, 2017 Broadband Revenue Broadband revenue for the years ended December 31, 2019, 2018 and 2017 was $3,222,605, $2,887,455 and $2,608,595, respectively. Broadband revenue is derived principally through monthly charges to residential subscribers of our broadband services. Revenue is impacted by rate increases, changes in the number of customers, including additional services sold to our existing subscribers, and changes in speed tiers. Broadband revenue increased $335,150 (12%) for the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase was due primarily to higher average recurring broadband revenue per broadband customer, primarily driven by certain rate increases and service level changes, and an increase in broadband customers. Broadband revenue increased $278,860 (11%) for the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase was due primarily to higher average recurring broadband revenue per broadband customer, primarily driven by certain rate increases and service level changes, and an increase in broadband customers. Video Revenue Video revenue for the years ended December 31, 2019, 2018 and 2017 was $3,997,873, $4,156,428 and $4,274,122, respectively. Video revenue is derived principally through monthly charges to residential customers of our video services. Revenue is impacted by rate increases, changes in the number of customers, including additional services sold to our existing customers, and changes in programming packages. Video revenue decreased $158,555 (4%) for the year ended December 31, 2019 compared to the year ended December 31, 2018. The decrease was due primarily to a decline in video customers and lower average revenue per video customer. Video revenue decreased $117,694 (3%) for the year ended December 31, 2018 compared to the year ended December 31, 2017. The decrease was due primarily to a decline in video customers, partially offset by higher average revenue per video customer primarily due to rate increases. We believe our video customer declines noted in the table above are largely attributable to competition, particularly from Verizon in our Optimum footprint and DBS providers in our Suddenlink footprint, as well as competition from companies that deliver video content over the Internet directly to customers. These factors are expected to continue to impact our ability to maintain or increase our existing customers and revenue in the future. Telephony Revenue Telephony revenue for the years ended December 31, 2019, 2018 and 2017 was $598,694, $652,895 and $700,765, respectively. Telephony revenue is derived principally through monthly charges to residential customers of our telephony services. Revenue is impacted by changes in rates for services, changes in the number of customers, and additional services sold to our existing customers. Telephony revenue decreased $54,201 (8%) for the year ended December 31, 2019 compared to the year ended December 31, 2018. The decrease was due to lower average revenue per telephony customer and a decline in telephony customers. Telephony revenue decreased $47,870 (7%) for the year ended December 31, 2018 compared to the year ended December 31, 2017. The decrease was due to lower average revenue per telephony customer and a decline in telephony customers. Business Services and Wholesale Revenue Business services and wholesale revenue for the years ended December 31, 2019, 2018 and 2017 was $1,428,532, $1,362,758, and $1,298,213, respectively. Business services and wholesale revenue is derived primarily from the sale of fiber based telecommunications services to the business market, and the sale of broadband, video and telephony services to SMB customers. Business services and wholesale revenue increased $65,774 (5%) for the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase was primarily due to higher average recurring broadband revenue per SMB customer, primarily driven by certain rate increases and service level changes, an increase in revenue from the backhaul of carrier data and an increase in installation revenue. Business services and wholesale revenue increased $64,545 (5%) for the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase was primarily due to higher average recurring broadband revenue per SMB customer, higher Ethernet and managed services revenue and an increase in the number of customers, partially offset by reduced traditional voice and data services for commercial customers. News and Advertising Revenue News and advertising revenue for the years ended December 31, 2019, 2018 and 2017, was $475,904, $487,264, and $396,187, respectively. News and advertising revenue is primarily derived from the sale of advertising time available on the programming carried on our cable television systems, OTT distribution partners, digital advertising and data analytics revenue and affiliation fees for news programming. News and advertising revenue decreased $11,360 (2%) for the year ended December 31, 2019 compared to the year ended December 31, 2018. The decrease was primarily due to lower political revenue, partially offset by an increase in digital advertising, and strong national sales. News and advertising revenue increased $91,077 (23%) for the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase was primarily due to an increase in digital advertising, higher political spending, and an increase in data analytics revenue. Mobile Revenue Mobile revenue for the year ended December 31, 2019 was $21,264 and relates to sales of devices and mobile services that were launched to consumers in September 2019. As of December 31, 2019, we had approximately 69,000 mobile lines. Other Revenue Other revenue for the years ended December 31, 2019, 2018 and 2017 was $15,987, $19,808, and $29,068, respectively. Other revenue includes revenue from other miscellaneous revenue streams. Programming and Other Direct Costs Programming and other direct costs for the years ended December 31, 2019, 2018 and 2017 amounted to $3,300,528, $3,173,076 and $3,035,655, respectively. Programming and other direct costs include cable programming costs, which are costs paid to programmers (net of amortization of any incentives received from programmers for carriage) for cable content (including costs of VOD and pay-per-view) and are generally paid on a per-customer basis. These costs typically rise due to increases in contractual rates and new channel launches and are also impacted by changes in the number of customers receiving certain programming services. These costs also include interconnection, call completion, circuit and transport fees paid to other telecommunication companies for the transport and termination of voice and data services, which typically vary based on rate changes and the level of usage by our customers. These costs also include franchise fees which are payable to the state governments and local municipalities where we operate and are primarily based on a percentage of certain categories of revenue derived from the provision of video service over our cable systems, which vary by state and municipality. These costs change in relation to changes in such categories of revenues or rate changes. Additionally, these costs include the costs of mobile devices sold to our customers and direct costs of providing mobile services. The increase of $127,452 (4%) for the year ended December 31, 2019, as compared to the prior year was primarily attributable to the following: The increase of $137,421 (5%) for the year ended December 31, 2018, as compared to December 31, 2017 was primarily attributable to the following: Programming costs Programming costs aggregated $2,722,656, $2,620,585, and $2,533,244 for the years ended December 31, 2019, 2018 and 2017, respectively. Our programming costs in 2020 will continue to be impacted by changes in programming rates, which we expect to increase, and by changes in the number of video customers. Other Operating Expenses Other operating expenses for the years ended December 31, 2019, 2018 and 2017 amounted to $2,300,398, $2,290,266, and $2,347,315, respectively. Other operating expenses include staff costs and employee benefits including salaries of company employees and related taxes, benefits and other employee related expenses, as well as third-party labor costs. Other operating expenses also include network management and field service costs, which represent costs associated with the maintenance of our broadband network, including costs of certain customer connections and other costs associated with providing and maintaining services to our customers. Customer installation and network repair and maintenance costs may fluctuate as a result of changes in the level of activities and the utilization of contractors as compared to employees. Also, customer installation costs fluctuate as the portion of our expenses that we are able to capitalize changes. Costs associated with the initial deployment of new customer premise equipment necessary to provide broadband, video and telephony services are capitalized (asset-based). The redeployment of customer premise equipment is expensed as incurred. Other operating expenses also include costs related to the operation and maintenance of our call center facilities that handle customer inquiries and billing and collection activities and sales and marketing costs, which include advertising production and placement costs associated with acquiring and retaining customers. These costs vary period to period and certain of these costs, such as sales and marketing, may increase with intense competition. Additionally, other operating expenses include various other administrative costs, including legal fees, and product development costs. The increase in other operating expenses of $10,132, including an increase of $32,458 relating to our mobile service, for the year ended December 31, 2019 as compared to the prior year was attributable to the following: The decrease in other operating expenses of $57,049 (2%) for the year ended December 31, 2018 as compared to December 31, 2017 was attributable to the following: Restructuring and Other Expense Restructuring and other expense for the year ended December 31, 2019 amounted to $72,978, as compared to $38,548 for the year ended December 31, 2018 and $152,401 for the year ended December 31, 2017. These amounts primarily related to severance and other employee related costs resulting from headcount reductions, facility realignment costs and impairments of certain ROU assets, related to initiatives which commenced in 2016 and 2019 that are intended to simplify the Company's organizational structure. We currently anticipate that additional restructuring expenses will be recognized as we continue to analyze our organizational structure. Depreciation and Amortization Depreciation and amortization for the years ended December 31, 2019, 2018 and 2017 amounted to $2,263,144, $2,382,339 and $2,930,571, respectively. The decrease in depreciation and amortization of $119,195 (5%) for the year ended December 31, 2019 as compared to the prior year is due to certain fixed assets and intangible assets becoming fully depreciated or amortized, partially offset by an increase in depreciation as a result of asset additions. The decrease in depreciation and amortization of $548,232 (19%) in 2018 as compared to 2017 was due primarily to certain fixed assets and intangible assets becoming fully depreciated or amortized. These decreases were partially offset by depreciation of new asset additions. Adjusted EBITDA Adjusted EBITDA amounted to $4,265,471, $4,163,078, and $3,981,410 for the years ended December 31, 2019, 2018 and 2017, respectively. Adjusted EBITDA is a non-GAAP measure that is defined as net income (loss) excluding income taxes, income (loss) from discontinued operations, non-operating income or expenses, loss on extinguishment of debt and write-off of deferred financing costs, gain (loss) on interest rate swap contracts, gain (loss) on derivative contracts, gain (loss) on investments and sale of affiliate interests, net, interest expense (including cash interest expense), interest income, depreciation and amortization (including impairments), share-based compensation expense or benefit, restructuring expense or credits and transaction expenses. See reconciliation of net income to adjusted EBITDA above. The increase in adjusted EBITDA for the years ended December 31, 2019 and 2018 as compared to the prior years were due to the increases in revenue, net of increases in operating expenses (excluding depreciation and amortization, restructuring and other expense and share-based compensation), as discussed above. Operating Free Cash Flow Operating free cash flow was $2,910,121, $3,009,489 and $3,030,061 for the years ended December 31, 2019, 2018 and 2017, respectively. The decrease in operating free cash flow in 2019 as compared to 2018 and 2018 as compared to 2017 are both due to an increase in capital expenditures, partially offset by an increase in adjusted EBITDA. Free Cash Flow Free cash flow was $1,198,819, $1,354,728 and $1,066,898 for the years ended December 31, 2019, 2018 and 2017, respectively. The decrease in free cash flow in 2019 as compared to 2018 is primarily due to an increase in capital expenditures. The increase in free cash flow in 2018 as compared to 2017 is primarily due to a an increase in net cash provided by operating activities, partially offset by an increase in capital expenditures. Interest expense Interest expense, net was $1,530,850, $1,545,426, and $1,601,211 for the years ended December 31, 2019, 2018 and 2017, respectively, and includes interest on debt issued to finance the Cablevision Acquisition and Cequel Acquisition, as well as interest on debt assumed in connection with these acquisitions. The decrease of $14,576 for the year ended December 31, 2019 as compared to the year ended December 31, 2018 and the decrease of $55,785 for the year ended December 31, 2018 as compared to the year ended December 31, 2017 were attributable to the following: Gain (Loss) on Investments and Sale of Affiliate Interests, net Gain (loss) on investments, net for the years ended December 31, 2019, 2018 and 2017, of $473,406, $(250,877) and $237,354 consists primarily of the increase (decrease) in the fair value of Comcast common stock owned by the Company for the periods. The effects of these gains (losses) are partially offset by the losses (gains) on the related equity derivative contracts, net described below. Gain (Loss) on Derivative Contracts, net Gain (loss) on derivative contracts, net for the year ended December 31, 2019 amounted to $(282,713), $218,848 and $(236,330) for the years ended December 31, 2019, 2018 and 2017, respectively, and includes realized and unrealized gains or losses due to the change in fair value of equity derivative contracts relating to the Comcast common stock owned by the Company. The effects of these gains (losses) are offset by losses (gains) on investment securities pledged as collateral, which are included in gain (loss) on investments, net discussed above. The loss for the year ended December 31, 2017 also includes the realized loss on the settlement of certain put-call options of $97,410. Gain (loss) on Interest Rate Swap Contracts Gain (loss) on interest rate swap contracts was $(53,902), $(61,697) and $5,482 for the years ended December 31, 2019, 2018 and 2017, respectively. These amounts represent the increase or decrease in the fair value of interest rate swap contracts. These swap contracts are not designated as hedges for accounting purposes. Loss on Extinguishment of Debt and Write-off of Deferred Financing Costs Loss on extinguishment of debt and write-off of deferred financing costs amounted to $243,806, $48,804 and $600,240 for the years ended December 31, 2019, 2018 and 2017, respectively. The following table provides a summary of the loss on extinguishment of debt and the write-off of deferred financing costs recorded by the Company upon the redemption of senior notes and the refinancing of credit facilities: Other Income (Expense), Net Other income (expense), net amounted to $1,183, $(12,484) and $(13,651), for the years ended December 31, 2019, 2018 and 2017, respectively. These amounts include the non-service cost components of the Company's pension expense of $8,274, $9,529 and $11,863, net of dividends received on Comcast common stock owned by the Company. The 2018 amounts also include the equity in the net losses of Newsday through April 2018 and i24NEWS through March 31, 2018. Income Tax Benefit (Expense) The Company recorded income tax expense of $47,190 for the year ended December 31, 2019, resulting in an effective tax rate of 25% which is higher than the U.S. federal statutory tax rate of 21%. The primary difference between the effective tax rate and the statutory tax rate is due to nondeductible share-based compensation expense, a revaluation of state deferred taxes primarily due to certain changes to the state tax rates used to measure the Company’s deferred tax liabilities and certain other non-deductible expenses. The Company recorded income tax benefit of $38,655 for the year ended December 31, 2018. During 2018, the Company determined that it met the definition of a Qualified Technology Company for New York State tax purposes and thereby was eligible for the reduced tax rate. Additionally, during 2018, the state of New Jersey enacted significant tax law changes imposing a 2.5% surtax for tax years beginning January 1, 2018 and mandating combined return filing requirements for unitary corporations for tax years beginning January 1, 2019. Accordingly, the Company recorded a net non-cash deferred tax benefit of $52,915 based on a remeasurement of the net deferred tax liability. The Company recorded income tax benefit of $2,862,352 for the year ended December 31, 2017. Pursuant to the enactment of Tax Cuts and Jobs Act on December 22, 2017, the Company recorded a non-cash deferred tax benefit of $2,332,677 to remeasure the net deferred tax liability to adjust for the reduction in the corporate federal income tax rate from 35% to 21% which is effective on January 1, 2018. Nondeductible share-based compensation expense for the year ended December 31, 2017 reduced income tax benefit by $22,938. CSC HOLDINGS, LLC The consolidated statements of operations of CSC Holdings are essentially identical to the consolidated statements of operations of Altice USA, except for the following: Refer to Altice USA's Management's Discussion and Analysis of Financial Condition and Results of Operations herein. LIQUIDITY AND CAPITAL RESOURCES Altice USA has no operations independent of its subsidiaries. Funding for our subsidiaries has generally been provided by cash flow from their respective operations, cash on hand and borrowings under their revolving credit facilities and the proceeds from the issuance of securities and borrowings under syndicated term loans in the capital markets. Our decision as to the use of cash generated from operating activities, cash on hand, borrowings under the revolving credit facility or accessing the capital markets has been based upon an ongoing review of the funding needs of the business, the optimal allocation of cash resources, the timing of cash flow generation and the cost of borrowing under the revolving credit facility, debt securities and syndicated term loans. We target a year-end leverage ratio of 4.5x to 5.0x. We calculate our consolidated net leverage ratio as net debt to L2QA EBITDA (Adjusted EBITDA for the two most recent consecutive fiscal quarters multiplied by 2.0). We expect to utilize free cash flow and availability under the revolving credit facility, as well as future refinancing transactions, to further extend the maturities of, or reduce the principal on, our debt obligations. The timing and terms of any refinancing transactions will be subject to, among other factors, market conditions. Additionally, we may, from time to time, depending on market conditions and other factors, use cash on hand and the proceeds from other borrowings to repay the outstanding debt securities through open market purchases, privately negotiated purchases, tender offers, or redemptions. We believe existing cash balances, operating cash flows and availability under our revolving credit facility will provide adequate funds to support our current operating plan, make planned capital expenditures and fulfill our debt service requirements for the next twelve months. However, our ability to fund our operations, make planned capital expenditures, make scheduled payments on our indebtedness and repay our indebtedness depends on our future operating performance and cash flows and our ability to access the capital markets, which, in turn, are subject to prevailing economic conditions and to financial, business and other factors, some of which are beyond our control. However, competition, market disruptions or a deterioration in economic conditions could lead to lower demand for our products, as well as lower levels of advertising, and increased incidence of customers' inability to pay for the services we provide. These events would adversely impact our results of operations, cash flows and financial position. Although we currently believe amounts available under the revolving credit facility will be available when, and if, needed, we can provide no assurance that access to such funds will not be impacted by adverse conditions in the financial markets or other conditions. The obligations of the financial institutions under the revolving credit facility are several and not joint and, as a result, a funding default by one or more institutions does not need to be made up by the others. In the longer term, we may not be able to generate sufficient cash from operations to fund anticipated capital expenditures, meet all existing future contractual payment obligations and repay our debt at maturity. As a result, we could be dependent upon our continued access to the capital and credit markets to issue additional debt or equity or refinance existing debt obligations. We intend to raise significant amounts of funding over the next several years to fund capital expenditures, repay existing obligations and meet other obligations, and the failure to do so successfully could adversely affect our business. If we are unable to do so, we will need to take other actions including deferring capital expenditures, selling assets, seeking strategic investments from third parties or reducing or eliminating stock repurchases and discretionary uses of cash. Debt Outstanding The following tables summarize the carrying value of our outstanding debt, net of unamortized deferred financing costs, discounts and premiums (excluding accrued interest), as well as interest expense. (a)This indebtedness is collateralized by shares of Comcast common stock. We intend to settle this debt by (i) delivering shares of Comcast common stock and the related equity contracts, or (ii) delivering cash from the net proceeds from new monetization contracts. The following table provides details of our outstanding credit facility debt, net of unamortized discounts and deferred financing costs as of December 31, 2019: (a)At December 31, 2019, $178,014 of the revolving credit facility was restricted for certain letters of credit issued on behalf of the Company and $2,296,986 of the facility was undrawn and available, subject to covenant limitations. (b)The revolving credit facility matures on January 31, 2024, however $200,000 matures on November 30, 2021. Payment Obligations Related to Debt As of December 31, 2019, total amounts payable by us in connection with our outstanding obligations, including related interest, as well as notes payable and supply chain financing, and the value deliverable at maturity under monetization contracts, but excluding finance lease obligations (see Note 9 to our consolidated financial statements) are as follows: (a)Includes $1,776,378 related to the Company's collateralized indebtedness (including related interest). This indebtedness is collateralized by shares of Comcast common stock. We intend to settle this debt by (i) delivering shares of Comcast common stock and the related equity contracts or (ii) delivering cash from the net proceeds on new monetization contracts. CSC Holdings Restricted Group For financing purposes, the Company is structured as a restricted group (the “Restricted Group”) and an unrestricted group, which includes certain designated subsidiaries and investments (the “Unrestricted Group”). The Restricted Group is comprised of CSC Holdings and substantially all of its wholly-owned operating subsidiaries. These subsidiaries are subject to the covenants and restrictions of the credit facility and indentures governing the notes issued by CSC Holdings. Sources of cash for the Restricted Group include primarily cash flow from the operations of the businesses in the Restricted Group, borrowings under its credit facility and issuance of securities in the capital markets, contributions from its parent, and, from time to time, distributions or loans from its subsidiaries. The Restricted Group's principal uses of cash include: capital spending, in particular, the capital requirements associated with the upgrade of its digital broadband, video and telephony services, including costs to build a FTTH network and enhancements to its service offerings such as WiFi; debt service, including distributions made to Cablevision to service interest expense and principal repayments on its debt securities prior to the Assumption of the Cablevision Senior Notes discussed below; other corporate expenses and changes in working capital; and investments that it may fund from time to time. CSC Holdings Credit Facility In October 2015, a wholly-owned subsidiary of Altice USA, which merged with and into CSC Holdings on June 21, 2016, entered into a senior secured credit facility, which currently provides U.S. dollar term loans currently in an aggregate principal amount of $3,000,000 ($2,925,000 outstanding at December 31, 2019) (the "CSC Term Loan Facility", and the term loans extended under the CSC Term Loan Facility, the "CSC Term Loans") and U.S. dollar revolving loan commitments in an aggregate principal amount of $2,475,000 at December 31, 2019 (the "CSC Revolving Credit Facility" and, together with the CSC Term Loan Facility, the "CSC Credit Facilities"), which are governed by a credit facilities agreement entered into by, inter alios, CSC Holdings certain lenders party thereto and JPMorgan Chase Bank, N.A. as administrative agent and security agent (as amended, restated, supplemented or otherwise modified on June 20, 2016, June 21, 2016, July 21, 2016, September 9, 2016, December 9, 2016, March 15, 2017, January 12, 2018, October 15, 2018, January 24, 2019, February 7, 2019, May 14, 2019, and October 3, 2019, respectively, and as further amended, restated, supplemented or otherwise modified from time to time, the "CSC Credit Facilities Agreement"). The revolving credit facility of an aggregate principal amount of $2,275,000 matures in January 2024 and priced at LIBOR plus 2.25%. The remaining revolving credit facility of an aggregate principal amount of $200,000 matures in November 2021 and priced at LIBOR plus 3.25%. In January 2018, CSC Holdings entered into a $1,500,000 incremental term loan facility (the "Incremental Term Loan B-2") under its existing credit facilities agreement. The Incremental Term Loan B-2 was priced at 99.5% and was due to mature on January 25, 2026. The Incremental Term Loan B-2 was comprised of eurodollar borrowings or alternate base rate borrowings, and bore interest at a rate per annum equal to the adjusted LIBOR or the alternate base rate, as applicable, plus the applicable margin, where the applicable margin was (i) with respect to any alternate base rate loan, 1.50% per annum and (ii) with respect to any eurodollar loan, 2.50% per annum. The Company was required to make scheduled quarterly payments equal to 0.25% (or $3,750) of the principal amount of the Incremental Term Loan B-2, beginning with the fiscal quarter ended September 30, 2018, with the remaining balance scheduled to be paid on January 25, 2026. The Incremental Term Loan B-2 was repaid in full in October 2019 with proceeds from the Incremental Term Loan B-5 discussed below. In October 2018, CSC Holdings entered into a $1,275,000 ($1,265,438 outstanding at December 31, 2019) incremental term loan facility (the “Incremental Term Loan B-3”) under its existing credit facilities agreement. The proceeds from the Incremental Term Loan B-3 were used to repay the entire principal amount of loans under Cequel’s then existing Term Loan Facility and certain transaction costs. The Incremental Term Loan B-3 is comprised of eurodollar borrowings or alternative base rate borrowings, and will bear interest at a rate per annum equal to the Adjusted LIBOR or the alternate base rate, as applicable, plus the applicable margin, where the applicable margin is (i) with respect to any alternate base rate loan, 1.25% per annum and (ii) with respect to any eurodollar loan, 2.25% per annum. The Company is required to make scheduled quarterly payments equal to 0.25% (or $3,188) of the principal amount of the Incremental Term Loan B-3, beginning with the fiscal quarter ended June 30, 2019, with the remaining balance scheduled to be paid on January 15, 2026. In February 2019, CSC Holdings entered into a $1,000,000 incremental term loan facility ("Incremental Term Loan B-4") under its existing credit facilities agreement. The proceeds from the Incremental Term Loan B-4 were used to redeem $894,700 in aggregate principal amount of CSC Holdings’ 10.125% senior notes due 2023, representing the entire aggregate principal amount outstanding, and paying related fees, costs and expenses. The Incremental Term Loan B-4 was due to mature on April 15, 2027 and was issued with an original issue discount of 1.0%. The Incremental Term Loan B-4 bore interest at a rate per annum equal to the adjusted LIBOR or the alternate base rate, as applicable, plus the applicable margin, where the applicable margin was (i) with respect to any alternate base rate loan, 2.00% per annum and (ii) with respect to any eurodollar loan, 3.0%. The Incremental Term Loan B-4 was repaid in full in October 2019 with proceeds from Incremental Term Loan B-5 discussed below. In October 2019, CSC Holdings entered into a new $3,000,000, incremental term loan facility ("Incremental Term Loan B-5") under its existing credit facilities agreement, out of which $500,000 was available on a delayed draw basis. The Incremental Term Loan B-5 matures on April 15, 2027 and was issued at par. The Incremental Term Loan B-5 may be comprised of eurodollar borrowings or alternative base rate borrowings, and will bear interest at a rate per annum equal to the Adjusted LIBOR or the alternate base rate, as applicable, plus the applicable margin, where the applicable margin is (i) with respect to any alternate base rate loan, 1.50% per annum and (ii) with respect to any eurodollar loan, 2.50% per annum. The Company is required to make scheduled quarterly payments equal to 0.25% (or $7,500) of the principal amount of the Incremental Term Loan B-5, beginning with the fiscal quarter ended June 30, 2020. Voluntary prepayments of the Incremental Term Loan B-5 in connection with certain repricing transactions on or prior to the date that is six months after the draw date will be subject to a call premium of 1.00%. The initial proceeds of the Incremental Term Loan B-5 were used to repay approximately $2,500,000 of the outstanding term loans (Incremental Term Loan B-2 and Incremental Term Loan B-4) under the credit agreement, and the proceeds of the delayed draw tranche of the Incremental Term Loan B-5 were used to distribute $500,000 in cash to Cablevision, the proceeds of which were used to redeem Cablevision’s 8.00% senior notes due 2020, representing the entire aggregate principal amount outstanding, and in each case, paying related fees, costs and expenses in connection with such transactions, with the remainder being used to fund cash on the balance sheet. In connection with the repayment of approximately $2,500,000 of the outstanding term loans, a portion of the unamortized discount and unamortized deferred financing costs aggregating $3,879 was written-off and recorded as a loss on extinguishment of debt in the fourth quarter of 2019. During the year ended December 31, 2019, CSC Holdings borrowed $1,050,000 under its revolving credit facility and repaid $1,300,000 of amounts outstanding under its revolving credit facility. The Company was in compliance with all of its financial covenants under the CSC Credit Facilities Agreement as of December 31, 2019. See Note 11 to our consolidated financial statements for further information regarding the CSC Credit Facilities Agreement. Senior Guaranteed Notes and Senior Notes In January 2019, CSC Holdings issued $1,500,000 in aggregate principal amount of senior guaranteed notes due 2029 ("CSC Holdings 2029 Guaranteed Notes"). The notes bear interest at a rate of 6.50% and will mature on February 1, 2029. The net proceeds from the sale of the notes were used to repay certain indebtedness, including to repay at maturity $526,000 aggregate principal amount of CSC Holdings' 8.625% senior notes due February 2019 plus accrued interest, redeem approximately $905,300 of the aggregate outstanding amount of CSC Holdings' 10.125% senior notes due 2023 at a redemption price of 107.594% plus accrued interest, and paid fees and expenses associated with the transactions. In February 2019, CSC Holdings issued an additional $250,000 CSC Holdings 2029 Guaranteed Notes at a price of 101.75% of the principal amount, plus accrued interest from January 31, 2019. The proceeds of these notes were used to repay the outstanding balance under the CSC Revolving Credit Facility. In July 2019, CSC Holdings issued $1,000,000 in aggregate principal amount of senior notes which bear interest at a rate of 5.75% and will mature on January 15, 2030 ("2030 Senior Notes"). The net proceeds from the sale of the notes were used to repay outstanding borrowings under the CSC Revolving Credit Facility of approximately $622,857, along with accrued interest and pay fees associated with the transactions. The remaining proceeds were used for general corporate purposes. In July 2019, CSC Holdings distributed cash on hand to Cablevision, the proceeds of which were used to redeem in full $8,886 of outstanding principal amount of 5.125% senior notes due 2021 that were not exchanged in connection with the Exchange Offer. In October 2019, CSC Holdings issued an additional $1,250,000 aggregate principal amount of its 2030 Senior Notes at a price of 104.00% of the principal amount plus accrued interest from July 10, 2019 until October 7, 2019. The proceeds of these notes were used to redeem $1,240,762 aggregate outstanding principal amount of CSC Holdings 5.125% senior notes due 2021 in full and to pay accrued interest, fees, costs and expenses associated with these transactions. In connection with the redemption, the Company recorded a loss on extinguishment of debt of $65,151, representing the unamortized discount and deferred financing costs as of the redemption date. See Note 11 of our consolidated financial statements for further details of the Company’s outstanding senior guaranteed notes and senior notes. As of December 31, 2019, the Company was in compliance with all of its financial covenants under the indentures under which our senior guaranteed notes and senior notes were issued. Assumption of Cablevision Senior Notes In November 2019, pursuant to an asset contribution agreement (the "Asset Contribution"), Cablevision contributed to CSC Holdings substantially all of its assets and CSC Holdings assumed all of Cablevision’s liabilities, including Cablevision’s 5.875% senior notes due September 2022 with an aggregate outstanding principal amount of $649,024, Cablevision’s 7.750% senior notes due July 2025 with an aggregate outstanding principal amount of $1,740, and Cablevision's 7.500% senior notes due April 2028 with an aggregate outstanding principal amount of $4,118 (the "Assumption of Cablevision Senior Notes"). Other Events In June 2019, the Company completed the acquisition of Cheddar Inc., a digital-first news company, for approximately $198,754 in cash and stock. See Note 10 to the consolidated financial statements for further details. In December 2019, Altice USA entered into an agreement with CVC 3 B.V., an indirect subsidiary of Altice Europe ("CVC 3"), whereby CVC 3 assigned all of its interest (the "Partnership Interest") in Neptune Holding US Limited Partnership ("Neptune LP") to Altice USA in exchange for 6,290,292 shares of Class A common stock of Altice USA with an aggregate value of $163,862. At the time of the assignment, the Partnership Interest represented 6,290,292 shares of Class A common stock of Altice USA held by Neptune LP. As a result of this transaction, Altice USA obtained control of Neptune LP and accordingly, Neptune LP is consolidated within the Altice USA financial statements. The assets of Neptune LP which consisted solely of shares of class A common stock of Altice USA are presented as treasury stock in the consolidated balance sheet of Altice USA at December 31, 2019. Capital Expenditures The following table presents the Company's capital expenditures: Customer premise equipment includes expenditures for set-top boxes, cable modems, routers and other equipment that is placed in a customer's home, as well as installation costs for placing assets into service. Network infrastructure includes: (i) scalable infrastructure, such as headend equipment, (ii) line extensions, such as FTTH and fiber/coaxial cable, amplifiers, electronic equipment, make-ready and design engineering, and (iii) upgrade and rebuild, including costs to modify or replace existing fiber/coaxial cable networks, including enhancements. Support and other capital expenditures includes costs associated with the replacement or enhancement of non-network assets, such as office equipment, buildings and vehicles. Business services capital expenditures include primarily equipment, installation, support, and other costs related to our fiber based telecommunications business serving SMB and enterprise customers. Cash Flow Discussion Altice USA Operating Activities Net cash provided by operating activities amounted to $2,554,169, $2,508,317 and $2,018,247 for the years ended December 31, 2019, 2018 and 2017, respectively. The 2019 cash provided by operating activities resulted from $2,833,078 of income before depreciation and amortization and non-cash items, an increase in liabilities related to interest rate swap contracts of $30,338, partially offset by increases in accounts receivable of $91,718, other receivables of $21,755, and prepaid expenses and other assets of $100,343, a net decrease in amounts due to affiliates of $7,857, and decreases in accounts payable of $33,107, accrued expenses of $44,083 and deferred revenue of $10,384. The 2018 cash provided by operating activities resulted from $2,644,639 of income before depreciation and amortization and non-cash items, an increase in deferred revenue of $72,426, an increase in liabilities related to interest rate swap contracts of $53,101, and a net increase in amounts due to affiliates of $11,049, partially offset by an increase in accounts receivable of $144,079, a decrease in accounts payable and accrued expenses of $118,176, and an increase in current and other assets of $10,643. The 2017 cash provided by operating activities resulted from $2,318,941 of income before depreciation and amortization and non-cash items and an increase in deferred revenue of $12,310, partially offset by a decrease in accounts payable and accrued expenses of $167,813, a net increase in current and other assets of $109,944, a net decrease in amounts due to affiliates of $34,326, and a decrease in liabilities related to interest rate swap contracts of $921. Investing Activities Net cash used in investing activities for the years ended December 31, 2019, 2018 and 2017 was $1,525,469, $1,148,357 and $1,092,199, respectively. The 2019 investing activities consisted primarily of primarily of capital expenditures of $1,355,350 and payments for acquisitions, net of cash acquired of $172,269, partially offset by other net cash receipts of $2,150. The 2018 investing activities consisted primarily of capital expenditures of $1,153,589, partially offset by other net cash receipts of $5,232. The 2017 investing activities consisted primarily of capital expenditures of $951,349, payments of $97,410 related to the settlement of put-call options, and payments for acquisitions, net of cash acquired of $46,703, partially offset by $3,263 in other net cash proceeds. Financing Activities Net cash used in financing activities amounted to $624,412, $1,390,996, and $1,099,041 for the years ended December 31, 2019, 2018 and 2017. In 2019, the Company's financing activities consisted primarily of the redemption and repurchase of senior notes, including premiums and fees of $4,225,786, the repayment of credit facility debt of $3,832,062, the purchase of common stock pursuant to a share repurchase program of $1,686,873, additions to deferred financing costs of $23,583, net repayment of notes payable of $36,212, and other net cash payments of $10,480, partially offset by net proceeds from credit facility debt, net of discounts of $5,040,000, proceeds from the issuance of senior notes, including premiums and fees of $4,054,375, proceeds from collateralized indebtedness of $93,000, and proceeds from stock option exercises of $3,209. In 2018, the Company's financing activities consisted primarily of the redemption and repurchase of senior notes, including premiums and fees of $2,628,962, dividends to stockholders of $1,499,935, the purchase of common stock pursuant to a share repurchase program of $500,000, payments of collateralized indebtedness and related derivatives of $516,513, contingent payment for acquisition of $30,000, additions to deferred financing costs of $28,468, net repayment of notes payable of $16,677, and other net cash payments of $11,087, partially offset by net proceeds from credit facility debt of $1,268,138, proceeds from the issuance of senior notes of $2,050,000, proceeds from collateralized indebtedness of $516,513, and contributions from noncontrolling interests of $5,995. In 2017, the Company's financing activities consisted primarily of the repayment of senior notes, including premiums and fees, of $1,729,400, cash distributions paid to stockholders of $919,317, principal payments on finance lease obligations of $15,157, and additions to deferred financing costs of $8,600, partially offset by net proceeds from credit facility debt of $1,182,094, net proceeds from collateralized indebtedness and related derivative contracts of $7,735, net proceeds from the Company's IPO of $349,071, proceeds from notes payable of $33,733, and other net cash receipt of $800. CSC Holdings Operating Activities Net cash provided by operating activities amounted to $2,623,742, $2,766,075, and $2,061,935 for the years ended December 31, 2019, 2018 and 2017, respectively. The 2019 cash provided by operating activities resulted from $2,621,132 of income before depreciation and amortization and non-cash items, a net increase in amounts due to affiliates of $247,917 and an increase in liabilities related to interest rate swap contracts of $30,338, partially offset by increases in accounts receivable of $91,718, other receivables of $12,512, and prepaid expenses and other assets of $100,343, and decreases in accounts payable of $33,107, accrued expenses of $27,581 and deferred revenue of $10,384. The 2018 cash provided by operating activities resulted from $2,628,133 of income before depreciation and amortization and non-cash items, an increase in deferred revenue of $72,426, an increase in liabilities related to interest rate swap contracts of $53,101, a net increase in amounts due from affiliates of $175,159, and an increase in accounts payable and accrued expenses of $5,273, partially offset by an increase in accounts receivable of $144,079 and an increase in current and other assets of $23,938. The 2017 cash provided by operating activities resulted from $2,593,943 of income before depreciation and amortization and non-cash items and an increase in deferred revenue of $20,634, offset by a net decrease in amounts due to affiliates of $413,930, an increase in accounts receivable of $89,683, a decrease in accounts payable and accrued expenses of $23,266, a net decrease in current and other assets of $24,842, and a decrease in liabilities related to interest rate swap contracts of $921. Investing Activities Net cash used in investing activities for the years ended December 31, 2019, 2018 and 2017 was $1,525,469, $1,160,184, and $994,789, respectively. The 2019 investing activities consisted primarily of primarily of capital expenditures of $1,355,350 and payments for acquisitions, net of cash acquired of $172,269, partially offset by other net cash receipts of $2,150. The 2018 investing activities consisted primarily of capital expenditures of $1,153,589 and other net cash receipts of $6,595. The 2017 investing activities consisted primarily of capital expenditures of $951,349, payments for acquisitions, net of cash acquired of $46,703, partially offset by $3,263 in other net cash proceeds. Financing Activities Net cash used in financing activities amounted to $697,888, $1,625,199, and $1,166,402 for the years ended December 31, 2019, 2018 and 2017, respectively. In 2019, the Company's financing activities consisted primarily of the redemption and repurchase of senior notes, including premiums and fees of $3,703,454, the repayment of credit facility debt of $3,832,062, distributions to its parent of $2,279,472, additions to deferred financing costs of $23,583, net repayment of notes payable of $36,212, and other net cash payments of $10,480, partially offset by net proceeds from credit facility debt, net of discounts of $5,040,000, proceeds from the issuance of senior notes, including premiums and fees of $4,054,375 and proceeds from collateralized indebtedness of $93,000. In 2018, the Company's financing activities consisted primarily of distributions to its parent of $3,058,750, the redemption and repurchase of senior notes, including premiums and fees of $805,206, payments of collateralized indebtedness and related derivatives of $516,513, net repayment of notes payable of $32,632, contingent payment for acquisition of $30,000, additions to deferred financing costs of $28,471, and principal payments on finance lease obligations of $10,228, partially offset by net proceeds from credit facility debt of $1,268,138, proceeds from the issuance of senior notes of $1,000,000, proceeds from collateralized indebtedness of $516,513, proceeds from contributions from parent of $50,000, proceeds from notes payable of $15,955, and contributions from noncontrolling interests of $5,995. In 2017, the Company's financing activities consisted primarily of cash distributions paid to its parent of $2,777,497, the repayment of senior notes, including premiums and fees, of $350,120, principal payments on finance lease obligations of $15,157, additions to deferred financing costs of $8,171 and distributions to noncontrolling interests of $335, partially offset by net proceeds from credit facility debt of $1,182,094, contributions from parent of $761,316, proceeds from notes payable of $33,733, and net proceeds from collateralized indebtedness and related derivative contracts of $7,735. Equity Derivative Contracts and Collateralized Debt In November 2019, the Company entered into a new monetization contract related to 5,337,750 shares of Comcast common stock held by us, which synthetically reversed the existing contract related to these shares. In addition, the Company entered into amendments to monetization contracts related to 37,617,486 shares of Comcast common stock held by us. The new and amended monetization contracts extended the maturity date to April 28, 2023 and provide the Company with downside protection below the hedge price of $40.95 per share and upside benefit of stock price appreciation up to $49.55 per share. Contractual Obligations and Off Balance Sheet Commitments Our contractual obligations as of December 31, 2019, which consist primarily of our debt obligations and the effect such obligations are expected to have on our liquidity and cash flow in future periods, are summarized in the following table: (a)Purchase obligations primarily include contractual commitments with various programming vendors to provide video services to our customers and minimum purchase obligations to purchase goods or services, including contracts to acquire handsets and other equipment. Future fees payable under contracts with programming vendors are based on numerous factors, including the number of customers receiving the programming. Amounts reflected above related to programming agreements are based on the number of customers receiving the programming as of December 31, 2019 multiplied by the per customer rates or the stated annual fee, as applicable, contained in the executed agreements in effect as of December 31, 2019. See Note 17 to our consolidated financial statements for a discussion of our program rights obligations. (b)Includes franchise and performance surety bonds primarily for our cable television systems. Also includes outstanding guarantees primarily by CSC Holdings in favor of certain financial institutions in respect of ongoing interest expense obligations in connection with the monetization of our holdings of shares of Comcast common stock. Payments due by period for these arrangements represent the year in which the commitment expires. (c)Consists primarily of letters of credit issued by the Company in favor of insurance providers and certain governmental authorities. Payments due by period for these arrangements represent the year in which the commitment expires. (d)Includes interest and principal payments due on our (i) credit facility debt, (ii) senior guaranteed notes, senior secured notes, and senior notes, (iii) notes payable and supply chain financing and (iv) collateralized indebtedness. See Notes 11 and 12 to our consolidated financial statements for a discussion of our long-term debt. (e)Reflects the principal amount of operating and finance lease obligations, including related interest. Lease obligations presented in the table above do not include rent related to utility poles used in our operations. The Company's pole rental agreements are for varying terms, and management anticipates renewals as they expire. Rent expense incurred for pole rental attachments for the years ended December 31, 2019, 2018 and 2017 was $31,903, $33,082, and $31,308, respectively. See Note 9 to our consolidated financial statements for a discussion of our operating and finance leases. (f)Represents tax liabilities, including accrued interest, relating to uncertain tax positions. See Note 14 to our consolidated financial statements for a discussion of our income taxes. The table above does not include obligations for payments required to be made under multi-year franchise agreements based on a percentage of revenues generated from video services per year. For the years ended December 31, 2019, 2018 and 2017, the amount of franchise fees and certain other taxes and fees included as a component of revenue aggregated $254,227, $257,467 and $259,075, respectively. Dividends and Distributions In the second quarter of 2017, prior to the Company's IPO, the Company declared and paid cash distributions aggregating $839,700, $500,000 of which were funded with proceeds from borrowings under CSC Holdings' revolving credit facility. In 2016, the Company declared cash distributions of $445,176, of which $365,559 were paid in 2016 and $79,617 were paid in the first quarter of 2017. Prior to Altice Europe's announcement of the Distribution, the Board of Directors of Altice USA, acting through its independent directors, approved the payment of a $2.035 per share dividend to all shareholders of record on May 22, 2018. The payment of the dividend, aggregating $1,499,935, was made on June 6, 2018, and was funded with cash at CSC Holdings from financings completed in January 2018, and cash generated from operations. Share Repurchase Program In June 2018, the Board of Directors of Altice USA authorized a share repurchase program of $2.0 billion, and on July 30, 2019, the Board of Directors authorized a new incremental three-year share repurchase program of $5.0 billion that took effect following the completion in August 2019 of the $2.0 billion repurchase program. Under these repurchase programs, shares of Altice USA Class A common stock may be purchased from time to time in the open market and may include trading plans entered into with one or more brokerage firms in accordance with Rule 10b5-1 under the Securities Exchange Act of 1934. Size and timing of these purchases will be determined based on market conditions and other factors. Funding for the repurchase program will be met with cash on hand and/or borrowings under the Company's revolving credit facilities. For the year ended December 31, 2019, the Company repurchased 72,668,712 shares for a total purchase price of approximately $1,686,873. From the inception of the repurchase program, the Company acquired 100,697,392 for a total purchase price of approximately $2,186,874. These acquired shares have been retired and the associated cost was recorded in paid-in capital in the Company’s consolidated balance sheet. Managing our Interest Rate and Equity Price Risk Interest Rate Risk Interest rate risk is primarily a result of exposures to changes in the level, slope and curvature of the yield curve, the volatility of interest rates and credit spreads. Our exposure to interest rate risk results from changes in short-term interest rates. Interest rate risk exists primarily with respect to our credit facility debt, which bears interest at variable rates. To manage interest rate risk, we have from time to time entered into interest rate swap contracts to adjust the proportion of total debt that is subject to variable and fixed interest rates. Such contracts effectively fix the borrowing rates on floating rate debt to provide an economic hedge against the risk of rising rates and/or effectively convert fixed rate borrowings to variable rates to permit the Company to realize lower interest expense in a declining interest rate environment. We monitor the financial institutions that are counterparties to our interest rate swap contracts and we only enter into interest rate swap contracts with financial institutions that are rated investment grade. All such contracts are carried at their fair market values on our consolidated balance sheet, with changes in fair value reflected in the consolidated statement of operations. See "
0.039629
0.039805
0
<s>[INST] We operate in a highly competitive, consumer and technology driven and rapidly changing business that is affected by government regulation and economic, strategic, technological, political and social conditions. Various factors could adversely affect our operations, business or financial results in the future and cause our actual results to differ materially from those contained in the forwardlooking statements. In addition, important factors that could cause our actual results to differ materially from those in our forwardlooking statements include: competition for broadband, video and telephony customers from existing competitors (such as broadband communications companies, DBS providers and Internetbased providers) and new competitors entering our footprint; changes in consumer preferences, laws and regulations or technology that may cause us to change our operational strategies; increased difficulty negotiating programming agreements on favorable terms, if at all, resulting in increased costs to us and/or the loss of popular programming; increasing programming costs and delivery expenses related to our products and services; our ability to achieve anticipated customer and revenue growth, to successfully introduce new products and services and to implement our growth strategy; our ability to complete our capital investment plans on time and on budget, including our plan to build a FTTH network, and deploy Altice One, our home communications hub; our ability to develop mobile voice and data services and our ability to attract customers to these services; the effects of economic conditions or other factors which may negatively affect our customers’ demand for our current and future products and services; the effects of industry conditions; demand for digital and linear advertising products and services; our substantial indebtedness and debt service obligations; adverse changes in the credit market; changes as a result of any tax reforms that may affect our business; financial community and rating agency perceptions of our business, operations, financial condition and the industries in which we operate; the restrictions contained in our financing agreements; our ability to generate sufficient cash flow to meet our debt service obligations; fluctuations in interest rates which may cause our interest expense to vary from quarter to quarter; technical failures, equipment defects, physical or electronic breakins to our services, computer viruses and similar problems; the disruption or failure of our network, information systems or technologies as a result of computer hacking, computer viruses, "cyberattacks," misappropriation of data, outages, natural disasters and other material events; our ability to obtain necessary hardware, software, communications equipment and services and other items from our vendors at reasonable costs; our ability to effectively integrate acquisitions and to maximize expected operating efficiencies from our acquisitions or as a result of the transactions, if any; significant unanticipated increases in the use of bandwidthintensive Internetbased services; the outcome of litigation, government investigations and other proceedings; our ability to successfully operate our business following the completion of our separation from Altice Europe; and other risks and uncertainties inherent in our cable and other broadband communications businesses and our other businesses, including those listed under the caption "Risk Factors" and "Management's Discussion and Analysis of Financial Condition and Results of Operations" contained herein. These factors are not necessarily all of the important factors that could cause our actual results to differ materially from those expressed in any of our forwardlooking statements. Other unknown or unpredictable factors could cause our actual results to differ materially from those expressed in any of our forwardlooking statements. Given these uncertainties, you are cautioned not to place undue reliance on such forwardlooking statements. The forwardlooking statements are made only as of the date of this Annual Report. Except to the extent required by law, we do not undertake, and specifically decline any obligation, to update any forwardlooking statements or to publicly announce the results of any revisions to any of such statements to reflect future events or developments. Comparisons of results for current and any prior periods are not intended to express any future trends or indications of future performance, unless expressed as such, and should only be viewed as historical data. You should read this Annual Report with the understanding that our actual future results, levels of activity, performance and events and circumstances may be materially different from what we expect. We qualify all forwardlooking statements by these cautionary statements. Certain numerical figures included in this Annual Report have been subject to rounding adjustments. Accordingly, such numerical figures shown as totals [/INST] Positive. </s>
2,020
11,045
1,664,703
Bloom Energy Corp
2019-03-22
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 consolidated financial statements and the notes thereto included elsewhere in this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10-K, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties as described under the heading Special Note Regarding Forward-Looking Statements following the Table of Contents of this Annual Report on Form 10-K. You should review the disclosure under ITEM 1A - Risk Factors in 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 Our solution, the Bloom Energy Server, is a stationary power generation platform built for the digital age and capable of delivering highly reliable, uninterrupted, 24x7 constant power that is also clean and sustainable. The Bloom Energy Server converts standard low-pressure natural gas or biogas into electricity through an electrochemical process without combustion, resulting in very high conversion efficiencies and lower harmful emissions than conventional fossil fuel generation. A typical configuration produces 250 kilowatts of power in a footprint roughly equivalent to that of half of a standard thirty-foot shipping container, or approximately 125 times more space-efficient than solar power generation. 250 kilowatts of power is roughly equivalent to the constant power requirement of a typical big box retail store. Any number of these Energy Server systems can be clustered together in various configurations to form solutions from hundreds of kilowatts to many tens of megawatts. We market and sell our Energy Servers primarily through our direct sales organization in the United States, and also have direct and indirect sales channels internationally. Recognizing that deploying our solutions requires a material financial commitment, we have developed a number of financing options to support sales of Energy Servers to customers that lack the financial capability to purchase our Energy Servers directly, who prefer to finance the acquisition using third party financing or who prefer to contract for our services on a pay-as-you-go model. Our typical target commercial or industrial customer has historically been either an investment-grade entity or a customer with investment-grade attributes such as size, assets and revenue, liquidity, geographically diverse operations and general financial stability. We have recently expanded our below investment-grade customer base and have also expanded internationally to target customers with deployments on a wholesale grid. Given that our customers are typically large institutions with multi-level decision making processes, we generally experience a lengthy sales process. Purchase Options Aside from our direct sales channel targeting those potential customers who prefer to make an outright direct purchase, we have expanded our potential customer base by providing the ability to purchase an Energy Server by other financial vehicles, such as those incorporating third-party capital resources. We have a lease offering through one of our financing partners which we refer to as a Traditional Lease. Similarly, we offer a sale-leaseback sublease arrangement, which we refer to as Managed Services. Additionally, some of our customers have elected to purchase electricity produced by our Energy Servers through a financed offering which we refer to as a Power Purchase Agreement Program, whereby one or more parties are equity investors in financing the entities that purchase the Energy Servers. Our Power Purchase Agreement Programs include both the Bloom Electrons program, which includes an equity investment by us, and our Third-Party PPA programs, where we have no equity investment. For both the Bloom Electrons program and Third-Party PPA programs, we directly manage the end customer (electricity user) relationship from originating the sale to servicing the systems over the course of the deal term. Depending upon the purchase option chosen by our customer, either the customer or the financing provider may utilize investment tax credits and other government incentives. However, the timing of the product-related cash flows to us is generally consistent across all of the purchase options. We generally receive all product-related payments by the time that the product is accepted by the end customer. Our capacity to offer our Energy Servers through any of these arrangements depends in large part on the ability of the parties involved in providing payment for the Energy Servers to monetize the related investment tax credits, accelerated tax depreciation and other incentives, and/or the future power purchase obligations of the end customer. Interest rate fluctuations would also impact the attractiveness of any financing offerings for our customers, and currency exchange fluctuations may also impact the attractiveness of international offerings. The Traditional Lease, Managed Services and Power Purchase Agreement Program options are limited by the creditworthiness of the customer. Additionally, the Managed Services and Traditional Lease options, as with all leases, are also limited by the customer’s willingness to commit to making fixed payments regardless of the performance of the Energy Servers or our performance of our obligations under the customer agreement. Under each purchase option, we provide warranties and performance guaranties for the Energy Servers’ efficiency and output. Under direct purchase, Traditional Lease, and Power Purchase Agreement program options, the warranty and guaranty is typically included in the price of the Energy Server for the first year. The warranty and guaranty may be renewed annually at the customer’s option - as an operations and maintenance services agreement - at predetermined prices for a period of up to 25 years. Historically, our customers have almost always exercised their option to renew under these operations and maintenance services agreements. Under the Managed Services program, the operations and maintenance performance guaranties are priced separately and included for a fixed period specified in the customer agreement. This period is typically either 6 or 10 years, which may be extended at the option of the parties for additional years with all payments made annually. Under the Power Purchase Agreement Programs, we provide warranties and performance guaranties regarding the Energy Servers’ efficiency to the customer (i.e., the end user of the electricity generated by the Energy Servers), and we provide warranties and performance guaranties regarding the Energy Servers’ output to the entity that purchases the Energy Servers. Acceptances We use "acceptances" as a key operating metric to measure the volume of our operational activity from period to period. We typically define an acceptance as when an Energy Server is installed and running at full power as provided in the customer contract or the financing agreements. The portion of acceptances in the year ended December 31, 2018 attributable to each purchase option was as follows: direct purchase (including Third Party PPAs) 88%, Traditional Lease 12%, Managed Services 0% and Bloom Electrons 0%. The portion of acceptances in the year ended December 31, 2018 attributable to each payment option was as follows: direct purchase (including Third Party PPAs and the Republic of Korea orders) 68%, Traditional Lease 16%, Managed Services 4% and Bloom Electrons 12%. The portion of acceptances in the year ended December 31, 2017 attributable to each purchase option was as follows: direct purchase (including Third Party PPAs) 72%, Traditional Lease 7%, Managed Services 21% and Bloom Electrons 0%. The portion of acceptances in the year ended December 31, 2017 attributable to each payment option was as follows: direct purchase (including Third Party PPAs) 61%, Traditional Lease 7%, Managed Services 8% and Bloom Electrons 24%. The portion of acceptances in the year ended December 31, 2016 attributable to each purchase option was as follows: direct purchase (including Third Party PPAs) 10%, Traditional Lease 6%, Managed Services 31% and Bloom Electrons 53%. The portion of acceptances in the year ended December 31, 2016 attributable to each payment option was as follows: direct purchase (including Third Party PPAs) 40%, Traditional Lease 18%, Managed Services 4% and Bloom Electrons 38%. Backlog The timing of delivery and installations of our products have a significant impact on the timing of the recognition of product revenue. Many factors can cause a lag between the time that a customer signs a purchase order and our recognition of product revenue. These factors include the number of Energy Servers installed per site, local permitting and utility requirements, environmental, health and safety requirements, weather, and customer facility construction schedules. Many of these factors are unpredictable and their resolution is often outside of our or our customers’ control. Customers may also ask us to delay an installation for reasons unrelated to the foregoing, including delays in their obtaining financing. Further, due to unexpected delays, deployments may require unanticipated expenses to expedite delivery of materials or labor to ensure the installation meets the timing objectives. These unexpected delays and expenses can be exacerbated in periods in which we deliver and install a larger number of smaller projects. In addition, if even relatively short delays occur, there may be a significant shortfall between the revenue we expect to generate in a particular period and the revenue that we are able to recognize. For our installations, revenue and cost of revenue can fluctuate significantly on a periodic basis depending on the timing of acceptance and the type of financing used by the customer. Our product sales backlog was $772.8 million, equivalent to 1,384 systems, or 138.4 megawatts, as of December 31, 2018. Our product sales backlog was $803.9 million, equivalent to 1,187 systems, or 118.7 megawatts, as of December 31, 2017. Our product sales backlog was $489.6 million, equivalent to 871 systems, or 87.1 megawatts, as of December 31, 2016. We define product sales backlog as signed customer product sales orders received prior to the period end, but not yet accepted, excluding site cancellations. The timing of the deployment of our backlog depends on the factors described above. However, as a general matter, at any point in time, we expect at least 50% of our backlog to be deployed within the next 12 months. The portion of our backlog in the year ended December 31, 2018 attributable to each payment option was as follows: direct purchase (including Third Party PPAs) 98%, Traditional Lease 2%, Managed Services 0% and Bloom Electrons 0%. The portion of our backlog in the year ended December 31, 2017 attributable to each payment option was as follows: direct purchase (including Third Party PPAs) 61%, Traditional Lease 7%, Managed Services 8% and Bloom Electrons 24%. The portion of our backlog in the year ended December 31, 2016 attributable to each payment option was as follows: direct purchase (including Third Party PPAs) 40%, Traditional Lease 18%, Managed Services 4% and Bloom Electrons 38%. Purchase and Lease Programs Initially, we only offered our Energy Servers on a direct purchase basis, in which the customer purchases the product directly from us. In order to expand our offerings to customers who lack the financial capability to purchase our Energy Servers directly and/or who prefer to lease the product or contract for our services on a pay-as-you-go model, we subsequently developed the Traditional Lease, Managed Services, Bloom Electrons program and further, our Third-Party PPA Program. The Third-Party PPA Program carries many of the same obligations as a traditional Bloom Electrons program, except that we do not have any equity interest in the PPA structure. Therefore, the Bloom Electrons programs and the various Third-Party PPA Programs are collectively described here under the Power Purchase Agreement Program(s). The substantial majority of bookings made in recent periods are pursuant to Third-Party PPA Programs. Traditional Lease Under the Traditional Lease arrangement, the customer enters into a lease directly with a financier, which pays us for the Energy Servers pursuant to a sales agreement (a Financing Agreement, described below). We recognize product and installation revenue upon acceptance. After the standard one-year warranty period, our customers have almost always exercised the option to enter into operations and maintenance services agreements with us, under which we receive annual service payments from the customer. The price for the annual operations and maintenance services is set at the time we enter into the Financing Agreement. The duration of our Traditional Leases ranges from 6 to 15 years. Under a Financing Agreement, we are generally paid the full price of the Energy Servers as if sold as a purchase by the customer based on four milestones. The four payment milestones are typically as follows: (i) 15% upon execution of the financier's entry into the lease with a customer, (ii) 25% on the day that is 180 days prior to delivery of the Energy Servers, (iii) 40% upon shipment of the Energy Servers, and (iv) 20% upon acceptance of the Energy Servers. The financier receives title to the Energy Servers upon installation at the customer site and the customer has risk of loss while the Energy Server is in operation on the customer’s site. The Financing Agreement provides for the installation of the Energy Servers and includes a standard one-year warranty, which includes the performance guaranties described below, with the warranty offered on an annually renewing basis at the discretion of the customer. The customer must provide gas for the Energy Servers to operate. Warranty Commitments We typically provide (i) an Output Warranty to operate at or above a specified baseload output of the Energy Servers on a site, and (ii) an Efficiency Warranty to operate at or above a specified level of fuel efficiency. Both are measured on a monthly, cumulative, or other basis, as specified in the Financing Agreement. Upon the applicable customer making a warranty claim for a failure of any of our warranty commitments, we are then obligated to repair or replace the Energy Server, or if a repair or replacement is not feasible, to pay the customer an amount approximately equal to the net book value of the Energy Server, after which the Financing Agreement would be terminated. As of December 31, 2018, we had incurred no obligations to make payments pursuant to these warranty commitments. Performance Guaranties Our performance guaranties are negotiated on a case-by-case basis for projects deployed through the Traditional Lease program, but we typically provide an Output Guaranty of 95% measured cumulatively from the date the applicable Energy Server(s) are commissioned and an Efficiency Guaranty of 52% measured cumulatively from the date the applicable Energy Server(s) are commissioned. In each case, underperformance obligates us to make a payment to the applicable customer. As of December 31, 2018, the fleet of Energy Servers deployed pursuant to the Traditional Lease programs were performing at a lifetime average output of approximately 86% and a lifetime average efficiency of approximately 54%. As of December 31, 2018, our obligation to make payments for underperformance against the performance guaranties for Traditional Lease projects was capped at an aggregate total of approximately $5.9 million (including payments both for low output and for low efficiency). As of December 31, 2018, our aggregate remaining potential liability under this cap was approximately $5.5 million. Remarketing at Termination of Lease At the end of any customer lease in the event the financier or customer does not renew or purchase the Energy Servers, we may remarket any such Energy Servers to a third party, and any proceeds of such sale would be allocated between us and the applicable financing partner as agreed between them at the time of such sale. Managed Services Under our Managed Services program, we initially enter into a master lease agreement with the financing partner which holds title to the Energy Server. Once a customer is identified, we sell the Energy Server to the financing partner and enter into a project-specific operating lease with the financing partner and a service agreement with the customer. The duration of our Managed Services leases is currently either 6 or 10 years. We recognize revenue from the sale of the equipment to the financing partner once the Energy Server has been accepted by the customer. Under the service agreement with the customer, there are two payment components: a monthly equipment fee payable to the financing partner which covers the amount of the lease payment, which is guaranteed by us, and a service payment payable to us for our operation and maintenance of the Energy Server. The service payment may either be fixed or based on the monthly output of electric power produced by the Energy Server. Under the master lease with the financing party, the Company assigns it right to the monthly equipment fee to the financing partner in satisfaction of its rights to make the equipment lease payments. Our warranty commitments under the Managed Services option are substantially similar to those applicable to the Traditional Lease program described above. Our Managed Services deployments do not typically include any performance guaranties above the warranty commitments, but the customer’s payment to us may include a payment that is proportionate to the output generated by the Energy Server(s) and our pricing assumes service revenues at the 95% output level. Since the customer’s payment is based on the Energy Server’s output, our service revenues are lower if output is less than 95% (and higher if output exceeds 95%). As of December 31, 2018, the fleet of Energy Servers deployed pursuant to the Managed Services program were performing at a lifetime average output of approximately 94%. Power Purchase Agreement Programs Our customers have the option to purchase electricity produced by our Energy Servers through a financed offering which we refer to as a Power Purchase Agreement Program, whereby one or more parties are equity investors in financing the entities that purchase the Energy Servers. Our Power Purchase Agreement Programs include both the Bloom Electrons program, which includes an equity investment by us and in which we recognize revenue as the electricity is produced, and our Third-Party PPA programs, in which we have no equity investment and we recognize revenue on acceptance. * Under the Third Party PPA arrangements there is no link with an investment company, as we do not have an equity investment in those arrangements. In each Power Purchase Agreement Program, we sell our Energy Servers to an entity that owns the Energy Servers (an Operating Company) which sells the electricity generated by the Energy Servers to the ultimate end customers pursuant to a Power Purchase Agreement, energy services agreement, or similar contract. Because the end customer's payment is stated on a dollar-per-kilowatt-hour ("$/kWh") basis, we refer to these agreements as Power Purchase Agreements ("PPAs"). Our Bloom Electrons program involved an equity investment by us (through an Investment Company) in the applicable Operating Company. Under our Power Purchase Agreement Programs, we perform many of the functions of a typical project developer, including identification of end customers, leading negotiations with such end customer regarding the PPA, and entering into an Energy Server sales, operations and maintenance agreement ("EPC and O&M Agreement") with the Operating Company that will own the Energy Servers for the full term of the PPA. In some cases, the applicable financier(s) assists with the identification of end customers, and the negotiation of the PPAs. The Operating Company then enters into the PPA with the end customer which purchases electricity generated by the Energy Servers at a price that includes the payment for the O&M services. The Operating Company receives all cash flows generated under the PPA(s), in addition to all investment tax credits, all accelerated tax depreciation benefits, and any other cash flows generated by the operation of the Energy Servers not allocated to the end customer under the PPA. The sales of our Energy Servers to the Operating Company in connection with the various Power Purchase Agreement Programs have many of the same terms and conditions as a direct sale. Payment of the purchase price is generally broken down into multiple installments, which may include payments prior to shipment, upon shipment or delivery of the Energy Server, and upon acceptance of the Energy Server. Acceptance typically occurs when the Energy Server is installed and running at full power as defined in each contract. A one-year service warranty is provided with the initial sale. After the expiration of the initial standard one-year warranty, the Operating Company has the option to enter into annual operations and maintenance services agreements with us at a price determined at the time of purchase of the Energy Server, which may be renewed annually for each Energy Server for up to 25 years. Pursuant to the service warranty for Power Purchase Agreement Program projects, we provide efficiency and minimum output warranty commitments (see below) to the Operating Company (collectively, "Performance Warranties") and provide a backstop of the efficiency commitments provided by the Operating Company to the end customer under each PPA. In the event that the Energy Servers fail to satisfy these warranty levels, we may be obligated to repurchase the applicable Energy Servers if we are unable to repair or replace them during the applicable cure period. Across all Power Purchase Agreement Program projects, as of December 31, 2018, we had incurred no repurchase obligations pursuant to such warranties. In addition, we guarantee minimum output and efficiency levels greater than the warranty levels and pay certain capped performance guaranty amounts if those levels are not achieved. These performance guaranties are negotiated on a case-by-case basis, but we provide an Output Guaranty of 95% measured annually or cumulatively from the date the applicable Energy Server(s) are commissioned and typically an Efficiency Guaranty of 52% measured cumulatively. In each case, underperformance obligates us to make a payment to the Operating Company, either to compensate the Operating Company for lost revenues under the applicable PPA or to reimburse the Operating Company for payments made to the end customer under such PPA. These payments are subject to caps set forth in the applicable PPA. As of December 31, 2018, the fleet of Energy Servers deployed pursuant to Power Purchase Agreement Programs performed at an average output of approximately 86% for three months ended December 31, 2018, and a lifetime average efficiency of approximately 54% through December 31, 2018. As of December 31, 2018, our obligation to make payments for underperformance on these projects was capped at an aggregate total of approximately $55.5 million (including payments both for low output and for low efficiency). As of December 31, 2018, our aggregate remaining potential liability under this cap was approximately $41.8 million. Obligations to Operating Companies In each Power Purchase Agreement Program, we and the applicable Operating Company enter into one or more EPC and O&M Agreements pursuant to which we perform certain manufacturing, design, installation, commissioning, operation, and maintenance obligations for the Operating Company for a term of up to 25 years. Our obligations under the EPC and O&M Agreement(s) for each Power Purchase Agreement Program project include: i. designing, manufacturing, and installing the Energy Servers, and selling such Energy Servers to the Operating Company, ii. obtaining all necessary permits and other governmental approvals necessary for the installation and operation of the Energy Servers, and maintaining such permits and approvals throughout the term of the EPC and O&M Agreement(s), iii. operating and maintaining the Energy Servers in compliance with all applicable laws, permits and regulations, iv. satisfying the efficiency and output warranties set forth in such EPC and O&M Agreement(s) and the PPA(s) (Performance Warranties), and v. complying with any specific requirements contained in the PPA(s) with individual end-customer(s). The EPC and O&M Agreement(s) obligate us to repurchase the Energy Servers in the event the Energy Servers fail to comply with the Performance Warranties or we otherwise breach the terms of the applicable EPC and O&M Agreement(s) and we fail to remedy such failure or breach after a cure period, or in the event that a PPA terminates as a result of any failure by us to comply with the applicable EPC and O&M Agreement(s). In some Power Purchase Agreement Program projects, our obligation to repurchase Energy Servers extends to the entire fleet of Energy Servers sold pursuant to the applicable EPC and O&M Agreement(s) in the event such failure affects more than a specified number of Energy Servers. In some Power Purchase Agreement Programs, we have also agreed to pay liquidated damages to the applicable Operating Company in the event of delays in the manufacture and installation of Energy Servers, either in the form of a cash payment or a reduction in the purchase price for the applicable Energy Server(s). Both the upfront purchase price for the Energy Servers and the ongoing fees for our operations and maintenance are paid on a fixed dollar-per-kilowatt ($/kW) basis. The EPC and O&M Agreement(s) for each Power Purchase Agreement Program project generally provides for the following performance and indemnity obligations: Efficiency Obligations - We warrant to the applicable Operating Company that each Energy Server and/or the portfolio of Energy Servers sold to such entity will operate at an average efficiency level specified in the O&M Agreement, calculated over a period specified in the O&M Agreement following the commercial operations date of such Energy Server. In some cases, we are obligated to repair or replace Energy Servers that are unable to satisfy the minimum efficiency level, or if a repair or replacement is not feasible, to repurchase such Energy Servers at the original purchase price, subject to adjustment for depreciation (Efficiency Warranty(ies)). In other cases, we are obligated to make a payment to compensate for the increased costs of procuring natural gas for the applicable Energy Server(s) resulting from the underperformance as against the minimum efficiency level, which payments are capped at a level specified in the applicable PPA agreement (the "Efficiency Guaranty"). Output Obligations - In addition, we warrant that the Energy Servers will generate a minimum amount of electricity during specified periods of time. Under O&M Agreements, our output obligations include: (i) the generation of a minimum amount of electricity on a monthly, quarterly, annual, or cumulative basis (as specified in the applicable EPC and O&M Agreement(s)), the failure of which obligates us to repair or replace the Energy Servers that are unable to satisfy such minimum output level, or if such repair or replacement is not feasible, to repurchase such Energy Servers at the original purchase price, subject to adjustment for depreciation ("Output Warranties"), and (ii) the generation of a minimum amount of electricity on either an annual or cumulative basis beginning on the commercial operations date of such Energy Server (as specified in the applicable EPC and O&M Agreement(s), the failure of which obligates us to make a payment to the applicable Operating Company based on the volume of the shortfall below the minimum output level, subject in some cases to a liability cap specified in the applicable EPC and O&M Agreement(s) ("Output Guaranties"). In some Power Purchase Agreement Program projects, these generation obligations are aggregated across the entire fleet of Energy Servers deployed pursuant to such project; in others, each Energy Server must satisfy the minimum generation obligations measured individually. Indemnification of Performance Warranty Expenses Under PPAs - In addition to the efficiency and output obligations, we also have agreed to indemnify certain Operating Companies for any expenses they incur to any of the end customers resulting from failures of the applicable Energy Servers to satisfy any of the Performance Warranties set forth in the applicable PPA(s). In addition, in the event that a PPA is terminated by an end customer as to any Energy Servers as a result of our failure to perform any of our obligations under the applicable EPC and O&M Agreement(s), we are obligated to repurchase such Energy Server from the applicable Operating Company for a repurchase price equal to the original purchase price, subject to adjustment for depreciation. Administration of Operating Companies - In each of the Bloom Electrons programs, we perform certain administrative services on behalf of the applicable Operating Company, including invoicing the end customers for amounts owed under the PPAs, administering the cash receipts of the Operating Company in accordance with the requirements of the financing arrangements, interfacing with applicable regulatory agencies, and other similar obligations. We are compensated for these services on a fixed dollar-per-kilowatt ($/kW) basis. Obligations to End Customers While the counterparty to the PPAs under each Power Purchase Agreement Program project is the applicable Operating Company, under the applicable EPC and O&M Agreement(s) we are obligated to perform each of the obligations of such Operating Company set forth in each PPA. These obligations include: i. designing, manufacturing, and installing the Energy Servers, ii. obtaining (or, where applicable under applicable law, assisting the end customer in obtaining) all necessary permits and other governmental approvals necessary for the installation and operation of the Energy Servers, and maintaining such permits and approvals throughout the term of the PPA, iii. operating and maintaining the Energy Servers in compliance with all applicable laws, permits and regulations, iv. satisfying the Performance Warranties set forth in the PPA, and v. complying with any additional requirements of contained in the PPA. Each PPA is negotiated on a case-by-case basis, but the PPAs generally adhere to the following terms: Term; Early Termination - The PPAs typically provide for an initial term of 15 or 20 years, and may be renewed by the mutual agreement of the end customer and the applicable Operating Company for additional periods at the expiration of the initial term. In the event that the end customer desires to terminate the PPA before the end of the contract term, or in the event that the PPA is terminated by the applicable Operating Company due to an end customer default, the end customer is required to pay a “termination value” payment as liquidated damages. Energy Server Installation and Operation - The applicable Operating Company is responsible for the installation, operation and maintenance of the Energy Servers on a turn-key basis. Take-Or-Pay Purchase Obligation - The end customer is required to purchase all of the electricity generated by the Energy Servers for the duration of the PPA. In the event that the end customer is unwilling or unable to accept delivery of such electricity or fails to supply the necessary fuel to the Energy Servers, the end customer is required to make a payment to the Operating Company for the amount of electricity that would have been delivered had the Energy Servers continued to operate. Fuel Supply Obligation - The end customer is required to provide all necessary fuel for the operation of the Energy Servers. Ownership of Energy Servers - The applicable Operating Company retains title to the Energy Servers at all times unless the PPA provides a purchase option and the end customer elects to purchase the Energy Server(s). Financial Incentives and Environmental Attributes - As the owner of the Energy Servers, the Operating Company retains ownership of any tax benefits associated with the installation and operation of the Energy Servers. Additional financial incentives available in connection with each installation (such as payments under state incentive programs or renewable portfolio standard programs) and any environmental benefits associated with the Energy Servers (such as carbon emissions reductions credits) are allocated to either the Operating Company or the end customer on a case-by-case basis. In some circumstances, the Operating Company has also agreed to purchase and deliver renewable energy credits to the end customer in connection with the PPA. Efficiency Commitments - The Operating Company makes certain warranties and guaranties regarding the Energy Servers’ efficiency to the end customer. Generally, these consist of (i) an Efficiency Warranty, where the Operating Company is obligated to repair or replace Energy Servers that fail to operate at or above a specified level of efficiency, and/or (ii) an Efficiency Guaranty, where the Operating Company is obligated to make payments to the end customer to cover the cost of procuring excess fuel if the Energy Servers fail to operate at or above a specified level of efficiency on a cumulative basis during the term of the PPA. Where an Efficiency Guaranty is provided, the Operating Company’s aggregate liability for payments (and, thereby, our indemnity exposure to the Operating Company) is capped. In certain circumstances, we may negotiate modifications to the efficiency commitments with the end customer, including different efficiency thresholds or providing for monetary payments under the Efficiency Warranty in lieu of or in addition to an obligation to repair or replace underperforming Energy Servers. Output Commitments - Although our standard PPA offering does not include a minimum output commitment to the end customer, exceptions may be negotiated on a case-by-case basis if we believe the opportunity justifies such exception. These output commitments are at an output level lesser than or equal to the Output Warranty provided by us to the Operating Company under the applicable EPC and O&M Agreement(s), and provide either for a payment to the end customer for the shortfall in electricity produced or for an end customer termination right. In addition, where the end customer (as opposed to the Operating Company) is entitled to the benefits of an incentive program that requires a minimum output level, the Operating Company may agree to reimburse the end customer for any decrease in incentive payments resulting from the Energy Servers’ failure to operate at such minimum output level. Defaults; Remedies - Defaults under the PPAs are typically limited to (i) bankruptcy events, (ii) unexcused failure to perform material obligations (including payment obligations), and (iii) breaches of representations and warranties. Additional defaults may be negotiated on a case-by-case basis. The parties are generally afforded cure periods of at least 30 days to cure any such defaults. In the event of an uncured default by the Operating Company, the end customer may terminate the PPA either in whole or in part as to the Energy Server(s) affected by such default, and may seek other remedies afforded at law or in equity. In the event of an uncured default by the end customer, the Operating Company may terminate the PPA either in whole or in part as to the Energy Server(s) affected by such default, and may seek other remedies afforded at law or in equity; in addition, in the event a PPA is terminated due to an end customer default, the end customer is obligated to make a termination value payment to the Operating Company. The Operating Company in each of the Power Purchase Agreement Programs (other than PPA I) has incurred debt in order to finance the acquisition of Energy Servers. The lenders for these projects are a combination of banks and/or institutional investors. In each case, the debt is secured by all of the assets of the Operating Company (primarily comprised of the Energy Servers and a collateral assignment of each of the contracts to which the Operating Company is a party, including the O&M Agreement entered into with us and the offtake agreements entered into with the Operating Company’s customers), and is senior to all other debt obligations of the Operating Company. As further collateral, the lenders receive a security interest in 100% of the membership interest of the Operating Company. However, as is typical in structured finance transactions of this nature, although the Project Debt is secured by all of the Operating Company’s assets, the lenders have no recourse to us or to any of the other tax equity investors in the project. The applicable debt agreements include provisions that implement a customary “payment waterfall” that dictates the priority in which the Operating Company will use its available funds to satisfy its payment obligations to us, the lenders, the tax equity investors and other third parties. We have determined that we are the primary beneficiary in the PPA Entities. Accordingly, we consolidate 100% of the assets, liabilities and operating results of these entities, including the Energy Servers and lease income, in our consolidated financial statements. We recognize the tax equity investors’ share of the net assets of the investment entities as noncontrolling interests in subsidiaries in our consolidated balance sheet. We recognize the amounts that are contractually payable to these investors in each period as distributions to noncontrolling interests in our consolidated statements of convertible redeemable preferred stock and equity. Our consolidated statements of cash flows reflect cash received from these investors as proceeds from investments by noncontrolling interests in subsidiaries. Our consolidated statements of cash flows also reflect cash paid to these investors as distributions paid to noncontrolling interests in subsidiaries. We reflect any unpaid distributions to these investors as distributions payable to noncontrolling interests in subsidiaries on our consolidated balance sheets. However, the PPA Entities are separate and distinct legal entities, and Bloom Energy Corporation may not receive cash or other distributions from the PPA Entities except in certain limited circumstances and upon the satisfaction of certain conditions, such as compliance with applicable debt service coverage ratios and the achievement of a targeted internal rate of return to the tax equity investors, or otherwise. For further information about our Power Purchase Agreement Programs, see Note 12 - Power Purchase Agreement Programs, to our consolidated financial statements included in this Annual Report on Form 10-K. Third-Party PPA Programs With our Bloom Electrons program, we endeavored to assist our customers' purchases by directly participating in financing the purchase of their Energy Server. More recently, we have moved to providing the same service to our customers without our direct involvement in the capital financing and therefore, having no equity investment in the resulting PPA. We refer to this purchase option as Third-Party PPA arrangements, structured in a near-identical manner and with the same terms and conditions as our Bloom Electrons program (described above), only without our assuming an equity position in the PPA structure. This way, we retain the benefits for the marketability of our Energy Servers without the capital burden and without the potential financial liability. International Channel Partners Prior to 2018, we consummated a small number of sales outside the United States of America, including in India and Japan. In India, sales activities are currently conducted by Bloom Energy (India) Pvt. Ltd., our wholly-owned indirect subsidiary; however, we are currently evaluating the Indian market to determine whether the use of channel partners would be a beneficial go-to-market strategy to grow our India market sales. In Japan, sales are conducted pursuant to a Japanese joint venture established between us and subsidiaries of SoftBank Corp, called Bloom Energy Japan Limited ("Bloom Energy Japan"). Under this arrangement, we sell Energy Servers to Bloom Energy Japan and we recognize revenue once the Energy Servers leave the port of the U.S. as Bloom Energy Japan enters into the contract with the end customer and performs all installation work as well as some of the operations and maintenance work. In 2018, Bloom Energy Japan consummated a sale of Energy Servers in the Republic of Korea to Korea South-East Power Company. Following this sale, we entered into a Preferred Distributor Agreement with SK Engineering & Construction Co., Ltd. ("SK E&C") to enable us to sell directly into the Republic of Korea. SK E&C Agreement SK E&C has a right of first refusal during the term of the agreement, with certain exceptions, to serve as distributor of Energy Servers for any fuel cell generation project in the Republic of Korea, and we have the right of first refusal to serve as SK E&C’s supplier of generation equipment for any Bloom Energy fuel cell project in the Republic of Korea. Under the terms of the Preferred Distributor Agreement, title, risk of loss and acceptance of the Energy Servers pass from us to SK E&C upon delivery at the named port of lading for shipment in the United States for the Energy Servers shipped in 2018 and thereafter upon delivery at the named port of unlading in the Republic of Korea, prior to unloading. The Preferred Distributor Agreement has an initial term expiring on December 31, 2021 (the "Initial Term") and thereafter will automatically be renewed for three year renewal terms unless not so extended by either party (each, a "Renewal Term", and together with the initial term, the "Term"). Either party may terminate the Preferred Distributor Agreement by written notice under certain circumstances. Under the terms of the Preferred Distributor Agreement, we (or our subsidiary) will contract directly with the customer to provide operations and maintenance services for the Energy Servers. We have established a subsidiary in the Republic of Korea, Bloom Energy Korea, LLC, to which we will subcontract such operations and maintenance services. The terms of the operations and maintenance will be negotiated on a case-by-case basis with each customer, but are generally expected to provide the customer with the option to receive services for at least ten (10) years, and for up to the life of the Energy Servers, with terms specified below. Output Obligations - We commit that the Energy Servers will generate minimum amount(s) of output during specified periods of time. Our output obligations include the generation of a minimum amount of electricity on a quarterly, annual or cumulative basis (as specified in the applicable agreement). As of December 31, 2018, the fleet of Energy Servers deployed pursuant to Power Purchase Agreement Programs performed at an average output of approximately 95% for three months ended December 31, 2018, and a lifetime average efficiency of approximately 52% through December 31, 2018. As of December 31, 2018, our obligation to make payments for underperformance on the direct purchase projects was capped at an aggregate total of approximately $2.9 million (including payments both for low output and for low efficiency). As of December 31, 2018, our aggregate remaining potential liability under this cap was approximately $2.9 million. Remedies for underperformance may include (a) the payment of “buy-down” liquidated damages (subject to a cap), for underperformance in connection with the commencement of operations or during an initial performance period following commencement of operations; (b) payment of liquidated damages (subject to a cap) based upon the amount of foregone electricity production; or (c) repair or replacement of the Energy Servers, or, if repair or replacement is not feasible, repurchase of such Energy Servers at a price equal to fair market value or the original purchase price, subject to adjustment for depreciation. As of December 31, 2018, we have incurred no obligations to make payments pursuant to these warranty commitments. Efficiency Obligations - We commit that the Energy Servers will operate at minimum efficiency level(s) during specified periods of time. Our efficiency obligations include operating at guaranteed efficiency on a quarterly, annual or cumulative basis (as specified in the applicable agreement). Remedies for underperformance may include (a) the payment of “buy-down” liquidated damages (subject to a cap), for underperformance in connection with the commencement of operations or during an initial performance period following commencement of operations; (b) payment of liquidated damages (subject to a cap) based upon the amount of excess natural gas consumed by the Energy Servers; (c) repair or replacement of the Energy Servers, or, if repair or replacement is not feasible, repurchase of such Energy Servers at a price equal to fair market value or the original purchase price, subject to adjustment for depreciation. As of December 31, 2018, we have incurred no obligations to make payments pursuant to these warranty commitments. Key Operating Metrics In addition to the measures presented in the consolidated financial statements, we use the following key operating metrics to evaluate business activity, to measure performance, to develop financial forecasts and to make strategic decisions: • Product accepted - the number of customer acceptances of our Energy Servers in any period. We recognize revenue when an acceptance is achieved. We use this metric to measure the volume of deployment activity. We measure each Energy Server manufactured, shipped and accepted in terms of 100 kilowatt equivalents. • Billings for product accepted in the period - the total contracted dollar amount of the product component of all Energy Servers that are accepted in a period. We use this metric to gauge the dollar value of the product acceptances and to evaluate the change in dollar amount of acceptances between periods. • Billings for installation on product accepted in the period - the total contracted dollar amount billable with respect to the installation component of all Energy Servers that are accepted. We use this metric to gauge the dollar value of the installations of our product acceptances and to evaluate the change in dollar value associated with the installation of our product acceptances between periods. • Billings for annual maintenance service agreements - the dollar amount billable for one-year service contracts that have been initiated or renewed. We use this metric to measure the cumulative billings for all service contracts in any given period. As our installation base grows, we expect our billings for annual maintenance service agreements to grow, as well. • Product costs of product accepted in the period (per kilowatt) - the average unit product cost for the Energy Servers that are accepted in a period. We use this metric to provide insight into the trajectory of product costs and, in particular, the effectiveness of cost reduction activities. • Period costs of manufacturing expenses not included in product costs - the manufacturing and related operating costs that are incurred to procure parts and manufacture Energy Servers that are not included as part of product costs. We use this metric to measure any costs incurred to run our manufacturing operations that are not capitalized (i.e., absorbed) into inventory and therefore, expensed to our consolidated statement of operations in the period that they are incurred. • Installation costs on product accepted (per kilowatt) - the average unit installation cost for Energy Servers that are accepted in a given period. This metric is used to provide insight into the trajectory of install costs and, in particular, to evaluate whether our installation costs are in line with our installation billings. Comparison of the Years Ended December 31, 2018 and 2017 Product accepted increased by approximately 187 systems, or 30.1%, for 2018 compared to 2017. Acceptance volume increased as we installed more systems from backlog as demand increased for our Bloom Energy servers, in addition to enhancing our ability and capacity to install more energy servers with our installation team. Billings for product accepted increased by approximately $210 million, or 84.7%, for 2018 compared to 2017. The increase was primarily due to three factors. First, product accepted increased by approximately 187 systems, or 30.1%, for 2018 compared to 2017. Second, ITC was reinstated on February 9, 2018. ITC was not available to the fuel cell industry in 2017, so our billings for product accepted for 2017 only included $1.3 million in benefit from ITC. Due to the reinstatement of ITC in 2018, billings for product accepted now includes the benefit of ITC. For 2018, billings for product accepted included $132.9 million in benefits from ITC, of which $45.1 million was retroactive ITC for 2017 acceptances. Third, the adoption of customer personalized applications, such as batteries and grid-independent solutions, increased in 2018 compared to 2017. Products that incorporate these personalized applications have, on average, a higher billings rate than our standard platform products that do not incorporate these personalized applications. Billings for installation on product accepted decreased $17.5 million for 2018, as compared to 2017. Although product acceptances in the period increased 30.1%, billings for installation on product accepted decreased due to the mix in installation billings driven by site complexity, size, customer purchase option and one large customer in particular in 2018 where the installation was performed by the customer and therefore, we did not have any installation billing for that customer. In general, when we do not perform the installation function for a customer, such as SK E&C in the Republic of Korea, we will not have any installation billings for those orders. When we analyze changes between the years ended 2018 and 2017, we take into account the impact of ITC that was available in 2018 as a result of the reinstatement of the ITC through December 2021. The effect of the reinstatement of ITC was higher billings in the periods eligible for ITC. For 2018, the combined total for billings for product and installation accepted was $537.2 million, an increase of 55.9% from the billings for product and installation accepted combined of $344.6 million for 2017. The increase was significantly greater than the 30.1% increase in associated acceptances during the same periods due to the reinstatement of the ITC benefit, including the one-time FY17 retroactive ITC benefit recognized in 2018 that is included in the 2018 billings numbers. Billings for annual maintenance service agreements increased $3.0 million for 2018 compared to 2017. This increase was driven by the incremental billings for new annual maintenance service agreement renewals as a result of our growing fleet of installed Energy Servers. Product costs of product accepted increased by approximately $80 per kilowatt, or 2.4%, for 2018 compared to 2017. This increase in cost is primarily related to the reinstatement of the ITC program in February 2018, in which we were required to repay certain suppliers for previously negotiated contractual discounts. This resulted in a one-time payment of $116 per kilowatt or $9.4 million, which was recorded to cost of product revenue. Period costs of manufacturing related expenses decreased by approximately $8.1 million, or 25.1%, for 2018 compared to 2017. Our period costs of manufacturing related expenses decreased primarily as a result of higher absorption of fixed manufacturing costs into product costs due to a larger volume of builds through our factory tied to our acceptance growth, which resulted in higher factory utilization. Installation costs on product accepted decreased by approximately $82 per kilowatt, or 6.5%, for 2018 compared to 2017. Each customer site is different and installation costs can vary due to a number of factors, including site complexity, size, location of gas, etc. As such, installation on a per kW basis can vary significantly from period-to-period. In addition, some customers do their own installation, or, as is the case for SK E&C in the Republic of Korea orders, we have a partner who performs the installation. In those instances, we have little to no installation cost. Comparison of the Years Ended December 31, 2017 and 2016 Product accepted decreased by approximately 65 systems, or 9.5%, for 2017 compared to 2016. The decline was driven by extreme weather-related seasonality on both the U.S. East Coast and West Coast, which impacted our ability to install Energy Servers at our customer sites. Billings for product accepted decreased by approximately $274.4 million, or 52.5%, for 2017 compared to 2016. The decrease was primarily due to two factors. First, product accepted decreased approximately 65 systems, or 9.5%, for 2017 compared to 2016. Second, the Federal Investment Tax Credit ("ITC") was not available to the fuel cell industry in 2017. Given that, our billings for product accepted did not include the benefit of the ITC in 2017. Our 2016 billings for product accepted included $159.8 million of ITC, whereas our 2017 billings from product accepted had $1.3 million associated with ITC. The ITC was subsequently reinstated on February 9, 2018. Billings for installation on product accepted decreased $18.2 million, or 15.9% for 2017, compared to 2016. Although product acceptances in the period decreased 9.5%, billings for installation on product accepted decreased due to the mix in installation billings driven by site complexity, size, customer purchase option and one large customer in particular in 2017 where the installation was performed by the customer and therefore, we did not have any installation billing for that customer. In general, when we do not perform the installation function for a customer, such as in SK E&C in the Republic of Korea, we do not have any installation billings for those orders. When we analyze changes between the years ended 2017 and 2016, we take into account the impact of ITC that was available in 2016. The effect of the loss of ITC in 2017 was lower billings in the period. For 2017, the combined total for billings for product and installation accepted was $344.6 million, a decrease of 45.9% from the billings for product and installation accepted combined of $637.2 million for 2016. The decrease was significantly greater than the 9.5% decrease in associated acceptances during the same periods due to the loss of ITC in 2017, which lowered billings for installations. Billings for annual maintenance service agreements increased $12.1 million for 2017 compared to 2016. This increase was driven by the billings for new annual maintenance service agreement renewals as a result of a growing fleet of installed Energy Servers. Product costs of product accepted decreased by approximately $1,165 per kilowatt, or 26.1%, for 2017 compared to 2016. The cost reduction was driven generally by our ongoing cost reduction efforts to reduce material costs, labor and overhead through improved automation of our manufacturing facilities, better facility utilization and ongoing material cost reduction programs with our vendors. Period costs of manufacturing related expenses increased by approximately $10.5 million, or 48.1%, for 2017 compared to 2016. Our period costs of manufacturing related expenses increased primarily as a result of lower absorption of fixed manufacturing costs into product costs due to a lower volume of builds through our factory. Installation costs on product accepted increased by approximately $37 per kilowatt, or 3.0%, for 2017 compared to 2016. Each customer site is different and installation costs can vary due to a number of factors, including site complexity, size, location of gas, etc. As such, installation on a per kW basis can vary significantly from period-to-period. In addition, some customers do their own installation, or, as is the case for Republic of Korea orders, we have a partner who performs the installation. In those instances, we have little to no installation cost. Results of Operations Revenue We primarily recognize revenue from the sale and installation of Energy Servers, by providing services under maintenance contracts, and from electricity sales by our PPA Entities. Product Revenue All of our product revenue is generated from the sale of our Energy Servers to direct purchase, Third-Party PPAs, traditional lease and managed services customers. We generally recognize product revenue from contracts with customers for the sales of our Energy Servers once we achieve acceptance; that is, generally when the system has been installed and is running at full power as defined in each contract. The amount of product revenue we recognize in a given period is materially dependent on the volume and size of installations of our Energy Servers and on the type of financing used by the customer. Installation Revenue All of our installation revenue is generated from the installation of our Energy Servers to direct purchase, traditional lease and managed services customers. The amount of installation revenue we recognize in a given period is materially dependent on the volume and size of installations of our Energy Servers in a given period, whether the customer chooses to do the installation themselves, and on the type of financing used by the customer. Service Revenue Service revenue is generated from operations and maintenance services agreements that extend the standard one-year warranty service coverage beyond the initial one-year coverage for Energy Servers sold under direct purchase, traditional lease and managed services sales. Customers of our purchase and lease programs can renew their operating and maintenance services agreements on an annual basis for the life of the contract at prices predetermined at the time of purchase of the Energy Server. We anticipate that almost all of our customers will continue to renew their operations and maintenance services agreements each year. Electricity Revenue Our PPA Entities purchase Energy Servers from us and sell the electricity produced by these systems to customers through long-term PPAs. Customers are required to purchase all of the electricity produced by the Energy Servers at agreed-upon rates over the course of the PPA’s term. We generally recognize revenue from such PPA Entities as the electricity is provided over the term of the agreement. Cost of Revenue Our total cost of revenue consists of cost of product revenue, cost of installation revenue, cost of service revenue and cost of electricity revenue. It includes personnel costs associated with our operations and global customer support organizations consisting of salaries, benefits, bonuses, stock-based compensation and allocated facilities costs. Cost of Product Revenue Cost of product revenue consists of costs of Energy Servers that we sell to direct, traditional lease and managed services customers, including costs of materials, personnel costs, allocated costs, shipping costs, provisions for excess and obsolete inventory and the depreciation costs of our equipment. Because the sale of our Energy Servers includes a standard one-year warranty, cost of product revenue also includes estimated first-year warranty costs. Warranty costs for customers that purchase under contracts where the revenue is recognized ratably are recognized as a cost of product revenue as they are incurred. We expect our cost of product revenue to increase in absolute dollars as we deliver and install more Energy Servers and our product revenue increases. Cost of Installation Revenue Cost of installation revenue consists of the costs to install the Energy Servers that we sell to direct, traditional lease and managed services customers, including costs of materials and service providers, personnel costs, and allocated costs. In both Japan and the Republic of Korea, the cost of the installations and resulting revenue is attributable to our channel partners. Notwithstanding the use of channel partners, for the next twelve months, we expect our cost of installation revenue to increase in absolute dollars as we deliver and install more Energy Servers, though it will be subject to variability as a result of the timing of installation and other factors. Cost of Service Revenue Cost of service revenue consists of costs incurred under maintenance service contracts for all customers including direct sales, traditional lease, managed services and PPA customers. Such costs include personnel costs for our customer support organization, allocated costs and extended maintenance-related product repair and replacement costs. We expect our cost of service revenue to increase in absolute dollars as our base of megawatts deployed grows, and we expect our cost of service revenue to fluctuate period by period depending on the timing of maintenance of Energy Servers. Cost of Electricity Revenue Cost of electricity revenue primarily consists of the depreciation of the cost of the Energy Servers owned by our PPA Entities and the cost of gas purchased in connection with PPAs entered into by our first PPA Entity. The cost of depreciation of the Energy Servers is reduced by the amortization of any U.S. Treasury grant payment in lieu of the energy investment tax credit associated with these systems. We expect our cost of electricity revenue to increase in absolute dollars as our base of megawatts deployed grows. Gross Profit (Loss) Gross profit (loss) has been and will continue to be affected by a variety of factors, including the sales price of our products, manufacturing costs, the costs to install the products, the costs to maintain the systems in the field, the mix of financing options used and the mix of revenue between product, service and electricity. We expect our gross profit to fluctuate over time depending on the factors described above. Operating Expenses Research and Development Research and development costs are expensed as incurred and consist primarily of personnel costs. Research and development expense also includes prototype related expenses and allocated facilities costs. We expect research and development expense to increase in absolute dollars as we continue to invest in our future products and services, and we expect our research and development expense to fluctuate as a percentage of total revenue. Sales and Marketing Sales and marketing expense consists primarily of personnel costs, including commissions. We expense commission costs as earned. Sales and marketing expense also includes costs for market development programs, promotional and other marketing costs, travel costs, office equipment and software, depreciation, professional services and allocated facilities costs. We expect sales and marketing expense to continue to increase in absolute dollars as we increase the size of our sales and marketing organizations and as we expand our international presence, and we expect our sales and marketing expense to fluctuate as a percentage of total revenue. General and Administrative General and administrative expense consists of personnel costs, fees for professional services and allocated facilities costs. General and administrative personnel include our executive, finance, human resources, information technology, facilities, business development and legal organizations. We expect general and administrative expense to increase in absolute dollars due to additional legal fees and costs associated with accounting, insurance, investor relations, SEC and stock exchange compliance and other costs associated with being a public company, and we expect our general and administrative expense to fluctuate as a percentage of total revenue. Stock-Based Compensation We measure and recognize compensation expense for all stock-based awards, including stock options and purchase rights issued to employees based on the estimated fair value of the awards on the grant date. We use the Black-Scholes-Merton ("Black-Scholes") option pricing model to estimate the fair value of stock options and 2018 ESPP purchase rights. The fair value of restricted stock units ("RSUs"), is measured using the fair value of our common stock on the date of the grant. The fair value of stock options is recognized as expense on a straight-line basis over the requisite service period, which is generally two years. The fair value of RSUs is recognized as expense on a straight-line basis over the requisite service period, which generally ranges from two to four years. For stock-based awards granted to employees with a performance condition, we recognize stock-based compensation expense using the accelerated attribution method over the requisite service period when management determines it is probable that the performance condition will be satisfied. The fair value of the 2018 ESPP purchase rights is recognized as expense on the vesting period of each offering period. Stock-based compensation expense is recorded net of estimated forfeitures such that expense is recorded only for those stock-based awards that are expected to vest. Stock-based compensation expense is recorded in the consolidated statements of operations based on the employees’ respective function. Interest Expense Interest expense primarily consists of interest charges associated with our secured line of credit, long-term debt facilities, financing obligations and capital lease obligations. Other Income (Expense), Net Other income (expense), net primarily consists of gains or losses associated with foreign currency fluctuations, net and of income earned on our cash and cash equivalents holdings in interest-bearing accounts. We have historically invested our cash in money-market funds. Gain (Loss) on Revaluation of Warrant Liabilities Warrants issued to investors and lenders that allow them to acquire our convertible preferred stock have been classified as liability instruments on our balance sheet. We record any changes in the fair value of these instruments between reporting dates as a separate line item in our statement of operations. Since the warrants issued were mandatorily convertible into common stock at the completion of our IPO, the liability related to these mandatorily converted warrants was reclassified to additional paid-in capital on the IPO date and total gains and losses for revaluation of warrant liabilities was recorded in the consolidated statement of operations. Provision for Income Taxes Provision for income taxes consists primarily of federal and state income taxes in the United States and income taxes in foreign jurisdictions in which we conduct business. We have provided a full valuation allowance on our U.S. deferred tax assets because we believe it is more likely than not that the deferred tax assets will not be realized. At December 31, 2018, we had federal and state net operating loss carryforwards of $1.7 billion and $1.5 billion, respectively, which will expire, if unused, beginning in 2022 and 2028, respectively. Net Income (Loss) Attributable to Noncontrolling Interests We allocate profits and losses to the noncontrolling interests under the hypothetical liquidation at book value ("HLBV") method. HLBV is a balance sheet-oriented approach for applying the equity method of accounting when there is a complex structure, such as our PPA entities. Net income (loss) attributable to noncontrolling interests is deducted from our net income (loss) in determining our net income (loss) attributable to common stockholders. Comparison of the Years Ended December 31, 2018 and 2017 Revenue Total Revenue Total revenue increased by approximately $366.0 million, or 97.4%, for 2018 compared to 2017. There were four principal drivers of this revenue increase. First, product acceptances increased by approximately 187 systems, or 30.1%, for 2018 compared to 2017. Second, we achieved a significantly higher mix of orders from customers where revenue is recognized on acceptance compared to orders where revenue is recognized over the term of the agreement. In 2018, we recognized 100.0% of our orders at acceptance whereas only 79.0% of total acceptances in 2017 were recognized at acceptance. Third, the Federal Investment Tax Credit (ITC) was reinstated on February 9, 2018. ITC was not available to the fuel cell industry in 2017, however, our revenue in 2018 includes the benefit of the reinstatement. The total revenue for 2018 included $171.1 million of benefit from ITC whereas the total revenue for 2017 included $9.6 million of benefit, thus an increase in benefit to revenue from ITC of $161.5 million compared to the same period in 2017. The $171.1 million benefit of ITC in 2018 included $45.5 million benefit of the retroactive ITC for 2017 acceptances and in that sense was benefited by a one-time “catch-up” (including the 2017 benefit). Lastly, the adoption of customer personalized applications, such as batteries and grid-independent solutions, increased in 2018 compared to 2017. Customer orders that include these personalized applications generated, on average, higher revenue than our standard orders that do not include these personalized applications. Product and installation revenue combined increased by approximately $360.7 million, or 148.5%, to $603.7 million for 2018 from $243.0 million for 2017. Depending on the customer purchase option elected by our customers, the product, installation and electricity revenue for that contract will either be recognized up front at acceptance or ratably over the life of the contract. The ratable portion of the product and installation revenue increased approximately $0.2 million to $25.2 million for 2018 from $25.0 million for 2017. This immaterial increase was due to acceptances on orders during 2017 where revenue is recognized over the term of the agreement. The upfront portion of the product and install revenue increased approximately $360.5 million to $578.5 million for 2018 from $218.0 million for 2017. This increase in upfront product and install revenue was primarily due to the increase in upfront acceptances to 809 in 2018 from 489 in 2017. The upfront product and install average selling price increased to $7,155 per kilowatt for 2018, from $4,460 per kilowatt for 2017, primarily driven by the reinstatement of the ITC benefit, including the one-time FY17 retroactive ITC benefit recognized in 2018, and the increased sales of customer personalized applications. Product Revenue Product revenue increased by approximately $332.6 million, or 185.0%, for 2018 compared to 2017. This increase was driven by the increase in acceptances, higher mix of orders where revenue is recognized on acceptance, the ITC reinstatement, and an increase in the sales of customer personalized applications. Installation Revenue Installation revenue increased by approximately $28.2 million, or 44.6%, from $63.2 million for 2017 to $91.4 million for 2018. This increase was driven by the increase in acceptances, higher mix of orders where revenue is recognized on acceptance, and increase in the sales of customer personalized applications, partially offset by the lower installation revenue associated with one large customer in 2018 where the installation was performed by the customer and as a result, we did not have any installation revenue for that customer. In general, when a customer or, in the case of SK E&C in the Republic of Korea, a partner performs the installation service, we do not generate revenue for the installation. Service Revenue Service revenue increased by approximately $5.5 million, or 7.1% for 2018 compared to 2017. This was primarily due to the increase in the number of annual maintenance contract renewals driven by our growing fleet of installed Energy Servers. Electricity Revenue Electricity revenue decreased by approximately $0.2 million, or 0.3%, for 2018 compared to 2017, due to a normal fluctuation in energy produced by the PPA entities' Energy Servers. Cost of Revenue Total Cost of Revenue Total cost of revenue increased by approximately $230.9 million, or 58.6%, for 2018 compared to 2017. Included as a component of total cost of revenue, stock-based compensation increased approximately $33.7 million for 2018 compared to 2017. Total cost of revenue, excluding stock-based compensation, increased approximately $197.2 million, or 51.0%, to $583.5 million for 2018 compared to $386.3 million for 2017. This increase in total cost of revenue was primarily attributable to higher product and install cost of revenue which was driven by an increase in the volume of product acceptances and a higher mix of orders with customers in which cost of revenue is recognized on acceptance, instead of ratably over the life of the agreement. Additionally there was an increase in the sales of customer personalized applications for 2018. These applications generally have a cost associated with them and therefore cause an increase in the cost of revenue. Combined product and installation cost of revenue increased approximately $223.4 million, or 82.5%, to $494.1 million for 2018, from $270.7 million for 2017. The ratable portion of the product and installation cost of revenue increased by approximately $1.6 million to $18.2 million for 2018 from $16.6 million in 2017. This increase was due to the increase in ratable acceptances through 2017 whose contract was started at various times throughout the year and therefore only recognized for a portion of the year, which would now have a full year of product and installation costs recognized in 2018. Product and installation stock-based expense increased approximately $30.2 million to $31.4 million for 2018 from $6.2 million for 2017. The remaining upfront portion of the product and installation cost of revenue, excluding stock based compensation, increased approximately $191.5 million to $438.6 million for 2018 from $247.1 million for 2017. This increase in upfront product and installation cost of revenue was primarily due to the increase in upfront acceptances to 809 in 2018 from 489 in 2017. The upfront product and installation average cost of revenue on a per kilowatt basis, also described as total install system cost ("TISC") increased to $5,425 per kilowatt for 2018 from $5,056 per kilowatt for 2017. The increase was primarily driven by the increase in the sales of customer personalized applications which have a higher per unit cost and the one-time cost associated with the reinstatement of ITC in 2018. Cost of Product Revenue Cost of product revenue increased by approximately $163.8 million, or 77.7%, for 2018 compared to 2017. This increase was driven by the increase in acceptances, higher mix of orders where cost of revenue is recognized on acceptance, increased costs from the sales of customer personalized applications, and an increase in stock-based compensation. Additionally, as a result of the reinstatement of the ITC program in February 2018, we were required to repay certain suppliers for previously negotiated contractual discounts. This one-time payment of $9.4 million was recorded to cost of product revenue. Cost of Installation Revenue Cost of installation revenue increased by approximately $59.5 million, or 99.4%, for 2018 compared to 2017. This increase was driven by the increase in acceptances, higher mix of orders where cost of revenue is recognized on acceptance, and increased costs from the sales of customer personalized applications where the installation is more complex, partially offset by the lower cost of installation associated with one large customer in 2018 where the installation was performed by the customer and as a result, we did not have any installation cost for that customer. In general, when we do not perform the installation function for a customer, such as in SK E&C in the Republic of Korea, we do not incur any installation costs on those orders. Cost of Service Revenue Cost of service revenue increased by approximately $11.0 million, or 13.2%, for 2018 compared to 2017. This increase in service cost was primarily due to more power module replacements required in the fleet as a result of a larger fleet of installed Energy Servers, as well as replacing older generation power modules during the normal service process. Cost of Electricity Revenue Cost of electricity revenue decreased by approximately $3.5 million, or 8.7%, for 2018 compared to 2017, mainly due to a gain recorded as a result of the fair value adjustment on our natural gas fixed price forward contract. Gross Profit (Loss) Total Gross Profit Gross profit improved $135.1 million, in 2018 compared to 2017. This improvement was generally as a result of higher product margins due to the increase in product acceptances which drove higher volume, a higher mix of orders recognized at acceptance versus ratably over the life of the agreement, and the reinstatement of the ITC. Product Gross Profit Product gross profit increased $168.7 million in 2018 compared to 2017. This increase was due to the increase in product acceptances which drove higher volume, a higher mix of orders recognized at acceptance versus ratably over the life of the Bloom Electrons' or managed service contracts and the reinstatement of the ITC. Installation Gross Loss Installation gross loss increased $31.4 million in 2018 compared to 2017. This increase in loss was due to higher installation costs associated with the initial installations for the new customer personalized applications. Our installation costs are driven by the complexity of each site at which we are installing an Energy Server, including personalized applications, as well as the size of each installation, which can cause variability in installation costs from year-to-year. Service Gross Loss Service gross loss increased $5.6 million in 2018 compared to 2017. This decrease was primarily due to more power module replacements required in the fleet as a result of a larger fleet of installed Energy Servers, as well as replacing older power modules during the normal service process. Electricity Gross Profit Electricity gross profit increased $3.3 million, or 20.1% in 2018 compared to 2017 mainly due to a gain recorded as a result of the fair value adjustment on a natural gas fixed price forward contract. Operating Expenses Total Operating Expenses Total operating expenses increased $131.7 million, or 94.6%, in 2018 compared to 2017. Included as a component of total operating expenses, stock-based compensation expenses increased approximately $116.1 million for 2018 compared to 2017, accounting for much of the year-over-year increase. The increase in stock-based compensation is primarily attributable to a one-time employee grant of restricted stock units (RSUs) at the time of our IPO, and that have a 2-year vesting period. These RSUs provided us with a market equity employee retention vehicle to help us compete for talent across our peer group. Additionally, the stock-based compensation included some previously granted RSUs that vested upon the completion of our IPO. Total operating expenses, excluding stock-based compensation, increased approximately $15.6 million, or 13.4%, in 2018 compared to 2017. This increase was primarily due to compensation related expenses associated with hiring new employees, investments for next generation servers and customer personalized application technology development, and expenses related to our efforts to increase demand and raise market awareness of our Energy Server solutions, as well as to drive new customer financing partners. Research and Development Research and development expenses increased by approximately $38.0 million, or 74.3%, in 2018 compared to 2017. Included as a component of research and development expenses, stock-based compensation expenses increased by approximately $33.5 million for 2018 compared to 2017. The majority of this increase was due to stock-based compensation expenses related to the RSU grants made at the time of our IPO. Total research and development expenses, excluding stock-based compensation, increased by approximately $4.5 million, or 9.9%, for 2018 compared to 2017. This increase was primarily due to compensation-related expenses related to hiring new employees and investments made for customer personalized applications, such as a battery solution, sustaining engineering projects for the current Energy Server platform and investments made for our next generation technology development. Sales and Marketing Sales and marketing expenses increased by approximately $30.6 million, or 94.3%, in 2018 compared to 2017. Included as a component of sales and marketing expenses, stock-based compensation expenses increased by approximately $27.6 million for 2018 compared to 2017. The majority of this increase was due to stock-based compensation expenses related to the RSU grants made at the time of our IPO. Total sales and marketing expenses, excluding stock-based compensation, increased by approximately $3.0 million, or 10.7%, for 2018 compared to 2017. This increase was primarily due to compensation expenses related to hiring new employees and expenses related to efforts to increase demand and raise market awareness of our Energy Server solutions, expanding outbound communications, as well as efforts to attract new customer financing partners. General and Administrative General and administrative expenses increased by approximately $63.1 million, or 113.4%, in 2018 compared to 2017. Included as a component of general and administrative expenses, stock-based compensation expenses increased by approximately $55.0 million for 2018 compared to 2017. The majority of this increase was due to stock-based compensation expenses related to the RSU grants made at the time of our IPO. Total general and administrative expenses, excluding stock-based compensation, increased by approximately $8.2 million, or 18.9%, for 2018 compared to 2017. The increase in general and administrative expenses was due to an increase in compensation related expenses associated with hiring new employees to support public company readiness across accounting and legal functions, expenses related to becoming a public company and information technology related expenses for infrastructure and security support. Stock-Based Compensation Total stock-based compensation increased $149.8 million, or 491.5%, in 2018 compared to 2017. Of the $180.3 million in stock based compensation for 2018, approximately $139.1 million was related to one-time employee grant of RSUs that were issued at the time of our IPO and that have a 2-year vesting period. These RSUs provided us with a market equity employee retention vehicle necessary to compete for talent across our peer group. In addition, the stock-based compensation included some previously granted RSUs that vested upon completion of our IPO. Other Income and Expense Total Other Expense Total other expense decreased $19.3 million in 2018 compared to 2017. This decrease was primarily due to the decrease in interest expense following the conversion of a portion of our debt into equity at the time of the IPO. Interest Income Interest income increased $3.6 million in 2018 compared to 2017. This increase was primarily due to the increase in interest on the short term investment balances which increased from proceeds from the IPO. Interest Expense Interest expense decreased $19.4 million in 2018 compared to 2017. This decrease was primarily due to lower amortization expense of our debt derivatives and due to the conversion of a portion of our debt into equity at the time of the IPO. Interest Expense, Related Parties Interest expense, related parties decreased $3.4 million due to the conversion of $40.1 million of our 8% Notes from related parties into equity at the time of the IPO. Other Income (Expense), net Other expense increased $27.4 million in 2018 compared to 2017. This change was primarily due to an increase in interest income, partially offset by foreign currency translation. Revaluation of Warrant Liabilities and Embedded Derivatives For 2018, the loss on revaluation of warrant liabilities and embedded derivatives increased $6.6 million when compared to 2017. This was due to an increase in our derivative valuation adjustment of $13.7 million and offset by the gain recognized from the revaluation of the preferred warrant liability of $6.6 million, which was driven by our valuation at the date of the IPO. Our convertible preferred stock warrants were converted into common stock warrants upon the completion of the IPO. At that time, the convertible preferred stock warrant liability was reclassified to additional paid-in capital. Upon the IPO, the final valuation of the embedded derivatives related to the 6% Notes was reclassified from a derivative liability to additional paid-in capital. Provision for Income Taxes Income tax provision increased in 2018 compared to 2017 and was primarily due to fluctuations in the effective tax rates on income earned by international entities. Net Loss Attributable to Noncontrolling Interests and Redeemable Noncontrolling Interests Total loss attributable to noncontrolling interests decreased $0.9 million, or 5.0%, in 2018 compared to 2017. The net loss decreased due to the allocation of the Company's lower net loss using HLBV allocation methodology. Comparison of the Years Ended December 31, 2017 and 2016 Revenue Total Revenue Total revenue increased by approximately $167.5 million, or 80.3%, for 2017 compared to 2016. Revenue across all product lines increased year-over-year, driving the increase in total revenue despite the loss of the Federal Investment Tax Credit ("ITC") benefit, which was not available to the fuel cell industry in 2017. The total revenue for the year ended December 31, 2016 included $35.9 million of benefit from ITC, while the total revenue for the year ended December 31, 2017 included $9.6 million of benefit from ITC, driven by the loss of the ITC in 2017. Product and install revenue combined increased by approximately $149.9 million, or 161.1% from $93.1 million for the year ended December 31, 2016, to $243.0 million for the year ended December 31, 2017. The ratable portion of the product and install revenue increased approximately $15.9 million from $9.1 million in 2016 to $25.0 million in 2017. This increase was due to the increase in ratable acceptances through 2017. The upfront portion of the product and install revenue increased by approximately $134.0 million from $84.0 million in 2016 to $218.0 million in 2017. This increase in upfront product and install revenue was primarily due to the increase in upfront acceptances from 109 in 2016 to 489 in 2017. The upfront product and install average selling price decreased from $7,705 per kilowatt in 2016 to $4,460 per kilowatt in 2017 due to the loss of ITC in 2017. Product Revenue Product revenue increased by approximately $103.3 million, or 135.1%, for 2017 compared to 2016. Despite a decrease in acceptances from 687 systems in 2016 to 622 systems in 2017, revenue increased due to a significantly higher mix of orders through direct sales to customers, where revenue is recognized upfront at the time of acceptance, compared to orders where revenue is recognized over the term of the agreement (generally 10 to 21 years). In 2016, 109 acceptances or 16% of total acceptances of 687 was recognized upfront at the time of the acceptance, while in 2017, 489 acceptances, or 79% of total acceptances of 622 was recognized upfront at the time of acceptance. A higher mix of upfront revenue recognition drove the increase in revenue. Installation Revenue Installation revenue increased by approximately $46.6 million, or 281.2%, from $16.6 million for 2016 to $63.2 million for 2017. Similar to product revenue, despite a decrease in acceptances from 687 systems in 2016 to 622 systems in 2017 and the loss of ITC, this increase was driven by the higher mix of orders through our direct purchase programs, where revenue is recognized upfront at acceptance instead of ratably over the life of the contract. Service Revenue Service revenue increased by approximately $9.3 million, or 13.7% for 2017 compared to 2016. This was primarily due to the increase in the number of annual maintenance contract renewals driven by our expanding customer base and growing fleet of installed Energy Servers. Electricity Revenue Electricity revenue increased by approximately $8.2 million, or 17.2%, for 2017 compared to 2016, due to an increase in energy produced by the PPA entities' Energy Servers. Cost of Revenue Total Cost of Revenue Total cost of revenue increased by approximately $82.0 million, or 26.3%, for 2017 compared to 2016. Included as a component of total cost of revenue, stock-based compensation increased approximately $1.7 million for 2017 compared to 2016. Total cost of revenue, excluding stock-based compensation, increased approximately $80.3 million, or 26.2%, to $386.3 million for 2017 compared to $306.0 million for 2016. This increase in total cost of revenue was primarily attributable to higher product and install cost of revenue which was driven by a higher mix of orders with customers in which cost of revenue is recognized on acceptance. The product and install cost of revenue increased by approximately $149.7 million, or 123.7% from $121.0 million for the year ended December 31, 2016, to $270.7 million for the year ended December 31, 2017. The ratable portion of the product and install cost of revenue increased approximately $11.4 million from $5.2 million in 2016 to $16.6 million in 2017. This increase was due to the increase in ratable acceptances through 2017. The product and install cost of revenue includes stock based compensation which also increased by $1.6 million from $5.4 million for the year ended December 31, 2016, to $7.0 million for the year ended December 31, 2017. The remaining upfront portion of the product and install cost of revenue excluding stock based compensation increased approximately $136.7 million from $110.4 million in 2016 to $247.1 million in 2017. This increase in upfront product and install cost of revenue was due to the increase in upfront acceptances from 109 in 2016 to 489 in 2017. The upfront product and install average cost of revenue on a per kilowatt basis, also described as total install system cost ("TISC") decreased from $10,127 per kilowatt in 2016 to $5,056 per kilowatt in 2017 due to the increase in upfront acceptances. Cost of Product Revenue Cost of product revenue increased by approximately $107.5 million, or 104.1%, for 2017 compared to 2016. This increase was driven by a higher mix of orders where cost of revenue is recognized on acceptance, partially offset by our ongoing cost reduction efforts. Cost of Installation Revenue Cost of installation revenue increased by approximately $42.2 million, or 238.1%, for 2017 compared to 2016. This increase was driven by the higher mix of orders where cost of revenue is recognized on acceptance. Cost of Service Revenue Cost of service revenue decreased by approximately $71.4 million, or 46.1%, for 2017 compared to 2016. This improvement was associated with ongoing operations and maintenance of deployed Energy Servers in the ordinary course of business due to a lower number of power module replacements as the life of our product continues to lengthen. Cost of Electricity Revenue Cost of electricity revenue increased by approximately $3.8 million, or 10.4%, for 2017 compared to 2016, mainly due to a gain recorded as a result of the fair value adjustment on our natural gas fixed price forward contract. Gross Profit (Loss) Total Gross Profit (Loss) Gross loss improved $135.1 million, in 2017 compared to 2016. This improvement was generally driven by improvement in the service loss. Product Gross Loss Product gross loss increased $4.2 million in 2017 compared to 2016. This increase was due to the loss of ITC in 2017, partially offset by higher profit from a higher mix of orders recognized at acceptance. Installation Gross Profit Installation gross profit increased $4.4 million in 2017 compared to 2016. Our installation costs are driven by the complexity of each site at which we are installing an Energy Server, including personalized applications, as well as the size of each installation, which can cause variability in installation profit from year-to-year. Service Gross Loss Service gross loss decreased $80.7 million in 2017 compared to 2016. This decrease was primarily due to a lower number of required power module replacements as a result of the longer lives of our Energy Servers. Electricity Gross Profit Electricity gross profit increased $4.5 million, or 37.8%, in 2017 compared to 2016 due to normal fluctuations in system performance offset by a gain recorded as a result of the fair value adjustment on our natural gas fixed price forward contract. Operating Expenses Total Operating Expenses Total operating expenses increased $1.7 million, or 1.3%, in 2017 compared to 2016. Included as a component of total operating expenses, stock-based compensation expenses increased approximately $0.6 million for 2017 compared to 2016. Total operating expenses, excluding stock-based compensation, increased approximately $1.1 million, or 1.0%, for 2017 compared to 2016. This increase was primarily due to compensation related expenses related to hiring new employees, investments for next generation technology development, and expenses related to expanding the market and driving new customer financing partners. Research and Development Research and development expenses increased by approximately $4.3 million, or 9.2%, in 2017 compared to 2016. Included as a component of research and development expenses, stock-based compensation expenses increased approximately $0.9 million for 2017 compared to 2016. Total research and development expenses, excluding stock-based compensation, increased approximately $3.4 million, or 8.1%, for 2017 compared to 2016. This increase was primarily due to compensation-related expenses related to hiring new employees and investments in next generation technology development. Sales and Marketing Sales and marketing expenses increased by approximately $3.3 million, or 11.4%, in 2017 compared to 2016. Included as a component of sales and marketing expenses, stock-based compensation expenses decreased approximately $0.9 million for 2017 compared to 2016. Total sales and marketing expenses, excluding stock-based compensation, increased approximately $4.2 million, or 18.0%, for 2017 compared to 2016. This increase was primarily due to compensation expenses related to hiring new employees and expenses related to expanding the market and driving new customer financing partners. General and Administrative General and administrative expenses decreased by approximately $5.9 million, or 9.5%, in 2017 compared to 2016. Included as a component of general and administrative expenses, stock-based compensation expenses increased by approximately $0.6 million for 2017 compared to 2016. Total general and administrative expenses, excluding stock-based compensation, decreased approximately $6.5 million, or 13.1%, for 2017 compared to 2016. The decrease in general and administrative expenses was primarily due to a decrease in professional service expenses of $5.8 million as a result of decreased legal expenses associated with closing costs incurred related to our traditional PPAs in the prior year, as compared to no closing costs in 2017. Stock-Based Compensation Total stock-based compensation increased $2.3 million, or 8.2%, in 2017 compared to 2016. Other Income and Expense Total Other Expense Total other expense increased $28.7 million in 2017 compared to 2016. This increase was primarily due to the increase in interest expense. Interest Income Interest income increased $0.4 million in 2017 compared to 2016. This increase was primarily due to higher cash balances in 2017. Interest Expense and Interest Expense to Related Parties Interest expense and interest expense to related parties increased $27.4 million in 2017 compared to 2016. This increase was primarily due to higher balances of financing obligations and outstanding debt in 2017, compared to the prior year. Other Income (Expense) Other expense decreased $0.3 in 2017 compared to 2016. This change was primarily due to a decrease in the impact of foreign currency translation. Revaluation of Warrant Liabilities and Embedded Derivatives For 2017, the loss on revaluation of warrant liabilities and embedded derivatives increased $2.0 million when compared to 2016. This was primarily due to an increase in our derivative valuation adjustment of $13.4 million, offset by a decrease in our warrant valuation of $11.4 million. Provision for Income Taxes Income tax provision decreased in 2017 compared to 2016 and was primarily due to fluctuations in the effective tax rates on income earned by international entities. Net Loss Attributable to Noncontrolling Interests and Redeemable Noncontrolling Interests Total loss attributable to noncontrolling interests decreased $38.0 million, or 67.1%, in 2017 compared to 2016. The net loss decreased due to the allocation of the Company's lower net loss using HLBV allocation methodology. Liquidity and Capital Resources As of December 31, 2018, we had an accumulated deficit of approximately $2.6 billion. We have financed our operations, including the costs of acquisition and installation of Energy Servers, mainly through a variety of financing arrangements and PPA Entities, credit facilities from banks, sales of our preferred and common stock, debt financings and cash generated from our operations. As of December 31, 2018, we had $400.5 million of total outstanding debt and other long term liabilities. See Note 6 - Outstanding Loans and Security Agreements for a complete description of our outstanding debt. As of December 31, 2018 and December 31, 2017, we had cash and cash equivalents and short-term investments of $325.1 million and $130.6 million, respectively. We believe that our existing cash and cash equivalents and short-term investments will be sufficient to meet our operating cash flow, capital requirements and other cash flow needs for at least the next 12 months. Our future capital requirements may vary materially from those currently planned and will depend on many factors, including our rate of revenue growth, the timing and extent of spending on research and development efforts and other business initiatives, the rate of growth in the volume of system builds, the expansion of sales and marketing activities, market acceptance of our products, the timing of receipt by us of distributions from our PPA Entities and overall economic conditions. We do not expect to receive significant cash distributions from our PPA Entities. To the extent that current and anticipated future sources of liquidity are insufficient to fund our future business activities and requirements, we may be required to seek additional debt or equity financing. In July 2018, we successfully completed an IPO with the sale of 20,700,000 shares of our Class A common stock at a price of $15.00 per share, resulting in cash proceeds of $282.3 million, net of underwriting discounts, commissions and estimated offering costs. We intend to use the net proceeds from this offering for general corporate purposes including research and development and sales and marketing activities, general and administrative matters and capital expenditures. Cash Flows - Years Ended December 31, 2018 and 2017 Overview A summary of our sources and uses of cash, cash equivalents and restricted cash for the Company for December 31, 2018 and 2017 is as follows (in thousands): In 2018, we generated cash of $99.9 million and in 2017, we used cash of $37.3 million. In 2018, cash used in operating activities decreased by $8.8 million to cash used in operating activities of $58.4 million in 2018 from cash used in operating activities of $67.2 million in 2017. The improvement in cash used in operating activities for 2018 was due to an increase of 187 acceptances over the period relative to the same period in 2017, as well as the reinstatement of the ITC. In 2018, cash used in investing activities increased by $62.9 million to cash used of $94.8 million in 2018 from cash used in operating activities of $31.9 million in 2017. In 2018, cash provided by financing activities increased by $191.3 million to cash provided of $253.1 million in 2018 from cash provided of $61.8 million in 2017. Net cash provided by our variable interest entities (the PPA Entities) which are incorporated into the consolidated statement of cash flows for December 31, 2018 and 2017, is as follows (in thousands): Operating Activities In 2018, we used approximately $58.4 million of cash in operating activities. This use of cash resulted primarily from a net operating loss of $259.5 million, which included net non-cash charges of $269.7 million. Non-cash items include depreciation of approximately $43.5 million, a revaluation of derivative contracts of $28.5 million, stock-based compensation of $180.3 million and amortization of debt discount of $20.5 million, partially offset by a revaluation of preferred stock warrants of $9.1 million. Cash used in operating activities consisted primarily of an increase in inventory of $42.2 million, an increase in accounts receivable of $54.6 million, a decrease in deferred revenue and customer deposits of approximately $92.0 million relating to upfront milestone payments received from customers and an increase in prepaid expenses and other current assets of $7.1 million, partially offset by a decrease in deferred cost of revenue of $88.3 million, an increase in accounts payable of $18.3 million, a decrease in other current liabilities of $6.8 million and an increase in other long-term liabilities of $18.2 million. In 2017, we used approximately $67.2 million in operating activities. This use of cash resulted primarily from a net operating loss of $281.3 million, which included net non-cash charges of $135.7 million. Non-cash items include depreciation of approximately $46.1 million, a revaluation of derivative contracts of $14.8 million, stock-based compensation of $30.5 million and amortization of debt discount of $43.0 million. Cash used in operating activities consisted primarily of an increase in deferred cost of revenue of $71.0 million, an increase in inventory of $7.1 million, and an increase in prepaid expenses and other current assets of $2.2 million, partially offset by an increase in accounts payable of $7.1 million, a decrease in accounts receivable of $4.8 million, an increase in other long term liabilities of $43.2 million, an increase of accrued and other current liabilities of $8.6 million and an increase in deferred revenue and customer deposits of $91.9 million relating to upfront milestone payments received from customers. Net cash used in operating activities decreased $8.8 million for 2018 when compared to 2017. This decrease was primarily the result of a decrease in our net loss of $21.8 million. Other activities providing cash flow improvements were a decrease in deferred cost of revenue of $88.3 million compared to the prior year's increase of $71.0 million and an increase in accounts payable of $18.3 million compared to an increase of $7.1 million in the prior year. Activities which partially offset the decrease of cash used in operating activities were an increase in inventory for 2018 of $42.2 million compared to the prior year's minimal increase, an increase in accounts receivable of $54.6 million compared to the prior year's decrease of $4.8 million and also from a decrease in deferred revenue and customer deposits of $92.0 million in the current year compared to an increase of $91.9 million of those accounts in the prior year. Investing Activities Our investing activities consist primarily of capital expenditures, which include our expenditures to maintain or increase the scope of our manufacturing operations. These capital expenditures also include leasehold improvements to our office space, purchases of office equipment, IT infrastructure equipment and furniture and fixtures. In 2018, we used approximately $94.8 million in cash from investing activities. This is primarily the result of cash used in investment account activities of $76.9 million (net) and $14.7 million used for the purchase of fixed assets. In 2017, we used approximately $31.9 million in cash from investing activities. This is primarily the result of cash used for the acquisition of investments of $26.8 million (net) and $5.1 million used for the purchase of fixed assets. Net cash used in investing activities increased (worsened) by $59.6 million for 2018 when compared to 2017. The change is primarily due to the investment of cash proceeds received from our IPO in 2018 in marketable securities. Our use of cash in 2018 for the purchase of property, plant and equipment increased when compared to the same period in 2017 as we scaled investment in our next generation technology and infrastructure. Financing Activities In 2018, we had $253.1 million of net cash provided by financing activities. This cash resulted primarily from the completion of our IPO in July 2018, which resulted in net proceeds of $287.0 million, partially offset by distributions paid to our PPA Equity Investors of $15.3 million and repayments of $20.2 million of long-term debt. In 2017, we had $61.8 million provided by financing activities. We had net proceeds of $93.9 million from the issuance of debt and proceeds from noncontrolling interests of $13.7 million, offset by distributions paid to our PPA Equity Investors of $23.7 million and repayments of $21.4 million of long-term debt. Net cash provided by financing activities increased $191.3 million for 2018 when compared to 2017, primarily as a result of our IPO in July 2018. Comparison of the Years Ended December 31, 2017 and 2016 Overview A summary of the sources and uses of our cash, cash equivalents and restricted cash for the years ended December 31, 2017 and 2016 is as follows (in thousands): In 2017, we used cash of $37.3 million. In 2016, we used cash of $8.4 million. In 2017, cash used in operating activities decreased (improved) $215.7 million to cash used of $67.2 million from cash used of $282.8 million in 2016. The improvement in cash used by operating activities for 2017 was due to a decrease in cash used for customer financing receivable. In 2017, cash used in investing activities increased (worsened) $23.0 million to cash used of $31.9 million from cash used of $9.0 million in 2016. In 2017, cash provided by financing activities decreased $221.6 million to cash provided of $61.8 million from cash provided of $283.4 million in 2016. Net cash provided by our variable interest entities (the PPA Entities) which are incorporated into the consolidated statement of cash flows for December 31, 2018 and 2016 is as follows (in thousands): Operating Activities In 2017, we used approximately $67.2 million of cash in operating activities. This use of cash resulted primarily from a net operating loss of $281.3 million, which included net non-cash charges of $135.7 million. Non-cash items include depreciation of approximately $46.1 million, a revaluation of derivative contracts of $14.8 million, stock-based compensation of $30.5 million and amortization of debt discount of $43.0 million. Cash used in operating activities consisted primarily of an increase in deferred cost of revenue of $71.0 million, an increase in inventory of $7.1 million, and an increase in prepaid expenses and other current assets of $2.2 million, partially offset by an increase in accounts payable of $7.1 million, a decrease in accounts receivable of $4.8 million, an increase in other long term liabilities of $43.2 million, an increase of accrued and other current liabilities of $8.6 million and an increase in deferred revenue and customer deposits of approximately $91.9 million relating to upfront milestone payments received from customers. In 2016, we used approximately $282.8 million of cash in operating activities. This use of cash resulted primarily from a net operating loss of $336.3 million, which included net non-cash charges of $116.8 million. Non-cash items include depreciation of approximately $43.1 million, a revaluation of derivative contracts of $1.3 million, stock-based compensation of $28.2 million and amortization of debt discount of $28.9 million. Cash used in operating activities consisted primarily of an increase in customer financing receivable of $211.7 million, an increase in deferred cost of revenue of $84.7 million, an increase in accounts receivable of $0.7 million, and an increase in prepaid expenses and other current assets of $8.4 million, partially offset by an increase in deferred revenue and customer deposits of approximately $183.6 million relating to upfront milestone payments received from customers, an increase in accounts payable of $4.8 million, an increase in other current liabilities of $11.3 million and an increase in other long-term liabilities of $46.8 million. Net cash used in operating activities decreased (improved) $215.7 million for 2017 when compared to 2016. This was primarily the result of an improvement in our net loss of $281.3 million. Investing Activities In 2017, we used approximately $31.9 million in cash from investing activities. This is primarily the result of cash used for the acquisition of investments of $26.8 million (net) and $5.1 million used for the purchase of fixed assets. In 2016, we used approximately $9.0 million in cash from investing activities attributable to $9.0 million used for the purchase of fixed assets. Net cash used in investing activities increased (worsened) $23.0 million for 2017 when compared to 2016. The change is primarily due to investment account activity in 2017. Our use of cash in 2017 for the purchase of property, plant and equipment did not change significantly when compared to the same period in 2016. Financing Activities In 2017, we had $61.8 million provided by financing activities. We had net proceeds of $93.9 million from the issuance of debt and proceeds from noncontrolling interests of $13.7 million, offset by distributions paid to our PPA Equity Investors of approximately $23.7 million and repayments of $21.4 million of long-term debt. In 2016, we had $283.4 million provided by financing activities. We had net proceeds of approximately $148.3 million from the issuance of debt and proceeds from noncontrolling interests of $209.9 million, offset by distributions paid to our PPA Equity Investors of approximately $45.8 million, repayments of $33.2 million of long-term debt. Net cash provided by financing activities decreased $221.6 million for 2017 when compared to 2016, primarily as a result of the decrease in amounts received from noncontrolling and redeemable noncontrolling interests in the same twelve month period in 2016. Outstanding Loans and Security Agreements The following is a summary of our debt as of December 31, 2018 (in thousands): Recourse debt refers to debt that Bloom Energy Corporation has an obligation to pay. Non-recourse debt refers to debt that is recourse to only specified assets or subsidiaries of the Company. The differences between the unpaid principal balances and the net carrying values are due to debt discounts and deferred financing costs. We were in compliance with all of our financial covenants as of December 31, 2018 and 2017. Recourse Debt Facilities LIBOR + 4% Term Loan due November 2020 - In May 2013, we entered into a $5.0 million credit agreement and a $12.0 million financing agreement to help fund the building of a new facility in Newark, Delaware. The $5.0 million credit agreement expired in December 2016. The $12.0 million financing agreement has a term of 90 months, payable monthly at a variable rate equal to one-month LIBOR plus the applicable margin. The weighted average interest rate as of December 31, 2018 and 2017 was 5.9% and 5.1%, respectively. The loan requires monthly payments and is secured by the manufacturing facility. In addition, the credit agreements also include a cross-default provision which provides that the remaining balance of borrowings under the agreements will be due and payable immediately if a lien is placed on the Newark facility in the event we default on any indebtedness in excess of $100,000 individually or $300,000 in the aggregate. Under the terms of these credit agreements, we are required to comply with various restrictive covenants. As of December 31, 2018 and 2017, the debt outstanding was $3.3 million and $4.9 million, respectively. 5% Convertible Promissory Notes due 2020 (Originally 8% Convertible Promissory Notes due December 2018) - Between December 2014 and June 2016, we issued $193.2 million of three-year convertible promissory notes ("8% Notes") to certain investors. The 8% Notes had a fixed interest rate of 8% compounded monthly, due at maturity or at the election of the investor with accrued interest due in December of each year. On January 18, 2018, amendments were finalized to extend the maturity dates for all the 8% Notes to December 2019. At the same time, the portion of the notes that was held by Constellation NewEnergy, Inc. ("Constellation") was extended to December 2020 and the interest rate decreased from 8% to 5% ("5% Notes"). Investors held the right to convert the unpaid principal and accrued interest of both the 8% and 5% notes to Series G convertible preferred stock at any time at the price of $38.64. In July 2018, upon our IPO, the $221.6 million of principal and accrued interest of outstanding 8% Notes automatically converted into additional paid-in capital, the conversion of which included all the related-party noteholders. The 8% Notes converted to shares of Series G convertible preferred stock and, concurrently, each such share of Series G convertible preferred stock converted automatically into one share of Class B common stock. Upon the Company's IPO, 5,734,440 shares of Class B common stock were issued from conversions and the 8% Notes were retired. Constellation, the holders of the 5% convertible promissory notes, have not elected to convert as of December 31, 2018. The outstanding unpaid principal and accrued interest debt balance of the 5% Note of $34.7 million was classified as non-current as of December 31, 2018, and the outstanding unpaid principal and accrued interest debt balance of the 8% Notes of $244.7 million was classified as non-current as of December 31, 2017. 6% Convertible Promissory Notes due December 2020 - Between December 2015 and September 2016, we issued $260.0 million convertible promissory notes due December 2020, ("6% Notes") to certain investors. The 6% Notes bore a 5% fixed interest rate, payable monthly either in cash or in kind, at our election. We amended the terms of the 6% Notes in June 2017 to increase the interest rate from 5% to 6% and to reduce the collateral securing the notes. As of December 31, 2018 and 2017, the amount outstanding on the 6% Notes, which includes interest paid in kind through the IPO date, was $296.2 million and $286.1 million, respectively. Upon the IPO, the debt is convertible at the option of the holders at the conversion price of $11.25 per share into common stock at any time through the maturity date. In January 2018, we amended the terms of the 6% Notes to extend the convertible put option, which investors could elect only if the IPO did not occur prior to December 2019. After the IPO, we paid the interest in cash when due and no additional interest accrued on the consolidated balance sheet on the 6% Notes. On or after July 27, 2020, we may redeem, at our option, all or part of the 6% Notes if the last reported sale price of our common stock has been at least $22.50 for at least 20 trading days (whether or not consecutive) during a period of 30 consecutive trading days ending within the three trading days immediately preceding the date on which we provide written notice of redemption In certain circumstances, the 6% Notes are also redeemable at our option in connection with a change of control. Under the terms of the indenture governing the 6% Notes, we are required to comply with various restrictive covenants, including meeting reporting requirements, such as the preparation and delivery of audited consolidated financial statements, and restrictions on investments. In addition, we are required to maintain collateral which secures the 6% Notes in an amount equal to 200% of the principal amount of and accrued and unpaid interest on the outstanding notes. This minimum collateral test is not a negative covenant and does not result in a default if not met. However, the minimum collateral test does restrict us with respect to investing in non-PPA subsidiaries. If we do not meet the minimum collateral test, we cannot invest cash into any non-PPA subsidiary that is not a guarantor of the notes. The 6% Notes also include a cross-acceleration provision which provides that the holders of at least 25% of the outstanding principal amount of the 6% Notes may cause such notes to become immediately due and payable if we or any of our subsidiaries default on any indebtedness in excess of $15.0 million such that the repayment of such indebtedness is accelerated. In connection with the issuance of the 6% Notes, we agreed to issue to J.P. Morgan and CPPIB, upon the occurrence of certain conditions, warrants to purchase we common stock up to a maximum of 146,666 shares and 166,222 shares, respectively. On August 31, 2017, J.P. Morgan transferred its rights to CPPIB. Upon completion of the IPO, the 312,888 warrants were net exercised for 312,575 shares of Class B Common stock. 10% Notes due July 2024 - In June 2017, we issued $100.0 million of senior secured notes ("10% Notes"). The 10% Notes mature between 2019 and 2024 and bear a 10.0% fixed rate of interest, payable semi-annually. The 10% Notes have a continuing security interest in the cash flows payable to us as servicing, operations and maintenance fees and administrative fees from the five active power purchase agreements in our Bloom Electrons program. Under the terms of the indenture governing the notes, we are required to comply with various restrictive covenants including, among other things, to maintain certain financial ratios such as debt service coverage ratios, to incur additional debt, issue guarantees, incur liens, make loans or investments, make asset dispositions, issue or sell share capital of our subsidiaries and pay dividends, meet reporting requirements, including the preparation and delivery of audited consolidated financial statements, or maintain certain restrictions on investments and requirements in incurring new debt. As of December 31, 2018, we were in compliance with all of such covenants. In addition, we are required to maintain collateral which secures the 10% Notes based on debt ratio analyses. This minimum collateral test is not a negative covenant and does not result in a default if not met. However, the minimum collateral test does restrict us with respect to investing in non-PPA subsidiaries. If we do not meet the minimum collateral test, we cannot invest cash into any non-PPA subsidiary that is not a guarantor of the notes. Non-recourse Debt Facilities 5.22% Senior Secured Term Notes - In March 2013, PPA Company II refinanced its existing debt by issuing 5.22% Senior Secured Notes due March 30, 2025. The total amount of the loan proceeds was $144.8 million, including $28.8 million to repay outstanding principal of existing debt, $21.7 million for debt service reserves and transaction costs and $94.3 million to fund the remaining system purchases. The loan is a fixed rate term loan that bears an annual interest rate of 5.22% payable quarterly. The loan has a fixed amortization schedule of the principal, payable quarterly, which began March 30, 2014 that requires repayment in full by March 30, 2025. The Note Purchase Agreement requires us to maintain a debt service reserve, the balance of which was $11.2 million and $11.3 million as of December 31, 2018 and 2017, respectively, and which was included as part of long-term restricted cash in the consolidated balance sheets. The notes are secured by all the assets of PPA II. 7.5% Term Loan due September 2028 - In December 2012 and later amended in August 2013, PPA IIIa entered into a $46.8 million credit agreement to help fund the purchase and installation of Energy Servers. The loan bears a fixed interest rate of 7.5% payable quarterly. The loan requires quarterly principal payments which began in March 2014. The credit agreement requires us to maintain a debt service reserve for all funded systems, the balance of which was $3.7 million and $3.7 million as of December 31, 2018 and 2017, respectively, and which was included as part of long-term restricted cash in the consolidated balance sheets. The loan is secured by all assets of PPA IIIa. LIBOR + 5.25% Term Loan due October 2020 - In September 2013, PPA IIIb entered into a credit agreement to help fund the purchase and installation of Energy Servers. In accordance with that agreement, PPA IIIb issued floating rate debt based on LIBOR plus a margin of 5.2%, paid quarterly. The aggregate amount of the debt facility is $32.5 million. The loan is secured by all assets of PPA IIIb and requires quarterly principal payments which began in July 2014. The credit agreement requires us to maintain a debt service reserve for all funded systems, the balance of which was $1.7 million and $1.7 million December 31, 2018 and 2017, respectively, and which was included as part of long-term restricted cash in the consolidated balance sheets. In September 2013, PPA IIIb entered into pay-fixed, receive-float interest rate swap agreement to convert the floating-rate loan into a fixed-rate loan. 6.07% Senior Secured Notes - In July 2014, PPA IV issued senior secured notes amounting to $99.0 million to third parties to help fund the purchase and installation of Energy Servers. The notes bear a fixed interest rate of 6.07% payable quarterly which began in December 2015 and ends in March 2030. The notes are secured by all the assets of the PPA IV. The Note Purchase Agreement requires us to maintain a debt service reserve, the balance of which was $7.5 million as of December 31, 2018 and $7.0 million as of December 31, 2017, and which was included as part of long-term restricted cash in the consolidated balance sheets. LIBOR + 2.5% Term Loan due December 2021 - In June 2015, PPA V entered into a $131.2 million credit agreement to fund the purchase and installation of Energy Servers. The lenders are a group of five financial institutions and the terms included commitments to a letter of credit (LC) facility (see below). The loan was initially advanced as a construction loan during the development of the PPA V Project and converted into a term loan on February 28, 2017 (the “Term Conversion Date”). As part of the term loan’s conversion, the LC facility commitments were adjusted. In accordance with the credit agreement, PPA V was issued a floating rate debt based on LIBOR plus a margin, paid quarterly. The applicable margins used for calculating interest expense are 2.25% for years 1-3 following the Term Conversion Date and 2.5% thereafter. The loan is secured by all the assets of the PPA V and requires quarterly principal payments which began in March 2017. In connection with the floating-rate credit agreement, in July 2015 the PPA V entered into pay-fixed, receive-float interest rate swap agreements to convert its floating-rate loan into a fixed-rate loan. Letters of credit due December 2021 - In June 2015, PPA V entered into a $131.2 million term loan due December 2021. The agreement also included commitments to a letter of credit ("LC") facility, with the characteristics of a line of credit, with the aggregate principal amount of $6.4 million, later adjusted down to $6.2 million. The amount reserved under the letter of credit as of December 31, 2018 and 2017 was $5 million and $4.4 million, respectively. The unused capacity as of December 31, 2018 and 2017 was $1.2 million and $1.8 million, respectively. Contractual Obligations and Other Commitments The following table summarizes our contractual obligations and the debt of our consolidated PPA entities that is non-recourse to Bloom as of December 31, 2018: (1) Our 6% Notes and our credit agreements related to the building of our facility in Newark, Delaware each contain cross-default or cross-acceleration provisions. See “-Credit Facilities-Bloom Energy Indebtedness” above for more details. (2) Each of the debt facilities entered into by PPA Company II, PPA Company IIIa, PPA Company IIIb, PPA Company IV and PPA Company V contain cross-default provisions. See “-Credit Facilities-PPA Entities’ Indebtedness” above for more details. (3) Accrued other current liabilities includes a liability payable in common stock in connection with a dispute settlement with the principals of a securities placement agent. Off-Balance Sheet Arrangements We include in our consolidated financial statements all assets and liabilities and results of operations of our PPA Entities that we have entered into and over which we have substantial control. For additional information, see Note 12 - Power Purchase Agreement Programs. We have not entered into any other transactions that have generated relationships with unconsolidated entities or financial partnerships or special purpose entities. Accordingly, as of December 31, 2018 and 2017, we had no off-balance sheet arrangements.
-0.039082
-0.038943
0
<s>[INST] You should read the following discussion of our financial condition and results of operations in conjunction with the consolidated financial statements and the notes thereto included elsewhere in this Annual Report on Form 10K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10K, including information with respect to our plans and strategy for our business, includes forwardlooking statements that involve risks and uncertainties as described under the heading Special Note Regarding ForwardLooking Statements following the Table of Contents of this Annual Report on Form 10K. You should review the disclosure under ITEM 1A Risk Factors in this Annual Report on Form 10K for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forwardlooking statements contained in the following discussion and analysis. Overview Our solution, the Bloom Energy Server, is a stationary power generation platform built for the digital age and capable of delivering highly reliable, uninterrupted, 24x7 constant power that is also clean and sustainable. The Bloom Energy Server converts standard lowpressure natural gas or biogas into electricity through an electrochemical process without combustion, resulting in very high conversion efficiencies and lower harmful emissions than conventional fossil fuel generation. A typical configuration produces 250 kilowatts of power in a footprint roughly equivalent to that of half of a standard thirtyfoot shipping container, or approximately 125 times more spaceefficient than solar power generation. 250 kilowatts of power is roughly equivalent to the constant power requirement of a typical big box retail store. Any number of these Energy Server systems can be clustered together in various configurations to form solutions from hundreds of kilowatts to many tens of megawatts. We market and sell our Energy Servers primarily through our direct sales organization in the United States, and also have direct and indirect sales channels internationally. Recognizing that deploying our solutions requires a material financial commitment, we have developed a number of financing options to support sales of Energy Servers to customers that lack the financial capability to purchase our Energy Servers directly, who prefer to finance the acquisition using third party financing or who prefer to contract for our services on a payasyougo model. Our typical target commercial or industrial customer has historically been either an investmentgrade entity or a customer with investmentgrade attributes such as size, assets and revenue, liquidity, geographically diverse operations and general financial stability. We have recently expanded our below investmentgrade customer base and have also expanded internationally to target customers with deployments on a wholesale grid. Given that our customers are typically large institutions with multilevel decision making processes, we generally experience a lengthy sales process. Purchase Options Aside from our direct sales channel targeting those potential customers who prefer to make an outright direct purchase, we have expanded our potential customer base by providing the ability to purchase an Energy Server by other financial vehicles, such as those incorporating thirdparty capital resources. We have a lease offering through one of our financing partners which we refer to as a Traditional Lease. Similarly, we offer a saleleaseback sublease arrangement, which we refer to as Managed Services. Additionally, some of our customers have elected to purchase electricity produced by our Energy Servers through a financed offering which we refer to as a Power Purchase Agreement Program, whereby one or more parties are equity investors in financing the entities that purchase the Energy Servers. Our Power Purchase Agreement Programs include both the Bloom Electrons program, which includes an equity investment by us, and our ThirdParty PPA programs, where we have no equity investment. For both the Bloom Electrons program and ThirdParty PPA programs, we directly manage the end customer (electricity user) relationship from originating the sale to servicing the systems over the course of the deal term. Depending upon the purchase option chosen by our customer, either the customer or the financing provider may utilize investment tax credits and other government incentives. However, the timing of the productrelated cash flows to us is generally consistent across all of the purchase options. We generally receive all productrelated payments by the time that the product is accepted by the end customer. Our capacity to offer our Energy Servers through any of these arrangements depends in large part on the ability of the parties involved in providing payment for the Energy Servers to monetize the related investment tax credits, accelerated tax depreciation and other [/INST] Negative. </s>
2,019
19,853
1,664,703
Bloom Energy Corp
2020-03-31
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 consolidated financial statements and the notes thereto included elsewhere in this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10-K, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties as described under the heading Special Note Regarding Forward-Looking Statements following the Table of Contents of this Annual Report on Form 10-K. You should review the disclosure under Item 1A - Risk Factors in 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 The following discussion should be read in conjunction with the other sections of this Annual Report on Form 10-K, including the consolidated financial statements and related notes contained in Item 8 Financial Statements and Supplementary Data. Restatement and Revision of Previously Issued Consolidated Financial Statements In this Annual Report on Form 10-K, we have restated our previously issued consolidated financial statements as of and for the year ended December 31, 2018 and revised our previously issued consolidated financial statements as of and for the year ended December 31, 2017. Refer to the “Explanatory Note” preceding Item 1, Business for background on the restatement and revision, the fiscal periods impacted, control considerations, and other information. As a result, we have also restated certain previously reported financial information as of and for the year ended December 31, 2018 and revised certain previously reported financial information as of and for the year ended December 31, 2017 in this Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, including but not limited to information within the Results of Operations and Liquidity and Capital Resources sections to conform the discussion with the appropriate restated and/or revised amounts. See Note 2, Restatement and Revision of Previously Issued Consolidated Financial Statements, in Item 8 Financial Statements and Supplementary Data, for additional information related to the restatement and revision, including descriptions of the misstatements and the impacts on our consolidated financial statements. Description of Bloom Energy Our solution, the Bloom Energy Server, is a stationary power generation platform built for the digital age and capable of delivering highly reliable, uninterrupted, 24x7 constant power that is also clean and sustainable. The Bloom Energy Server converts standard low-pressure natural gas, biogas or hydrogen into electricity through an electrochemical process without combustion, resulting in very high conversion efficiencies and lower harmful emissions than conventional fossil fuel generation. A typical configuration produces 250 kilowatts of power in a footprint roughly equivalent to that of half of a standard thirty-foot shipping container, or approximately 125 times more space-efficient than solar power generation. 250 kilowatts of power is roughly equivalent to the constant power requirement of a typical big box retail store. Any number of our Energy Server systems can be clustered together in various configurations to form solutions from hundreds of kilowatts to many tens of megawatts. We currently primarily target commercial and industrial customers. We market and sell our Energy Servers primarily through our direct sales organization in the United States, and also have direct and indirect sales channels internationally. Recognizing that deploying our solutions requires a material financial commitment, we have developed a number of financing options to support sales of our Energy Servers to customers who lack the financial capability to purchase our Energy Servers directly, who prefer to finance the acquisition using third party financing or who prefer to contract for our services on a pay-as-you-go model. Our typical target commercial or industrial customer has historically been either an investment-grade entity or a customer with investment-grade attributes such as size, assets and revenue, liquidity, geographically diverse operations and general financial stability. We have recently expanded our product and financing options to the below-investment-grade customers and have also expanded internationally to target customers with deployments on a wholesale grid. Given that our customers are typically large institutions with multi-level decision making processes, we generally experience a lengthy sales process. Purchase and Lease Options Initially, we only offered our Energy Servers on a direct purchase basis, in which the customer purchases the product directly from us. In order to expand our offerings to customers who lack the financial capability to purchase our Energy Servers directly (including customers who are unable to monetize the tax credits available to purchasers of our Energy Servers) and/or who prefer to lease the product or contract for our services on a pay-as-you-go model, we subsequently developed the traditional lease ("Traditional Lease"), Managed Services, and power purchase agreement programs ("PPA Programs"). Our capacity to offer our Energy Servers through any of these financed arrangements depends in large part on the ability of the financing party or parties involved to monetize the related investment tax credits, accelerated tax depreciation and other incentives. Interest rate fluctuations may also impact the attractiveness of any financing offerings for our customers, and currency exchange fluctuations may also impact the attractiveness of international offerings. The Traditional Lease, Managed Services and PPA Program options are limited by the creditworthiness of the customer. Additionally, the Managed Services and Traditional Lease options, as with all leases, are also limited by the customer’s willingness to commit to making fixed payments regardless of the performance of the Energy Servers or our performance of our obligations under the customer agreement. In each of our purchase options, we typically perform the functions of a project developer, including identifying end customers and financiers, leading the negotiations of the customer agreements and financing agreements, securing all necessary permitting and interconnections approvals, and overseeing the design and construction of the project up to and including commissioning the Energy Servers. Under each purchase option, we provide warranties and performance guaranties for the Energy Servers’ efficiency and output. We refer to a “warranty” as a commitment where the failure of the Energy Servers to satisfy the stated performance level obligates us to repair or replace the Energy Servers as necessary to improve performance. If we fail to complete such repair or replacement, or if repair or replacement is impossible, we may be obligated to repurchase the Energy Servers from the customer or financier. We refer to a “guaranty” as a commitment where the failure of the Energy Servers to satisfy the stated performance level obligates us to make a payment to compensate the beneficiary of such guaranty for the resulting increased cost or diminution in benefits resulting from such failure. Our obligation to make payments under the guaranty is always contractually capped and represents a contingency linked to our services obligation with no economic incentive for us to default and force an exercise of the payment obligation. Under direct purchase and Traditional Lease, the warranties and guaranties are typically included in the price of our Energy Server for the first year. The warranties and guaranties may be renewed annually at the customer’s option, as an operations and maintenance services agreement, at predetermined prices for a period of up to 30 years. Historically, our customers and financiers have almost always exercised their option to renew the warranties and guaranties under these operations and maintenance services agreements. Under the Managed Services Program, the warranties and guaranties are included for the fixed period specified in the customer agreement. This period is typically 10 years, which may be extended at the option of the parties for additional years. Under the PPA Programs, we typically provide warranties and guaranties regarding our Energy Servers’ efficiency to the customer (i.e., the end user of the electricity generated by our Energy Servers, who is also responsible for the purchase of the fuel required for our Energy Servers’ operations), and we provide warranties and guaranties regarding our Energy Servers’ output to the financier(s) that purchases our Energy Servers. The warranties and guaranties are typically included in the price of our Energy Server for the first year and may be renewed annually at the financier’s option, as an operations and maintenance services agreement, at predetermined prices for a period of up to 30 years. Historically, our financiers have almost always exercised their option to renew the warranties and guaranties under these operations and maintenance services agreements. We also provide a fixed schedule of prices for each year of the term of our agreements with our Customers and none of our Customers have failed to renew our operations and maintenance agreements. The substantial majority of bookings made in recent periods are pursuant to the PPA and the Managed Services Programs. Each of our financing structures is described in further detail below. Traditional Lease Under the Traditional Lease arrangement, the customer enters into a lease directly with a financier, which pays us for our Energy Servers purchased pursuant to a sales agreement (see the description of the Financing Agreement below). We recognize product and installation revenue upon acceptance. After the standard one-year warranty period, our customers have almost always exercised the option to enter into operations and maintenance services agreements with us, under which we receive annual service payments from the customer. The price for the annual operations and maintenance services is set at the time we enter into the Financing Agreement. The term of a lease in a Traditional Lease ranges from 5 to 8 years. Under a Financing Agreement, we are generally paid the full price of our Energy Servers as if sold as a purchase by the customer based on four milestones. The four payment milestones are typically as follows: (i) 15% upon execution of the financier's entry into the lease with a customer, (ii) 25% on the day that is 180 days prior to delivery of the Energy Servers, (iii) 40% upon shipment of the Energy Servers, and (iv) 20% upon acceptance of the Energy Servers. The financier receives title to the Energy Servers upon installation at the customer site and the financier has risk of loss while our Energy Server is in operation on the customer’s site. The Financing Agreement provides for the installation of our Energy Servers and includes a standard one-year warranty, to the financier, which includes the performance guaranties described below, with the warranty offered on an annually renewing basis at the discretion of, and to, the customer. The customer must provide fuel for the Bloom Energy Servers to operate. Our direct lease deployments typically provide for warranties and guaranties of both the efficiency and output of our Energy Servers, all of which are written in favor of the customer and contained in the operations and maintenance services agreement. These warranties and guaranties may be measured on a monthly, annual, cumulative or other basis. As of December 31, 2019, we had incurred no liabilities due to failure to repair or replace our Energy Servers pursuant to these warranties. Our obligation to make payments for underperformance against the performance guaranties for Traditional Lease projects was capped contractually under the sales agreements between us and each customer at an aggregate total of approximately $6.0 million (including payments both for low output and for low efficiency), and, our aggregate remaining potential liability under this cap was approximately $4.8 million. Remarketing at Termination of Lease In the event the customer does not renew or purchase our Energy Servers to the end of any customer lease, we may remarket any such Energy Servers to a third party. Any proceeds of such sale would be allocated between us and the applicable financing partner as agreed between them at the time of such sale. Managed Services Financing In a Managed Services financing, we enter into a Managed Services Agreement with a customer, pursuant to which the customer is able to use the Energy Server for a certain term. Under the Managed Services Agreement, the customer makes a monthly payment for the use of the Energy Server. The customer payment typically has two components: (1) a fixed monthly capacity-based payment and (2) a performance-based payment based on the output of electricity that month from the Energy Server. The fixed capacity-based payments made by the customer under the Managed Services Agreement are applied toward our obligation to pay down our liability under the master lease with the financier. The performance payment is transferred to us as compensation for operations and maintenance services and recorded as services revenue within the consolidated statements of operations. In some cases, the customer’s monthly payment consists solely of the first component, a fixed monthly capacity-based payment. Once a financier is identified and the Energy Server’s installation is complete, we sell the Energy Server contemplated by the Managed Services Agreement directly to a financier and the financier, as lessor, leases it back to us, as lessee, pursuant to a master lease in a sale-leaseback transaction. The proceeds from the sale are recorded as a financing obligation within the consolidated balance sheets. Any ongoing operations and maintenance service payments are scheduled in the Managed Services Agreement in the form of the performance-based payment described above. The financier typically pays the financing proceeds for the Energy Server contemplated by the Managed Services Agreement on or shortly after acceptance. The fixed capacity payments made by the customer under the Managed Services Agreement are recognized as electricity revenue when billed and applied toward our obligation to pay the financing obligation under the master lease. Our Managed Services financings have historically shifted customer credit risk to the financier, as lessor, by providing in the master lease agreement that we have no liability for payment of rent except in certain enumerated circumstances, including in the event we are in breach of the Managed Services Agreement between us and the customer. The duration of the master lease in a Managed Services financing is typically 10 years. The term of the master lease is typically the same as the term of the related Managed Services Agreement, but in some cases the term of the master lease is shorter than that of the Managed Services Agreement. Our Managed Services deployments typically provide only for warranties of both the efficiency and output of the Energy Server(s), all of which are written in favor of the customer and contained in the operations and maintenance services agreement. These warranties may be measured on a monthly, annual, cumulative or other basis. Managed Services projects typically do not include guaranties above the warranty commitments, but in projects where the customer agreement includes a service payment for our operations and maintenance, that payment is typically proportionate to the output generated by the Energy Server(s) and our pricing assumes service revenues at the 95% output level. This means that our service revenues may be lower than expected if output is less than 95% and higher if output exceeds 95%. As of December 31, 2019, we had incurred no liabilities due to failure to repair or replace our Energy Servers pursuant to these warranties and the fleet of our Energy Servers deployed pursuant to the Managed Services Program was performing at a lifetime average output of approximately 88%. Power Purchase Agreement Programs *Under the Third Party PPA arrangements, there is no link with an investment company, as we do not have an equity investment in these arrangements. In each Power Purchase Agreement, we sell our Energy Servers to an Operating Company which sells the electricity generated by the Energy Servers to the ultimate end customers pursuant to a Power Purchase Agreement, energy services agreement, or similar contract. Because the end customer's payment is stated on a dollar-per-kilowatt-hour ("$/kWh") basis, we refer to these agreements as Power Purchase Agreements ("PPAs"). Currently, our offerings for PPA Programs primarily include our Third-Party PPA Programs pursuant to which we recognize revenue on acceptance. Through 2017, as part of our PPA Programs, we had also offered the Bloom Electrons Program which included an equity investment by us in the Operating Company and in which we recognized revenue as the electricity was produced. For further discussion on our Bloom Electrons Programs, see Note 13 of our Notes to Consolidated Financial Statements. In our Power Purchase Agreement Program, we enter into an Energy Server sales, operations and maintenance agreement ("EPC and O&M Agreement") with the Operating Company that will own the Energy Servers. The Operating Company then enters into the PPA with the end customer which purchases electricity generated by the Energy Servers. The Operating Company receives all cash flows generated under the PPA(s), in addition to all investment tax credits, all accelerated tax depreciation benefits, and any other cash flows generated by the operation of the Energy Servers not allocated to the end customer under the PPA. The sales of our Energy Servers to the Operating Company in connection with the various Power Purchase Agreement Programs have many of the same terms and conditions as a direct sale. Payment of the purchase price is generally broken down into multiple installments, which may include payments prior to shipment, upon shipment or delivery of the Energy Server, and upon acceptance of the Energy Server. Acceptance typically occurs when the Energy Server is installed and running at full power as defined in the applicable EPC and O&M Agreement. A one-year service warranty is provided with the initial sale. After the expiration of the initial standard one-year warranty, the Operating Company has the option to extend our operations and maintenance services under the EPC and O&M Agreement on an annual basis at a price determined at the time of purchase of our Energy Server, which may be renewed annually for each Energy Server for up to 30 years. After the standard one-year warranty period, the Operating Company has almost always exercised the option to renew our operations and maintenance obligations under the EPC and O&M Agreement. We typically provide output warranties and output guaranties to the Operating Company pursuant to the applicable EPC and O&M Agreement with the Operating Company. The end customer agreement between the Operating Company and the end customer also provides efficiency warranties and efficiency guaranties to the end user, and we provide a backstop of all of the Operating Company’s obligations under those agreements, including both the repair or replacement obligations pursuant to the warranties and any payment liabilities under the guaranties. As of December 31, 2019, we had incurred no liabilities due to failure to repair or replace Energy Servers pursuant to these warranties. Our obligation to make payments for underperformance against the performance guaranties for Power Purchase Agreement projects was capped at an aggregate total of approximately $75.0 million (including payments both for low output and for low efficiency) and our aggregate remaining potential liability under this cap was approximately $59.4 million. Obligations to Operating Companies In addition to our obligations to the end customers, our Power Purchase Agreement Programs involve many obligations to the Operating Company that purchases our Energy Servers. These obligations are set forth in the applicable EPC and O&M Agreement(s), and may include some or all of the following obligations: • designing, manufacturing, and installing the Energy Servers, and selling such Energy Servers to the Operating Company, • obtaining all necessary permits and other governmental approvals necessary for the installation and operation of the Bloom Energy Servers, and maintaining such permits and approvals throughout the term of the EPC and O&M Agreements, • operating and maintaining the Bloom Energy Servers in compliance with all applicable laws, permits and regulations, • satisfying the efficiency and output warranties set forth in such EPC and O&M Agreements and the PPAs ("performance warranties"), and • complying with any specific requirements contained in the PPAs with individual end-customers. The EPC and O&M Agreements obligate us to repurchase the Energy Servers in the event the Energy Servers fail to comply with the performance warranties and in the event we otherwise breach the terms of the applicable EPC and O&M Agreements and we fail to remedy such failure or breach after a cure period, or in the event that a PPA terminates as a result of any failure by us to comply with the applicable EPC and O&M Agreements. In some PPA Program projects, our obligation to repurchase Energy Servers extends to the entire fleet of Energy Servers sold pursuant to the applicable EPC and O&M Agreements in the event such failure affects more than a specified number of Energy Servers. In some PPA Programs, we have also agreed to pay liquidated damages to the applicable Operating Company in the event of delays in the manufacture and installation of our Energy Servers, either in the form of a cash payment or a reduction in the purchase price for the applicable Energy Servers. Both the upfront purchase price for the Energy Servers and the ongoing fees for our operations and maintenance are paid on a fixed dollar-per-kilowatt ($/kW) basis. Indemnification of Performance Warranty Expenses Under PPAs - In addition to the performance warranties and guaranties in the EPC and O&M Agreements, we also have agreed to indemnify certain Operating Companies for any expenses they incur to any of the end customers resulting from failures of the applicable Energy Servers to satisfy any of the performance warranties and guaranties set forth in the applicable PPAs. Administration of Operating Companies - In each of the Bloom Electrons programs, we perform certain administrative services on behalf of the applicable Operating Company, including invoicing the end customers for amounts owed under the PPAs, administering the cash receipts of the Operating Company in accordance with the requirements of the financing arrangements, interfacing with applicable regulatory agencies, and other similar obligations. We are compensated for these services on a fixed dollar-per-kilowatt ($/kW) basis. The Operating Company in each of the Bloom Electrons Programs (other than PPA I) has incurred debt in order to finance the acquisition of Energy Servers. The lenders for these projects are a combination of banks and/or institutional investors. In each case, the debt is secured by all of the assets of the applicable Operating Company, such assets being primarily comprised of the Energy Servers and a collateral assignment of each of the contracts to which the Operating Company is a party, including the O&M Agreement entered into with us and the offtake agreements entered into with the Operating Company’s customers, and is senior to all other debt obligations of the Operating Company. As further collateral, the lenders receive a security interest in 100% of the membership interest of the Operating Company. However, as is typical in structured finance transactions of this nature, although the project debt is secured by all of the Operating Company’s assets, the lenders have no recourse to us or to any of the other equity investors in the project. The applicable debt agreements include provisions that implement a customary “payment waterfall” that dictates the priority in which the Operating Company will use its available funds to satisfy its payment obligations to us, the lenders, the tax equity investors and other third parties. We have determined that we are the primary beneficiary in the PPA Entities, subject to reassessments performed as a result of upgrade transactions (see Note 13, Power Purchase Agreement Programs). Accordingly, we consolidate 100% of the assets, liabilities and operating results of these entities, including the Energy Servers and lease income, in our consolidated financial statements. We recognize the tax equity investors’ share of the net assets of the investment entities as noncontrolling interests in subsidiaries in our consolidated balance sheet. We recognize the amounts that are contractually payable to these investors in each period as distributions to noncontrolling interests in our consolidated statements of convertible redeemable preferred stock, redeemable noncontrolling interest, stockholders' deficit and noncontrolling interest. Our consolidated statements of cash flows reflect cash received from these investors as proceeds from investments by noncontrolling interests in subsidiaries. Our consolidated statements of cash flows also reflect cash paid to these investors as distributions paid to noncontrolling interests in subsidiaries. We reflect any unpaid distributions to these investors as distributions payable to noncontrolling interests in subsidiaries on our consolidated balance sheets. However, the PPA Entities are separate and distinct legal entities, and Bloom Energy Corporation may not receive cash or other distributions from the PPA Entities except in certain limited circumstances and upon the satisfaction of certain conditions, such as compliance with applicable debt service coverage ratios and the achievement of a targeted internal rate of return to the tax equity investors, or otherwise. For further information about our Power Purchase Agreement Programs, see Note 13, Power Purchase Agreement Programs, to our consolidated financial statements included in this Annual Report on Form 10-K. Delivery and Installation The timing of delivery and installations of our products have a significant impact on the timing of the recognition of product revenue. Many factors can cause a lag between the time that a customer signs a purchase order and our recognition of product revenue. These factors include the number of Energy Servers installed per site, local permitting and utility requirements, environmental, health and safety requirements, weather, and customer facility construction schedules. Many of these factors are unpredictable and their resolution is often outside of our or our customers’ control. Customers may also ask us to delay an installation for reasons unrelated to the foregoing, including delays in their obtaining financing. Further, due to unexpected delays, deployments may require unanticipated expenses to expedite delivery of materials or labor to ensure the installation meets the timing objectives. These unexpected delays and expenses can be exacerbated in periods in which we deliver and install a larger number of smaller projects. In addition, if even relatively short delays occur, there may be a significant shortfall between the revenue we expect to generate in a particular period and the revenue that we are able to recognize. For our installations, revenue and cost of revenue can fluctuate significantly on a periodic basis depending on the timing of acceptance and the type of financing used by the customer. As described in the Power Purchase Agreements section above, we offered the Bloom Electrons purchase program through the end of 2016 and no longer offer this financing structure to potential customers. Our product sales backlog was $1.1 billion, equivalent to 1,983 systems, or 198 megawatts, as of December 31, 2019. Our product sales backlog was $0.8 billion, equivalent to 1,384 systems, or 138 megawatts, as of December 31, 2018. We define product sales backlog as signed customer product sales orders received prior to the period end, but not yet accepted, excluding site cancellations. The timing of the deployment of our backlog depends on the factors described above. However, as a general matter, at any point in time, we expect at least 50% of our backlog to be deployed within the next 12 months. The portion of our backlog in the year ended December 31, 2019 attributable to each payment option was as follows: Direct Purchase (including Third Party PPAs) 93% and Managed Services 7%. The portion of our backlog in the year ended December 31, 2018 attributable to each payment option was as follows: Direct Purchase (including Third Party PPAs) 98% and Managed Services 2%. International Channel Partners Prior to 2018, we consummated a small number of sales outside the United States of America, including in India and Japan. In India, sales activities are currently conducted by Bloom Energy (India) Pvt. Ltd., our wholly-owned indirect subsidiary; however, we are currently evaluating the Indian market to determine whether the use of channel partners would be a beneficial go-to-market strategy to grow our India market sales. Japan. In Japan, sales are conducted pursuant to a Japanese joint venture established between us and subsidiaries of SoftBank Corp, called Bloom Energy Japan Limited ("Bloom Energy Japan"). Under this arrangement, we sell Energy Servers to Bloom Energy Japan and we recognize revenue once the Energy Servers leave the port of the U.S. as Bloom Energy Japan enters into the contract with the end customer and performs all installation work as well as some of the operations and maintenance work. South Korea. In 2018, Bloom Energy Japan consummated a sale of Energy Servers in the Republic of Korea to Korea South-East Power Company. Following this sale, we entered into a Preferred Distributor Agreement with SK Engineering & Construction Co., Ltd. ("SK E&C") to enable us to sell directly into the Republic of Korea. Under our agreement with SK E&C, SK E&C has a right of first refusal during the term of the agreement, with certain exceptions, to serve as distributor of Energy Servers for any fuel cell generation project in the Republic of Korea, and we have the right of first refusal to serve as SK E&C’s supplier of generation equipment for any Bloom Energy fuel cell project in the Republic of Korea. Under the terms of each purchase order, title, risk of loss and acceptance of the Energy Servers pass from us to SK E&C upon delivery at the named port of lading for shipment in the United States for the Energy Servers shipped in 2018 and thereafter upon delivery at the named port of unlading in the Republic of Korea, prior to unloading subject to final purchase order terms. The Preferred Distributor Agreement has an initial term expiring on December 31, 2021, and thereafter will automatically be renewed for three-year renewal terms unless either party terminates the Preferred Distributor Agreement by written notice under certain circumstances. Under the terms of the Preferred Distributor Agreement, we (or our subsidiary) contract directly with the customer to provide operations and maintenance services for the Energy Servers. We have established a subsidiary in the Republic of Korea, Bloom Energy Korea, LLC, to which we subcontract such operations and maintenance services. The terms of the operations and maintenance are negotiated on a case-by-case basis with each customer, but are generally expected to provide the customer with the option to receive services for at least 10 years, and for up to the life of the Energy Servers, with terms specified below. SK E&C Joint Venture Agreement. In September 2019, we entered into a joint venture agreement with SK E&C to establish a light-assembly facility in South Korea for sales of certain portions of the Bloom Server for the stationary utility and commercial and industrial market in South Korea. The joint venture is majority controlled and managed by us. We expect the facility to be operational by mid-2020 subject to the completion of certain conditions precedent to the establishment of the joint venture company. Other than a nominal initial capital contribution by Bloom, the joint venture will be funded by SK E&C. SK E&C, who currently acts as a distributor for Bloom Servers for the stationary utility and commercial and industrial market in Korea, will be the primary customer for the products assembled by the joint venture. Community Distributed Generation Programs In July 2015, the state of New York introduced its Community Distributed Generation program, which extends New York’s net metering program in order to allow utility customers to receive net metering credits for electricity generated by distributed generation assets located on the utility’s grid but not physically connected to the customer’s facility. This program allows for the use of multiple generation technologies, including fuel cells. In December 2019, we entered into fuel cell sales, installation, operations and maintenance agreements with two developers for the deployment of fuel cells pursuant to this Community Distributed Generation program. These agreements have many of the same terms and conditions as a direct sale. Payment of the purchase price is generally broken down into multiple installments, which may include payments prior to shipment, upon shipment or delivery of the Energy Server, and upon acceptance of the Energy Server. Acceptance typically occurs when the Energy Server is installed and running at full power as defined in each contract. A one-year service warranty is provided with the initial sale. After the expiration of the initial standard one-year warranty, the owner has the option to renew our operations and maintenance services for subsequent quarterly or annual periods for up to 30 years. We provide warranties and guaranties regarding both efficiency and output to the owners of the Energy Servers pursuant to the operations and maintenance services agreement with the Operating Company. As of December 31, 2019, we had not yet completed the sale of any Energy Servers in connection with the New York Community Distributed Generation program. Key Operating Metrics In addition to the measures presented in the consolidated financial statements, we use the following key operating metrics to evaluate business activity, to measure performance, to develop financial forecasts and to make strategic decisions: • Product accepted - the number of customer acceptances of our Energy Servers in any period. We recognize revenue when an acceptance is achieved. We use this metric to measure the volume of deployment activity. We measure each Energy Server manufactured, shipped and accepted in terms of 100 kilowatt equivalents. • Billings for product accepted in the period - the total contracted dollar amount of the product component of all Energy Servers that are accepted in a period. We use this metric to gauge the dollar value of the product acceptances and to evaluate the change in dollar amount of acceptances between periods. • Billings for installation on product accepted in the period - the total contracted dollar amount billable with respect to the installation component of all Energy Servers that are accepted. We use this metric to gauge the dollar value of the installations of our product acceptances and to evaluate the change in dollar value associated with the installation of our product acceptances between periods. • Billings for annual maintenance service agreements - the dollar amount billable for one-year service contracts that have been initiated or renewed. We use this metric to measure the cumulative billings for all service contracts in any given period. As our installation base grows, we expect our billings for annual maintenance service agreements to grow, as well. • Product costs of product accepted in the period (per kilowatt) - the average unit product cost for the Energy Servers that are accepted in a period. We use this metric to provide insight into the trajectory of product costs and, in particular, the effectiveness of cost reduction activities. • Period costs of manufacturing expenses not included in product costs - the manufacturing and related operating costs that are incurred to procure parts and manufacture Energy Servers that are not included as part of product costs. We use this metric to measure any costs incurred to run our manufacturing operations that are not capitalized (i.e., absorbed, such as stock-based compensation) into inventory and therefore, expensed to our consolidated statement of operations in the period that they are incurred. • Installation costs on product accepted (per kilowatt) - the average unit installation cost for Energy Servers that are accepted in a given period. This metric is used to provide insight into the trajectory of install costs and, in particular, to evaluate whether our installation costs are in line with our installation billings. Comparison of the Years Ended December 31, 2019, 2018 and 2017 A discussion regarding our key operating metrics for fiscal 2019 compared to fiscal 2018 and fiscal 2018 compared to fiscal 2017 is presented below. Acceptances We use acceptances as a key operating metric to measure the volume of our completed Energy Server installation activity from period to period. We typically define an acceptance as when an Energy Server is installed and running at full power as defined in the customer contract or the financing agreements. For orders where a third party performs the installation, acceptances are generally achieved when the Energy Servers are shipped. The product acceptances in the periods were as follows: Product accepted increased by approximately 385 systems, or 47.6%, for 2019 compared to 2018. Acceptance volume increased as we installed more systems from backlog as demand increased for our Bloom Energy servers, in addition to enhancing our ability and capacity to install more energy servers with our installation team. As discussed in the Purchase and Lease Programs above, our customers have several purchase options for our Energy Servers. The portion of acceptances attributable to each purchase option in the years ended December 31, 2019 and 2018 was as follows: As discussed in the Purchase and Lease Programs above, our customers have several purchase options for our Energy Servers. The portion of total revenue attributable to each purchase option in the period was as follows: Billings Related to Our Products Billings for product accepted increased by approximately $222.7 million, or 48.6%, for 2019 compared to 2018. The increase was primarily driven by the increase in product accepted, including billings for product accepted under Managed Services agreements. Product accepted increased by approximately 385 systems, or 47.6%, for 2019 compared to 2018. Billings for installation on product accepted decreased $17.7 million for 2019, as compared to 2018. Although product acceptances in the period increased 48.6%, billings for installation on product accepted decreased due to the change in mix in installation billings driven by international sales, where our partners perform the installation, as well as site complexity, site size, customer financing option, and customer option to complete the installation of our Energy Servers themselves. In general, when we do not perform the installation function for a customer, such as SK E&C in the Republic of Korea, we will not have any installation billings for those orders. Billings for annual maintenance service agreements decreased $6.0 million for 2019 compared to 2018. This decrease was driven primarily by the relatively high number of PPA upgrades performed in 2019. When an upgrade occurs, new systems are installed and there are typically no billings for service during the first year after the upgrade as the first year period is covered under our standard warranty. Costs Related to Our Products Product costs of product accepted decreased by approximately $491 per kilowatt, or 14.6%, for 2019 compared to 2018. The product cost reduction was driven generally by our ongoing cost reduction efforts to reduce material costs in conjunction with our suppliers and our reduction in labor and overhead costs through improved processes and automation at our manufacturing facilities. Period costs of manufacturing related expenses decreased by approximately $7.3 million, or 30.1%, for 2019 compared to 2018. Our period costs of manufacturing related expenses decreased primarily as a result of higher absorption of fixed manufacturing costs into product costs due to a larger volume of builds through our factory tied to our acceptance growth, which resulted in higher factory utilization. Installation costs on product accepted decreased by approximately $545 per kilowatt, or 45.8%, for 2019 compared to 2018. Each customer site is different and installation costs can vary due to a number of factors, including site complexity, size, location of gas, etc. As such, installation on a per kW basis can vary significantly from period-to-period. When we achieve international acceptances, our partners are responsible for the installation, and therefore we do not incur installation costs. When we achieve acceptances for upgrading customer sites to our latest technology, installation costs are minimal as most of the installation work and costs were incurred when the site was initially installed. The mix of international acceptances, the PPA II upgrade and the PPA IIIb upgrade of Energy Servers contributed to the lower installation cost for 2019 compared to 2018. Comparison of the Years Ended December 31, 2018 and 2017 Acceptances Product accepted increased by approximately 187 systems, or 30.1%, for 2018 compared to 2017. Acceptance volume increased as we installed more systems from backlog as demand increased for our Bloom Energy servers, in addition to enhancing our ability and capacity to install more energy servers with our installation team. As discussed in the Purchase and Lease Programs above, our customers have several purchase options for our Energy Servers. The portion of acceptances attributable to each purchase option in the period was as follows: The portion of total revenue attributable to each purchase option in the period was as follows: Billings Related to Our Products Billings for product accepted increased by approximately $210.2 million, or 84.7%, for 2018 as compared to 2017. The increase was primarily due to three factors. First, product accepted increased by approximately 187 systems, or 30.1%, for 2018 compared to 2017. Second, ITC was reinstated on February 9, 2018. ITC was not available to the fuel cell industry in 2017, so our billings for product accepted for 2017 only included $1.3 million in benefit from ITC. Due to the reinstatement of ITC in 2018, billings for product accepted now includes the benefit of ITC. For 2018, billings for product accepted included $132.9 million in benefits from ITC, of which $45.1 million was retroactive ITC for 2017 acceptances. Third, the adoption of customer personalized applications, such as batteries and grid-independent solutions, increased in 2018 compared to 2017. Products that incorporate these personalized applications have, on average, a higher billings rate than our standard platform products that do not incorporate these personalized applications. Billings for installation on product accepted decreased $17.5 million for 2018, as compared to 2017. Although product acceptances in the period increased 30.1%, billings for installation on product accepted decreased due to the mix in installation billings driven by site complexity, size, customer purchase option and one large customer in particular in 2018 where the installation was performed by the customer and therefore, we did not have any installation billing for that customer. In general, when we do not perform the installation function for a customer, such as SK E&C in the Republic of Korea, we will not have any installation billings for those orders. When we analyze changes between the years ended 2018 and 2017, we take into account the impact of ITC that was available in 2018 as a result of the reinstatement of the ITC through December 2021. The effect of the reinstatement of ITC was higher billings in the periods eligible for ITC. For 2018, the combined total for billings for product and installation accepted was $537.2 million, an increase of 55.9% from the billings for product and installation accepted combined of $344.6 million for 2017. The increase was significantly greater than the 30.1% increase in associated acceptances during the same periods due to the reinstatement of the ITC benefit, including the one-time fiscal 2017 retroactive ITC benefit recognized in 2018 that is included in the 2018 billings numbers. Costs Related to Our Products Product costs of product accepted increased by approximately $80 per kilowatt, or 2.4%, for 2018 compared to 2017. This increase in cost is primarily related to the reinstatement of the ITC program in February 2018, in which we were required to repay certain suppliers for previously negotiated contractual discounts. This resulted in a one-time payment of $116 per kilowatt or $9.4 million, which was recorded to cost of product revenue. Period costs of manufacturing related expenses decreased by approximately $8.1 million, or 25.1%, for 2018 as compared to 2017. Our period costs of manufacturing related expenses decreased primarily as a result of higher absorption of fixed manufacturing costs into product costs due to a larger volume of builds through our factory tied to our acceptance growth, which resulted in higher factory utilization. Installation costs on product accepted decreased by approximately $82 per kilowatt, or 6.5%, for 2018 compared to 2017. Each customer site is different and installation costs can vary due to a number of factors, including site complexity, size, location of gas, etc. As such, installation on a per kW basis can vary significantly from period-to-period. In addition, some customers do their own installation, or, as is the case for SK E&C in the Republic of Korea orders, we have a partner who performs the installation. In those instances, we have little to no installation cost. Critical Accounting Policies and Estimates The consolidated financial statements have been prepared in accordance with generally accepted accounting principles as applied in the United States ("U.S. GAAP") The preparation of the consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses and related disclosures. Our discussion and analysis of our financial results under Results of Operations below are based on our audited results of operations, which we have prepared in accordance with U.S. GAAP. In preparing these financial statements, we make assumptions, judgments and estimates that can affect the reported amounts of assets, liabilities, revenues and expenses, and net income. On an ongoing basis, we base our estimates on historical experience, as appropriate, and on various other assumptions that we believe to be reasonable under the circumstances. Changes in the accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ significantly from the estimates made by our management. We evaluate our estimates and assumptions on an ongoing basis. To the extent that there are material differences between these estimates and actual results, our future financial statement presentation, financial condition, results of operations and cash flows will be affected. We believe that the following critical accounting policies involve a greater degree of judgment and complexity than our other accounting policies. Accordingly, these are the policies we believe are the most critical to understanding and evaluating the consolidated financial condition and results of operations. The accounting policies that most frequently require us to make assumptions, judgments and estimates, and therefore are critical to understanding our results of operations, include: Revenue Recognition We primarily earn product and installation revenue from the sale and installation of our Energy Servers, service revenue by providing services under operations and maintenance services contracts and electricity revenue by selling electricity to customers under power purchase agreements. We offer our customers several ways to finance their use of a Bloom Energy Server. Customers, including some of our international channel providers and Third Party PPAs, may choose to purchase our Energy Servers outright. Customers may also lease our Energy Servers through one of our financing partners via our Managed Services Program or as a traditional lease. Finally, customers may purchase electricity through our Power Purchase Agreement Programs. Prior to Adoption of ASC 606 Revenue from Contracts with Customers Prior to the adoption of ASC 606 Revenue from Contracts with Customers, we recognized revenue from contracts with customers for the sales of products, installation and services in accordance with ASC 605-25, Revenue Recognition for Multiple-Element Arrangements. Revenue from the sale and installation of Energy Servers was recognized when all of the following criteria are met: • Persuasive evidence of an arrangement exists. We rely upon non-cancelable sales agreements and purchase orders to determine the existence of an arrangement. • Delivery and acceptance has occurred. We use shipping documents and confirmation from our installations team that the deployed systems are running at full power as defined in each contract to verify delivery and acceptance. • The fee is fixed or determinable. We assess whether the fee is fixed or determinable based on the payment terms associated with the transaction. • Collectability is reasonably assured. We assess collectability based on the customer’s credit analysis and payment history. When these criteria are met, we allocate revenue to each element of the customer arrangement (product, installation and services) based on an estimated selling price at the arrangement inception. The estimated selling price for each element is based upon the following hierarchy: vendor-specific objective evidence ("VSOE") of selling price, if available; third-party evidence ("TPE") of selling price, if VSOE of selling price is not available; or best estimate of selling price ("BESP") if neither VSOE of selling price nor TPE of selling price are available. We limit the amount of revenue recognized for delivered elements to an amount that is not contingent upon future delivery of additional products or services or upon meeting any specified performance conditions. We have not been able to obtain reliable evidence of the selling price of the standalone Energy Server. Given that we typically sell an Energy Server with a maintenance service agreement and have not provided maintenance services to a customer who does not have use of an Energy Server, we have no evidence of selling prices for either and virtually no customers have elected to cancel their maintenance service agreements while continuing to operate the Energy Servers. Our objective is to determine the price at which we would transact business if the items were being sold separately. As a result, our estimate of our selling price is driven primarily by our expected margin on both the Energy Server and installation based on their respective costs or, in the case of maintenance service agreements, the estimated costs to be incurred during the expected service period. Costs for Energy Servers include all direct and indirect manufacturing costs, applicable overhead costs and costs for normal production inefficiencies (i.e., variances). We then apply a margin to the Energy Servers and to expected installation costs to determine the selling price to be used in our BESP model. Costs for maintenance service arrangements are estimated over the expected life of the maintenance contracts and include estimated future service costs and future material costs. Material costs over the expected period of the service arrangement are impacted significantly by the longevity of the fuel cells themselves. After considering the total service costs, we apply a lower margin to our service costs than to our Energy Servers as it best reflects our long-term service margin expectations. As our business offerings and eligibility for the Investment Tax Credit ("ITC") evolve over time, we may be required to modify our estimated selling prices in subsequent periods and our revenue could be adversely affected. Subsequent to adoption of ASC 606 Revenue from Contracts with Customers We adopted ASC 606 Revenue from Contracts with Customers as of January 1, 2019 using the modified retrospective method and present the impacts for the first time in our Annual Report on Form 10-K for the fiscal year ended December 31, 2019. In applying ASC 606, we frequently combine contracts governing the sale and installation of an Energy Server with the related maintenance service contracts and account for them as a single contract at contract inception to the extent the contracts are with the same customer. These contracts are not combined when the customer for the sale and installation of the Energy Server is different to the maintenance service contract customer. We also assess whether any contract terms including default provisions, put or call options result in components of our contracts being accounted for as financing or leasing transactions outside of the scope of ASC 606. Most of our contracts contain performance obligations with a combination of our Energy Server product, installation and maintenance services. For these performance obligations, we allocate revenue to each performance obligation based on the total transaction price for each contract. Our maintenance service contracts are typically subject to renewal by customers on an annual basis. We assess these maintenance service renewal options at contract inception to determine whether they provide customers with material rights that give rise to a separate performance obligation. The total transaction price is determined based on the total consideration specified in the contract, including variable consideration in the form of a production guarantee payment that represents potential amounts payable to customers. The expected value method is generally used when estimating variable consideration, which typically reduces the total transaction price due to the nature of the performance obligations to which the variable consideration relates. These estimates reflect our historical experience and current contractual requirements which cap the maximum amount that may be paid. The expected value method requires judgment and considers multiple factors that may vary over time depending upon the unique facts and circumstances related to each performance obligation. Depending on the facts and circumstances, a change in variable consideration estimate will either be accounted for at the contract level or using the portfolio method. We also consider the customers’ rights of return in determining the transaction price where applicable. We exclude from the transaction price all taxes assessed by governmental authorities that are both (i) imposed on and concurrent with a specific revenue-producing transaction and (ii) collected from customers. Accordingly, such tax amounts are not included as a component of net sales or cost of sales. We allocate the transaction price to each performance obligation in an amount that depicts the amount of consideration to which we expect to be entitled in exchange for transferring and installing the Energy Server and providing associated maintenance services. Given that we typically sell an Energy Server with a maintenance service agreement and have not provided maintenance services to a customer who does not have use of an Energy Server, standalone selling prices are estimated using a cost-plus approach. Costs relating to Energy Servers include all direct and indirect manufacturing costs, applicable overhead costs and costs for normal production inefficiencies (i.e., variances). We then apply a margin to the Energy Servers which may vary with the size of the customer, geographic region and the scale of the Energy Server deployment. As our business offerings and eligibility for the Investment Tax Credit ("ITC") evolve over time, we may be required to modify the expected margin in subsequent periods and our revenue could be adversely affected. Costs relating to installation include all direct and indirect installation costs. The margin we apply reflects our profit objectives relating to installation. Costs for maintenance service arrangements are estimated over the life of the maintenance contracts and include estimated future service costs and future material costs. Material costs over the period of the service arrangement are impacted significantly by the longevity of the fuel cells themselves. After considering the total service costs, we apply a lower margin to our service costs than to our Energy Servers as it best reflects our long-term service margin expectations and comparable historical industry service margins. As a result, our estimate of our selling price is driven primarily by our expected margin on both the Energy Server and the maintenance service agreements based on their respective costs or, in the case of maintenance service agreements, the estimated costs to be incurred. We recognize product and installation revenue at the point in time that the Customer obtains control of the Energy Server. We recognize service revenue, including revenue associated with any related customer material rights, over time as we perform service maintenance activities. Amounts billed to customers for shipping and handling activities are considered contract fulfillment activities and not a separate performance obligation of the contract. Shipping and handling fees are recorded as revenue and the related cost is a cost to fulfill the contract that is recognized within costs of goods sold. The following is a description of the principal activities from which we generate revenue. Our four revenue streams are classified as follows: Product Revenue - All of our product revenue is generated from the sale of our Energy Servers to direct purchase, including financing partners on Third-Party PPAs, international channel providers and traditional lease customers. We generally recognize product revenue from contracts with customers at the point that control is transferred to the customers. This occurs when we achieve customer acceptance which is when the system has been installed and is running at full power or, in the case of sales to our international channel providers, based upon shipment terms. Under our traditional leases financing option, we sell our Energy Servers through a direct sale to a financing partner who, in turn, leases the Energy Servers to the customer under a lease agreement. With our sales to our international channel providers, our international channel providers typically sell the Energy Servers to, or sometimes provide a PPA to, an end customer. In both traditional lease and international channel providers transactions, we contract directly with the end customer to provide extended maintenance services after the end of the standard warranty period. As a result, since the customer that purchases the server is a different and unrelated party to the customer that purchases extended warranty services, the product and maintenance service contract are not combined. Payments received from customers are recorded within deferred revenue and customer deposits in the consolidated balance sheets until the acceptance criteria as defined within the customer contract are met. The related cost of such product and installation is also deferred as a component of deferred cost in the consolidated balance sheets until acceptance. Installation Revenue - Nearly all of our installation revenue relates to the installation of Energy Servers sold to direct purchase, including financing partners on Third-Party PPAs and traditional lease customers. Generally, we recognize installation revenue when the system has been installed and is running at full power. Service Revenue - Service revenue is generated from maintenance services agreements. We typically provide to our customers a standard one-year warranty against manufacturing or performance defects in our Energy Servers. We also sell to these customers extended annual maintenance services that effectively extend the standard one-year warranty coverage at the customer’s option. These customers generally have an option to renew or cancel the extended maintenance services on an annual basis and nearly every customer has renewed historically. The contractual renewal price may be less than the standalone selling price of the maintenance services and consequently the contract renewal option may provide the customer with a material right. Revenue is recognized over the term of the renewed one-year service period. Given our customers' renewal history, we anticipate that almost all of our customers will continue to renew their maintenance services agreements each year through their expected use of the Energy Server. As a result, we estimate the standalone selling price for customer renewal options that give rise to material rights using the practical alternative by reference to optional operations and maintenance services renewal periods expected to be provided and the corresponding expected consideration for these services. This reflects that our additional performance obligations in any contractual renewal period are consistent with the services provided under the initial maintenance service contract. Payments from customers for the extended maintenance contracts are received at the beginning of each service year. Accordingly, the customer payment received is recorded as a customer deposit and revenue is recognized over the related period as the services are performed using a cost-to-cost basis that reflects the cost of providing these services. Electricity Revenue - We sell electricity produced by our Energy Servers owned directly by us or by our consolidated PPA entities. Our PPA Entities purchase Energy Servers from us and sell electricity produced by these systems to customers through long-term power purchase agreements ("PPAs"). Customers are required to purchase all of the electricity produced by those Energy Servers at agreed-upon rates over the course of the PPAs' contractual term. In addition, in certain product sales, we are a party to master lease agreements that provide for the sale of our Energy Servers to third-parties and the simultaneous leaseback of the systems, which we then sublease to our customers. In sale-leaseback sublease arrangements ("Managed Services"), we first determine whether the Energy Servers under the sale-leaseback arrangement are “integral equipment”. As the Energy Servers are determined not to be integral equipment, we determine if the leaseback is classified as a capital lease or an operating lease. Our managed services arrangements with the financing party are classified as capital leases and are recorded as financing transactions, while the sub-lease arrangements with the end customer are classified as operating leases. Payments received from the financier are recorded as financing leases. We then recognize revenue for the electricity generated by allocating the total proceeds based on the relative standalone selling prices to electricity revenue and to service revenue. Electricity revenue relating to power purchase agreements is typically accounted for in accordance with ASC 840 Leases and service revenue in accordance with ASC 606. We recognize revenue from the PPAs and Managed Services contracts as the electricity is provided over the term of the agreement. Contract modifications are accounted for as separate contracts if the additional products and services are distinct and priced at standalone selling prices. If the additional products and services are distinct, but not priced at standalone selling prices, the modification is treated as a termination of the existing contract and the creation of a new contract. Lastly, if the additional products and services are not distinct within the context of the contract, the modification is combined with the original contract and either an increase or decrease in revenue is recognized on the modification date. During fiscal 2019, we did not recognize any material revenue for contracts modified during the period that had performance obligations satisfied in prior periods. We recognize a contract liability (deferred revenue) when we have an obligation to transfer products or services to a customer in advance of us satisfying a performance obligation and the contract liability is reduced as performance obligations are satisfied and revenue is recognized. The related cost of such product is deferred as a component of deferred cost of goods sold in the consolidated balance sheets. Prior to shipment of the product or the commencement of performance of maintenance services, any prepayment made by the customer is recorded as a customer deposit. Property, Plant and Equipment - Property, plant and equipment, including leasehold improvements are stated at cost less accumulated depreciation. Energy Servers are depreciated to their residual values over their useful economic lives which reflect consideration of the terms of their related power purchase and tariff agreements. These useful lives are reassessed when there is an expected change in the use of the Energy Servers. Leasehold improvements are depreciated over the shorter of the lease term or their estimated depreciable lives. The carrying amounts of our long-lived assets are periodically reviewed for impairment whenever events or changes in circumstances indicate that the carrying value of these assets may not be recoverable or that the useful life is shorter than originally estimated. Inventories - Inventories consist principally of raw materials, work-in-process and finished goods and are stated on a first-in, first-out basis at the lower of cost or net realizable value. We record inventory excess and obsolescence provisions for estimated obsolete or unsellable inventory, including inventory from purchase commitments, equal to the difference between the cost of inventory and estimated net realizable value based upon assumptions about market conditions and future demand for product generally expected to be utilized over the next 12 to 24 months, including product needed to fulfill our warranty obligations. If actual future demand for our products is less than currently forecasted, additional inventory provisions may be required. Once a provision is recorded, it is maintained until the product to which it relates to is sold or otherwise disposed. Derivative Financial Instruments We enter into derivative natural gas fixed price forward contracts to manage our exposure to the fluctuating price of natural gas under certain of our power purchase agreements entered in connection with the Bloom Electrons program. In addition, we enter into fixed forward interest rate swap arrangements to convert variable interest rates on debt to a fixed rate and on occasion have committed to certain utility grid price protection guarantees in sales agreements. We do not enter into derivative transactions for trading or speculative purposes. We account for our derivative instruments as either an asset or a liability which are carried at fair value on the consolidated balance sheets. Changes in the fair value of the derivatives that are designated and qualify as cash flow hedges are recorded in accumulated other comprehensive income (loss) on the consolidated balance sheets and for those that do not qualify for hedge accounting or are not designated hedges are recorded through earnings in the consolidated statements of operations. While we hedge certain of our natural gas purchase requirements under our power purchase agreements, we do not classify these natural gas fixed price forward contracts as designated hedges for accounting purposes. Therefore, we record the change in the fair value of our natural gas fixed price forward contracts in cost of revenue on the consolidated statements of operations. The fair value of the natural gas fixed price forward contracts is recorded on the consolidated balance sheets as a component of accrued expenses and other current liabilities and as derivative liabilities. As these forward contracts are considered economic hedges, the changes in the fair value of these forward contracts are classified as operating activities within the statement of cash flows, which is consistent with the classification of the cash flows of the hedged item. Our interest rate swap arrangements qualify as cash flow hedges for accounting purposes as they effectively convert variable rate obligations into fixed rate obligations. We evaluate and calculate the effectiveness of the hedge at each reporting date. The effective change is recorded in accumulated other comprehensive income (loss) and will be recognized as interest expense on settlement. As of January 1, 2019, we adopted Accounting Standards Update ("ASU") 2017-12 Derivatives and Hedging (Topic 815), Targeted Improvements to Accounting for Hedging Activities ("ASU 2017-12"). Per ASU 2017-12, ineffectiveness is no longer required to be measured or disclosed. If a cash flow hedge is discontinued due to changes in the forecasted hedged transactions, hedge accounting is discontinued prospectively and any unrealized gain or loss on the related derivative is recorded in accumulated other comprehensive income (loss) and is reclassified into earnings in the same period during which the hedged forecasted transaction affects earnings. The fair value of the swap arrangement is recorded on the consolidated balance sheets as a component of accrued expenses and other current liabilities and as derivative liabilities. The changes in fair value of swap agreement are classified as operating activities within the statement of cash flows, which is consistent with the classification of the cash flows of the hedged item. Stock-based Compensation We measure stock options and other stock-based awards such as restricted stock units, granted to employees and directors based on the fair value on the date of the grant and recognize 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 options with only service-based vesting conditions and record the expense for these awards using the straight-line method. The liability related to these awards is recognized over the period during which services are rendered until completed. The fair value of the stock-based compensation liability is estimated using the Black-Scholes option pricing model and are recorded in our consolidated statements of operations. The Black-Scholes option-pricing model 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 the award, the risk-free interest rate for a period that approximates the expected term of our stock options and our expected dividend yield. Principles of Consolidation These consolidated financial statements reflect our accounts and operations and those of our subsidiaries in which we have a controlling financial interest. We use a qualitative approach in assessing the consolidation requirement for each of our variable interest entities ("VIE"), which we refer to as our power purchase agreement entities ("PPA Entities"). This approach focuses on determining whether we haves the power to direct those activities of the PPA Entities that most significantly affect their economic performance and whether we have the obligation to absorb losses, or the right to receive benefits, that could potentially be significant to the PPA Entities. Noncontrolling Interests and Redeemable Noncontrolling Interests We generally allocate profits and losses to noncontrolling interests under the hypothetical liquidation at book value ("HLBV") method. HLBV is a balance sheet-oriented approach for applying the equity method of accounting when there is a complex structure, such as the flip structure of the PPE Entities. The determination of equity in earnings under the HLBV method requires management to determine how proceeds, upon a hypothetical liquidation of the entity at book value, would be allocated between our investors. The noncontrolling interest balance is presented as a component of permanent equity in the consolidated balance sheets. Noncontrolling interests with redemption features, such as put options, that are not solely within our control are considered redeemable noncontrolling interests. Exercisability of put options are solely dependent upon the passage of time, and hence, such put options are considered to be probable of becoming exercisable. We elected to accrete changes in the redemption value over the period from the date it becomes probable that the instrument will become redeemable to the earliest redemption date of the instrument by using an interest method. The balance of redeemable noncontrolling interests on the balance sheets is reported at the greater of its carrying value or its maximum redemption value at each reporting date. The redeemable noncontrolling interests are classified as temporary equity and therefore are reported in the mezzanine section of the consolidated balance sheets as redeemable noncontrolling interests. Emerging Growth Company Status The Jumpstart Our Business Startups Act of 2012 ("JOBS Act") provides that an “emerging growth company” can take advantage of the extended transition period afforded by the JOBS Act for the implementation of new or revised accounting standards. However, we have elected not to “opt out” of such extended transition period, which means that when a standard is issued or revised and it has different application dates for public or private companies, we will adopt the new or revised standard at the time private companies adopt the new or revised standard, provided that we continue to be an emerging growth company. Results of Operations Revenue We primarily recognize revenue from the sale and installation of Energy Servers, by providing services under maintenance contracts, and from electricity sales by our PPA Entities and from our Managed Services agreements. Product Revenue All of our product revenue is generated from the sale of our Energy Servers to direct purchase, Third-Party PPAs and traditional lease customers. We generally recognize product revenue from contracts with customers for the sales of our Energy Servers once we achieve acceptance; that is, generally when the system has been installed and is running at full power as defined in each contract or, for sales to some of our International Channel Partners, based upon shipment terms. The amount of product revenue we recognize in a given period is materially dependent on the volume and size of installations of our Energy Servers and on the type of financing used by the customer. Installation Revenue The majority of our installation revenue is generated from the installation of our Energy Servers to direct purchase Third-Party PPAs and traditional lease customers. The amount of installation revenue we recognize in a given period is materially dependent on the volume and size of installations of our Energy Servers in a given period, whether the customer chooses to do the installation themselves, and on the type of financing used by the customer. Service Revenue Service revenue is generated from operations and maintenance services agreements to support and maintain the Energy Servers in the field. Customers of our direct purchase, Third Party PPA and lease programs can renew their operating and maintenance services agreements on an annual basis for the life of the contract at prices predetermined at the time of purchase of the Energy Server. We anticipate that almost all of our customers will continue to renew their operations and maintenance services agreements each year throughout their expected use of the Energy Server. Electricity Revenue Our PPA Entities and financiers in our Managed Services contracts purchase Energy Servers from us and sell the electricity produced by these systems to end customers. Customers are required to purchase all of the electricity produced by the Energy Servers at agreed-upon rates over the course of the contract term. We generally recognize revenue from such PPA Entities and managed services customers as the electricity is provided over the term of the agreement. Cost of Revenue Our total cost of revenue consists of cost of product revenue, cost of installation revenue, cost of service revenue and cost of electricity revenue. It includes personnel costs associated with our operations and global customer support organizations consisting of salaries, benefits, bonuses, stock-based compensation and allocated facilities costs. Cost of Product Revenue Cost of product revenue consists of costs of Energy Servers that we sell to direct, Third Party PPA and traditional lease customers, including costs of materials, personnel costs, allocated costs, shipping costs, provisions for excess and obsolete inventory and the depreciation costs of our equipment. We expect our cost of product revenue to increase in absolute dollars as we deliver and install more Energy Servers and our product revenue increases. Cost of Installation Revenue Cost of installation revenue consists of the costs to install the Energy Servers that we sell to direct, Third Party PPA and traditional lease customers, including costs of materials and service providers, personnel costs, and allocated costs. In our Asia Pacific region, the cost of the installations and resulting revenue is attributable to our channel partners. Notwithstanding the use of channel partners, for the next twelve months, we expect our cost of installation revenue to increase in absolute dollars as we deliver and install more Energy Servers, though it will be subject to variability as a result of the timing of installation and other factors. Cost of Service Revenue Cost of service revenue consists of costs incurred under maintenance service contracts for all customers including direct sales, Third Party PPA, traditional lease, managed services and PPA customers. Such costs include personnel costs for our customer support organization, allocated costs and extended maintenance-related product repair and replacement costs. We expect our cost of service revenue to increase in absolute dollars as our base of megawatts deployed grows, and we expect our cost of service revenue to fluctuate period by period depending on the timing of maintenance of Energy Servers. Cost of Electricity Revenue Cost of electricity revenue primarily consists of the depreciation of the cost of the Energy Servers owned by our PPA Entities and by us through our managed services agreements and the cost of gas purchased in connection with our first PPA Entity. The cost of depreciation of the Energy Servers is reduced by the amortization of any U.S. Treasury grant payment in lieu of the energy investment tax credit associated with these systems. We expect our cost of electricity revenue to be correlated in absolute dollars to our base of megawatts deployed by our PPA entities and by us through our managed services agreements. Gross Profit (Loss) Gross profit (loss) has been and will continue to be affected by a variety of factors, including the sales price of our products, manufacturing costs, the costs to install the products, the costs to maintain the systems in the field, the mix of financing options used and the mix of revenue between product, service and electricity. We expect our gross profit to fluctuate over time depending on the factors described above. Operating Expenses Research and Development Research and development costs are expensed as incurred and consist primarily of personnel costs. Research and development expense also includes prototype related expenses and allocated facilities costs. We expect research and development expense to increase in absolute dollars as we continue to invest in our future products and services, and we expect our research and development expense to fluctuate as a percentage of total revenue. Sales and Marketing Sales and marketing expense consists primarily of personnel costs, including commissions. We expense commission costs as each performance obligation occurs over the duration of the contract. Sales and marketing expense also includes costs for market development programs, promotional and other marketing costs, travel costs, office equipment and software, depreciation, professional services and allocated facilities costs. We expect sales and marketing expense to continue to increase in absolute dollars as we increase the size of our sales and marketing organizations and as we expand our international presence, and we expect our sales and marketing expense to fluctuate as a percentage of total revenue. General and Administrative General and administrative expense consists of personnel costs, fees for professional services and allocated facilities costs. General and administrative personnel include our executive, finance, human resources, information technology, facilities, business development and legal organizations. We expect general and administrative expense to increase in absolute dollars due to additional legal fees and costs associated with accounting, insurance, investor relations, SEC and stock exchange compliance and other costs associated with being a public company, and we expect our general and administrative expense to fluctuate as a percentage of total revenue. Stock-Based Compensation We measure and recognize compensation costs for all stock-based awards, including stock options and purchase rights issued to employees based on the estimated fair value of the awards on the grant date. We use the Black-Scholes-Merton ("Black-Scholes") option pricing model to estimate the fair value of stock options and employee stock purchase plan ("ESPP") rights. The fair value of stock options is recognized as expense on a straight-line basis over the requisite service period, which is generally four years. The fair value of restricted stock units ("RSUs"), is measured using the fair value of our common stock on the date of the grant. The fair value of RSUs is recognized as expense on a straight-line basis over the requisite service period, which generally ranges from two to four years. For stock-based awards granted to employees with a performance condition, we recognize stock-based compensation costs using the accelerated attribution method over the requisite service period when management determines it is probable that the performance condition will be satisfied. For stock-based awards granted to employees with market conditions, we recognize stock-based compensation costs over the requisite service period and use the Monte Carlo simulation option pricing model to estimate the fair value of the awards at the time of grant. The fair value of the 2018 ESPP purchase rights is recognized as expense on the vesting period of each offering period. Stock-based compensation costs are recorded net of estimated forfeitures such that expense is recorded only for those stock-based awards that are expected to vest. Stock-based compensation expense is recorded in the consolidated statements of operations based on the employees’ respective function. Additionally, stock-based compensation costs relating to manufacturing employees are capitalized as a component of Energy Server manufacturing costs to inventory, deferred cost of revenues, construction-in-progress and property, plant and equipment as per ASC 330 and SEC Staff Accounting Bulletin Topic 14. These costs are expensed on consumption of the related inventory and over the economic useful life of the property, plant and equipment, as applicable. Interest Expense Interest expense primarily consists of interest charges associated with our secured line of credit, long-term debt facilities, financing obligations and capital lease obligations. Other Income (Expense), Net Other income (expense), net primarily consists of gains or losses associated with foreign currency fluctuations, net and of income earned on our cash and cash equivalents holdings in interest-bearing accounts. We have historically invested our cash in money-market funds. Gain (Loss) on Revaluation of Warrant Liabilities and Embedded Derivatives Warrants issued to investors and lenders that allow them to acquire our convertible preferred stock have been classified as liability instruments on our balance sheet. Since the warrants issued were mandatorily convertible into common stock at the completion of our IPO, the liability related to these mandatorily converted warrants was reclassified to additional paid-in capital on the IPO date and total gains and losses for revaluation of warrant liabilities was recorded in the consolidated statement of operations. We estimate the fair value of embedded derivatives in certain sales contracts using a Monte Carlo simulation model which considers various potential natural gas forward curves over the sales contract term. We record any changes in the fair value of these instruments between reporting dates in our consolidated statements of operations. Provision for Income Taxes Provision for income taxes consists primarily of federal and state income taxes in the United States and income taxes in foreign jurisdictions in which we conduct business. We have provided a full valuation allowance on our U.S. deferred tax assets because we believe it is more likely than not that the deferred tax assets will not be realized. At December 31, 2019, we had federal and state net operating loss carryforwards of $1.8 billion and $1.6 billion, respectively, which will expire, if unused, beginning in 2022 and 2028, respectively. Net Income (Loss) Attributable to Noncontrolling Interests We allocate profits and losses to the noncontrolling interests under the hypothetical liquidation at book value ("HLBV") method. HLBV is a balance sheet-oriented approach for applying the equity method of accounting when there is a complex structure, such as our PPA entities. Net income (loss) attributable to noncontrolling interests is deducted from our net income (loss) in determining our net income (loss) attributable to common stockholders. Deemed Dividend to Noncontrolling Interests We recognized a deemed dividend of $2.4 million on November 26, 2019 related to our buyout of the tax equity partner’s equity interest in PPA IIIb. The deemed dividend was recorded as a result of the buyout amount exceeding the hypothetical liquidation book value of the tax equity investor's equity interest in PPA IIIb on the date the buyout occurred. This charge impacted net income attributable to common stockholders and earnings per share in the year ended December 31, 2019. A discussion regarding our financial condition and results of operations for fiscal 2019 as compared to fiscal 2018 and for fiscal 2018 compared to fiscal 2017 is presented below. We adopted new revenue guidance, Accounting Standards Codification ("ASC") 606, Revenue From Contracts With Customers ("ASC 606"), which was effective from January 1, 2019 under the modified retrospective method which has limited the comparability of prior year results. The comparative information for periods prior to 2019 has not been recast for the impact of ASC 606. Additional comparative information is provided in Note 3 of the Notes to Consolidated Financial Statements for the adoption of ASC 606 and our proforma financial results under ASC 605, Revenue Recognition ("ASC 605"), for fiscal 2019. Comparison of the Years Ended December 31, 2019 and 2018 Revenue Total Revenue Total revenue increased by approximately $152.5 million, or 24.1%, for 2019 as compared to 2018. Revenue in 2019 included a revenue recognition timing adjustment decrease of $34.6 million associated with the adoption of ASC 606. Excluding this adjustment in 2019, revenue would have increased in 2019 by approximately $187.1 million, or 29.6%. Revenue in 2018 included a one-time benefit of $45.5 million associated with the 2017 retroactive ITC benefit recognized in the same period in 2018. In early 2018, the ITC law was retroactively reinstated, extending and phasing-out the ITC through 2021. Future application of ITC to new installations is subject to a phase-out schedule, see Note 14, Commitments and Contingencies - Investment Tax Credits for additional information. Excluding this one-time retroactive ITC benefit in 2018 and the adjustment in connection with the adoption of ASC 606, revenue would have increased in 2019 by approximately $232.6 million, or 39.6%, as compared to 2018. This increase was driven primarily by the increase in product acceptances of approximately 385 systems, or 47.6%, for 2019, as compared to 2018. Product Revenue Product revenue increased by approximately $156.7 million, or 39.1%, for 2019, as compared to 2018. This increase was driven by the increase in acceptances of 385 systems. Product revenue in 2018 included a one-time benefit of $45.5 million associated with the 2017 retroactive ITC benefit recognized in the same period in 2018 and product revenue in 2019 included an adjustment in connection with the adoption of ASC 606 of $44.5 million. Excluding these adjustments in 2018 and 2019, revenue increased during 2019 by approximately $246.7 million, or 69.5%, as compared to 2018, driven primarily by the increase in product acceptances of approximately 385 systems, or 47.6%, for 2019. Installation Revenue Installation revenue decreased by approximately $7.4 million, or 10.8%, for 2019, as compared to 2018. Installation revenue in 2019 included an adjustment in connection with the adoption of ASC 606 of $6.1 million. Excluding the adjustment in connection with the adoption of ASC 606, installation revenue would have decreased by approximately $13.5 million, or 19.8%. This decrease was generally driven by the higher mix of international acceptances, where we typically do not perform the installation service. Service Revenue Service revenue increased by approximately $12.5 million, or 15.0% for 2019, as compared to 2018. Service revenue in 2019 included an adjustment in connection with the adoption of ASC 606 of $3.8 million. Excluding the adjustment in connection with the adoption of ASC 606, service revenue would have increased by approximately $8.7 million, or 10.4%. This was primarily due to the increase in the number of annual maintenance contract renewals driven by our growing fleet of installed Energy Servers. Electricity Revenue Electricity revenue decreased by approximately $9.3 million, or 11.6%, for 2019, as compared to 2018, due to a reduction in electricity revenues resulting from the decommissioning and deconsolidation of the existing Energy Servers during the PPA II and PPA IIIb upgrades of Energy Servers. Electricity revenue is driven from our former Bloom Electrons program, which included PPA II and PPA IIIb. When these PPAs were decommissioned, we no longer recognized electricity revenue for them. Cost of Revenue Total Cost of Revenue Total cost of revenue increased by approximately $160.7 million, or 30.5%, for 2019, as compared to 2018. Total cost of revenue in 2019 included an adjustment in connection with the adoption of ASC 606 of $7.1 million. Excluding the adjustment in connection with the adoption of ASC 606, total cost of revenue increased by approximately $167.8 million, or 31.9%. Further, included as a component of total cost of revenue, stock-based compensation increased approximately $15.7 million for 2019, as compared to 2018. Total cost of revenue, excluding stock-based compensation, increased approximately $144.9 million, or 29.2%, for 2019, as compared to 2018. Cost of revenue for 2019 included $94.8 million in expenses associated with the PPA II and PPA IIIb upgrades of Energy Servers transactions. See Note 13, Power Purchase Agreement Programs - PPA II Upgrade of Energy Servers for further details. Cost of revenue for 2018 included a payment of $9.4 million driven by the reinstatement of the ITC program in February 2018 where we were required to repay certain suppliers for previously negotiated contractual discounts. Total cost of revenue, excluding stock-based compensation, the adjustment in connection with the adoption of ASC 606, the expenses associated with the PPA upgrades and the ITC reinstatement, increased approximately 66.7 million, or 13.7%, to $554.5 million for 2019, as compared to $487.8 million for 2018, primarily driven by higher volume of product acceptances. Cost of Product Revenue Cost of product revenue increased by approximately $154.2 million, or 54.8%, for 2019, as compared to 2018. Included as a component of cost of product revenue, stock-based compensation increased approximately $14.6 million for 2019, as compared to 2018. Cost of product revenue, excluding stock-based compensation, increased approximately $139.6 million, or 53.4%, for 2019, as compared to 2018. This increase was driven primarily by the increase in product acceptances of approximately 385 systems, or 47.6%, for 2019, as compared to 2018. There was also a $70.5 million write-off associated with the PPA upgrade projects in 2019, partially offset by a payment of $9.4 million recorded to cost of product revenue in 2018. This $9.4 million cost was driven by the reinstatement of the ITC program in February 2018 where we were required to repay certain suppliers for previously negotiated contractual discounts. Cost of Installation Revenue Cost of installation revenue decreased by approximately $18.8 million, or 19.7%, for 2019, as compared to 2018. This decrease was generally driven by the higher mix of international acceptances in 2019 where we do not perform the installation service and due to lower install cost associated with the PPA II and the PPA IIIb upgrades of Energy Servers. Cost of Service Revenue Cost of service revenue decreased by approximately $0.5 million, or 0.4%, for 2019, as compared to 2018. Cost of service revenue in 2019 included an adjustment in connection with the adoption of ASC 606 of $6.5 million. This adjustment is associated with performance guarantees to our customers and with the adoption of ASC 606, these costs are recorded as a reduction to service revenue. Excluding the adjustment in connection with the adoption of ASC 606, cost of service revenue increased by approximately $6.1 million, or 6.1%. This increase in service cost was primarily due to more power module replacements required in the fleet as our fleet of installed Energy Servers grows with acceptances and additional extended service contracts are executed and renewed. Cost of Electricity Revenue Cost of electricity revenue increased by approximately $25.8 million, or 51.9%, for 2019, as compared to 2018, mainly due to a $24.4 million charge related to the decommissioning and deconsolidation of Energy Servers associated with the PPA II and PPA IIIb upgrades of Energy Servers. Gross Profit (Loss) Total Gross Profit Gross profit decreased $8.2 million in 2019, as compared to 2018. During 2018, gross profit included a one-time benefit of $36.1 million associated with the 2017 retroactive ITC benefit and 2019 included an adjustment in connection with the adoption of ASC 606 of $27.4 million. Excluding the one-time retroactive ITC benefit in 2018 and the adjustment in connection with the adoption of ASC 606 in 2019, gross profit increased approximately $55.4 million, or 79.5% in 2019, as compared to 2018. This increase was generally due to the increase in product acceptances and lower product cost driven by ongoing cost reduction activities. Product Gross Profit Product gross profit increased $2.5 million in 2019, as compared to 2018. Excluding the one-time retroactive ITC benefit of $36.1 million in 2018 and the adjustment in connection with the adoption of ASC 606 in 2019 of $43.9 million, gross profit increased approximately $82.5 million, or 99.1% in 2019, as compared to 2018. This increase was generally due to the increase in product acceptances and lower product cost driven by ongoing cost reduction activities. Installation Gross Loss Installation gross loss decreased $11.5 million in 2019, as compared to 2018. Excluding the adjustment in connection with the adoption of ASC 606 in 2019 of $6.1 million, installation gross loss decreased by $5.4 million, or 19.7%. This improvement was due to lower installation costs due to a higher mix of international customer sites accepted in 2019, as compared to 2018. Our installation costs are driven by the complexity of each site at which we are installing an Energy Server, including personalized applications, the size of each installation, which can cause variability in installation costs, and whether we or our international partners perform the installation. Service Gross Loss Service gross loss decreased $13.0 million in 2019, as compared to 2018. Excluding the adjustment in connection with the adoption of ASC 606 in 2019 of $10.4 million, service gross loss decreased by $2.6 million, or 14.8%. This improvement was primarily due to an increase in service revenue outpacing the increase in service cost required for maintaining the fleet of installed Energy Servers. Electricity Gross Profit Electricity gross profit decreased $35.1 million, or 113.4% in 2019, as compared to 2018, mainly due to charges related to the decommissioning and deconsolidation of Energy Servers associated with the PPA II and PPA IIIb upgrades of Energy Servers. Operating Expenses Total Operating Expenses Total operating expenses increased $59.6 million, or 22.0%, in 2019, as compared to 2018. Included as a component of total operating expenses, stock-based compensation expenses increased approximately $12.1 million for 2019, as compared to 2018. The increase in stock-based compensation expense is primarily attributable to a one-time employee grant of restricted stock units ("RSUs") awarded prior to IPO with a performance condition of an IPO of the Company's securities. These RSUs have a two-year vesting period starting on the day of IPO and were issued as an employee retention vehicle to bring our stock-based compensation in line with our peer group. In addition to the one-time grant, the stock-based compensation includes some previously granted RSUs with vesting beginning upon the completion of our IPO. Total operating expenses, excluding stock-based compensation, increased approximately $47.6 million, or 36.1%, in 2019, as compared to 2018. This increase was primarily due to compensation related expenses associated with hiring new employees, investments for next generation servers and customer personalized application technology development, expenses related to our demand generation functions, expenses related to our public company readiness and a $5.9 million debt payoff make-whole penalty associated with the PPA II upgrade of Energy Servers. Research and Development Research and development expenses increased by approximately $15.0 million, or 16.9%, in 2019, as compared to 2018. Included as a component of research and development expenses, stock-based compensation expenses increased by approximately $1.9 million for 2019, as compared to 2018. Total research and development expenses, excluding stock-based compensation, increased by approximately $13.1 million, or 26.2%, for 2019, as compared to 2018. This increase was primarily due to compensation-related expenses for hiring new employees and investments made for our next generation technology development, sustaining engineering projects for the current Energy Server platform, and investments made for customer personalized applications, such as microgrid and storage solutions, and new fuel solutions utilizing biogas. Sales and Marketing Sales and marketing expenses increased by approximately $10.8 million, or 17.1%, in 2019, as compared to 2018. Included as a component of sales and marketing expenses, stock-based compensation expenses increased by approximately $0.2 million for 2019, as compared to 2018. Total sales and marketing expenses, excluding stock-based compensation, increased by approximately $10.6 million, or 34.6%, for 2019, as compared to 2018. This increase was primarily due to compensation expenses related to hiring new employees and expenses related to efforts to increase demand and raise market awareness of our Energy Server solutions, expanding outbound communications, as well as efforts to attract new customer financing partners. General and Administrative General and administrative expenses increased by approximately $33.8 million, or 28.5%, in 2019, as compared to 2018. Included as a component of general and administrative expenses, stock-based compensation expenses increased by approximately $9.9 million for 2019, as compared to 2018. The majority of this increase was due to stock-based compensation expenses related to the RSU grants made at the time of our IPO. Total general and administrative expenses, excluding stock-based compensation, increased by approximately $23.9 million, or 46.5% for 2019, as compared to 2018. The increase in general and administrative expenses was due to an increase in compensation related expenses associated with hiring new employees to support public company readiness across accounting and legal functions, expenses related to becoming a public company and information technology related expenses for infrastructure and security support, as well as $5.9 million for a debt payoff make-whole penalty associated with the PPA II upgrade of Energy Servers and a production insurance write-off of $1.8 million associated with the PPA IIIb upgrade of Energy Servers. Stock-Based Compensation Total stock-based compensation increased $27.8 million, or 16.5%, in 2019, as compared to 2018. Of the $196.3 million in stock-based compensation for 2019, approximately $91.3 million was related to one-time employee grants of RSUs that were issued at the time of our IPO and that have a two-year vesting period. These RSUs provided us an employee retention vehicle to bring our stock-based compensation in line with our peer group. In addition, the stock-based compensation included some previously granted RSUs that vested upon the completion of our IPO. Other Income and Expense Total Other Expense Total other expense decreased $34.7 million in 2019, as compared to 2018. This decrease was primarily due to the change in accounting for warrant liabilities and embedded derivatives that occurred at the time of the IPO removing the re-measurement requirement for these instruments, as well as due to a decrease in interest expense following the conversion of a portion of our debt into equity at the time of the IPO and the reduction of debt due to the PPA II and PPA IIIb upgrades. Interest Income Interest income increased $1.3 million in 2019, as compared to 2018. This increase was primarily due to the increase in interest on the cash and short-term investment balances which increased from proceeds from the IPO. Interest Expense Interest expense decreased $9.5 million in 2019, as compared to 2018. This decrease was primarily due to lower amortization expense of our debt derivatives and a decrease in interest expense with the debt buy-out due to the PPA II and PPA IIIb upgrades. Interest Expense, Related Parties Interest expense, related parties decreased $2.1 million due to the conversion of $40.1 million of our 8% Notes from related parties into equity at the time of the IPO. Other Income (Expense), net Other income (expense), net increased $1.7 million in 2019, as compared to 2018, due to changes in foreign currency translation expense. Loss on Revaluation of Warrant Liabilities and Embedded Derivatives Upon the IPO in 2018, the final valuation of the embedded derivatives related to the 6% Notes was reclassified from a derivative liability to additional paid-in capital and as a result, we did not record any valuation adjustments in 2019. In 2018, we recognized net loss of $22.1 million primarily due to an increase in the value of our derivatives of $31.2 million, which was partially offset by gains recognized from the revaluation of the preferred warrant liability of $9.1 million. Provision for Income Taxes Income tax provision decreased in 2019, as compared to 2018, and was primarily due to fluctuations in the effective tax rates on income earned by international entities. Net Loss Attributable to Noncontrolling Interests and Redeemable Noncontrolling Interests Total loss attributable to noncontrolling interests increased $1.3 million, or 7.4%, in 2019, as compared to 2018. The net loss increased due to increased losses in our PPA Entities which are allocated to our noncontrolling interests. Comparison of the Years Ended December 31, 2018 and 2017 Revenue Total Revenue Total revenue increased by approximately $267.0 million, or 73.0%, for 2018, as compared to 2017. There were four principal drivers of this revenue increase. First, product acceptances increased by approximately 187 systems, or 30.1%, for 2018, as compared to 2017. Second, we achieved a higher mix of orders from customers where revenue is recognized on acceptance compared to orders where revenue is recognized ratably over the term of the agreement. In 2018, we recognized 89.6% of our orders at acceptance, whereas only 77.4% of total acceptances in 2017 were recognized at acceptance. Third, the Federal Investment Tax Credit ("ITC") was reinstated on February 9, 2018. ITC was not available to the fuel cell industry in 2017, however, our revenue in 2018 includes the benefit of the reinstatement. Lastly, the adoption of customer personalized applications, such as batteries and grid-independent solutions, increased in 2018, as compared to 2017. Customer orders that include these personalized applications generated, on average, higher revenue than our standard orders that do not include these personalized applications. Product Revenue Product revenue increased by approximately $243.4 million, or 154.9%, for 2018, as compared to 2017. This increase was driven by the increase in acceptances, higher mix of orders where revenue is recognized on acceptance, the ITC reinstatement, and an increase in the sales of customer personalized applications. Installation Revenue Installation revenue increased by approximately $10.3 million, or 17.7%, for 2018, as compared to 2017. This increase was driven by the increase in acceptances, higher mix of orders where revenue is recognized on acceptance, and an increase in the sales of customer personalized applications, partially offset by the lower installation revenue associated with one large customer in 2018 where the installation was performed by the customer and as a result, we did not have any installation revenue for that customer. In general, when a customer or, in the case of SK E&C in the Republic of Korea, a partner performs the installation service, we do not generate significant revenue for the installation. Service Revenue Service revenue increased by approximately $8.4 million, or 11.2% for 2018, as compared to 2017. This was primarily due to the increase in the number of annual maintenance contract renewals driven by our growing fleet of installed Energy Servers. Electricity Revenue Electricity revenue increased by approximately $4.9 million, or 6.5%, for 2018, as compared to 2017, due primarily to a growing fleet of installed Energy Servers related to our managed service customers where revenue is recognized over the term of the agreement, as well as Bloom Electrons customers whose contracts were initiated in 2017 and therefore only recognized revenue for a partial year versus a full year in 2018. Cost of Revenue Total Cost of Revenue Total cost of revenue increased by approximately $145.0 million, or 38.0%, for 2018, as compared to 2017. Included as a component of total cost of revenue, stock-based compensation increased approximately $23.3 million for 2018, as compared to 2017. Total cost of revenue, excluding stock-based compensation, increased approximately $121.6 million, or 32.4%, to $497.2 million for 2018, as compared to $375.6 million for 2017. This increase in total cost of revenue was primarily attributable to higher product and install cost of revenue which was driven by an increase in the volume of product acceptances and a higher mix of orders with customers in which cost of revenue is recognized on acceptance, instead of ratably over the life of the agreement. Additionally there was an increase in the sales of customer personalized applications for 2018. These applications generally have a cost associated with them and therefore cause an increase in the cost of revenue. Cost of Product Revenue Cost of product revenue increased by approximately $88.9 million, or 46.2%, for 2018, as compared to 2017. This increase was driven by the increase in acceptances, higher mix of orders where cost of revenue is recognized on acceptance, increased costs from the sales of customer personalized applications, and an increase in stock-based compensation. Additionally, as a result of the reinstatement of the ITC program in February 2018, we were required to repay certain suppliers for previously negotiated contractual discounts. This payment of $9.4 million was recorded to cost of product revenue. Cost of Installation Revenue Cost of installation revenue increased by approximately $40.3 million, or 73.4%, for 2018, as compared to 2017. This increase was driven by the increase in acceptances, higher mix of orders where cost of revenue is recognized on acceptance, and increased costs from the sales of customer personalized applications where the installation is more complex, partially offset by the lower cost of installation associated with one large customer in 2018 where the installation was performed by the customer and as a result, we did not have any installation cost for that customer. In general, when we do not perform the installation function for a customer, such as in SK E&C in the Republic of Korea, we do not incur any significant installation costs on those orders. Cost of Service Revenue Cost of service revenue increased by approximately $15.6 million, or 18.3%, for 2018, as compared to 2017. This increase in service cost was primarily due to more power module replacements required in the fleet as a result of a larger fleet of installed Energy Servers, as well as replacing older generation power modules during the normal service process. Cost of Electricity Revenue Cost of electricity revenue increased by approximately $0.2 million, or 0.3%, for 2018, as compared to 2017, due to a growing fleet of installed Energy Servers related to our managed service customers where cost is recognized over the term of the agreement, as well as Bloom Electrons customers whose contracts were initiated in 2017 and therefore, we only recognized cost for a partial year versus a full year in 2018. These increases were offset by a gain recorded as a result of the fair value adjustment on our natural gas fixed price forward contract. Gross Profit (Loss) Total Gross Profit Gross profit improved $122.1 million in 2018, as compared to 2017. This improvement was generally as a result of higher product margins due to the increase in product acceptances which drove higher volume, a higher mix of orders recognized at acceptance versus ratably over the life of the agreement, and the reinstatement of the ITC. Product Gross Profit Product gross profit improved $154.5 million in 2018, as compared to 2017. This increase was due to the increase in product acceptances which drove higher volume, a higher mix of orders recognized at acceptance versus ratably over the life of the Bloom Electrons' or managed service contracts and the reinstatement of the ITC. Installation Gross Loss Installation gross amount worsened $30.1 million in 2018, as compared to 2017. This decrease from profit to a loss was due to higher installation costs associated with the initial installations for the new customer personalized applications. Our installation costs are driven by the complexity of each site at which we are installing an Energy Server, including personalized applications, as well as the size of each installation, which can cause variability in installation costs from year-to-year. Service Gross Loss Service gross loss worsened $7.2 million in 2018, as compared to 2017. This increased loss was primarily due to more power module replacements required in the fleet as a result of a larger fleet of installed Energy Servers, as well as replacing older power modules during the normal service process. Electricity Gross Profit Electricity gross profit increased $4.8 million, or 18.3%, in 2018, as compared to 2017 due to a gain recorded as a result of the fair value adjustment on a natural gas fixed price forward contract and a growing fleet of installed Energy Servers related to our managed service customers. Operating Expenses Total Operating Expenses Total operating expenses increased $132.0 million, or 95.1%, in 2018, as compared to 2017. Included as a component of total operating expenses, stock-based compensation expenses increased approximately $116.1 million for 2018, as compared to 2017, accounting for much of the year-over-year increase. The increase in stock-based compensation is primarily attributable to a one-time employee grant of restricted stock units ("RSUs") at the time of our IPO and that have a two-year vesting period. These RSUs provided us with a market equity employee retention vehicle to help us compete for talent across our peer group. Additionally, the stock-based compensation included some previously granted RSUs that vested upon the completion of our IPO. Total operating expenses, excluding stock-based compensation, increased approximately $15.9 million, or 13.7%, in 2018, as compared to 2017. This increase was primarily due to compensation related expenses associated with hiring new employees, investments for next generation servers and customer personalized application technology development, and expenses related to our efforts to increase demand and raise market awareness of our Energy Server solutions, as well as to drive new customer financing partners. Research and Development Research and development expenses increased by approximately $38.0 million, or 74.3%, in 2018, as compared to 2017. Included as a component of research and development expenses, stock-based compensation expenses increased by approximately $33.5 million for 2018, as compared to 2017. The majority of this increase was due to stock-based compensation expenses related to the RSU grants made at the time of our IPO. Total research and development expenses, excluding stock-based compensation, increased by approximately $4.5 million, or 9.9%, for 2018, as compared to 2017. This increase was primarily due to compensation-related expenses related to hiring new employees and investments made for customer personalized applications, such as a battery solution, sustaining engineering projects for the current Energy Server platform and investments made for our next generation technology development. Sales and Marketing Sales and marketing expenses increased by approximately $30.9 million, or 96.7%, in 2018, as compared to 2017. Included as a component of sales and marketing expenses, stock-based compensation expenses increased by approximately $27.6 million for 2018, as compared to 2017. The majority of this increase was due to stock-based compensation expenses related to the RSU grants made at the time of our IPO. Total sales and marketing expenses, excluding stock-based compensation, increased by approximately $3.3 million, or 12.0%, for 2018, as compared to 2017. This increase was primarily due to compensation expenses related to hiring new employees and expenses related to efforts to increase demand and raise market awareness of our Energy Server solutions, expanding outbound communications, as well as efforts to attract new customer financing partners. General and Administrative General and administrative expenses increased by approximately $63.1 million, or 113.4%, in 2018, as compared to 2017. Included as a component of general and administrative expenses, stock-based compensation expenses increased by approximately $55.0 million for 2018, as compared to 2017. The majority of this increase was due to stock-based compensation expenses related to the RSU grants made at the time of our IPO. Total general and administrative expenses, excluding stock-based compensation, increased by approximately $8.1 million, or 18.8%, for 2018, as compared to 2017. The increase in general and administrative expenses was due to an increase in compensation related expenses associated with hiring new employees to support public company readiness across accounting and legal functions, expenses related to becoming a public company and information technology related expenses for infrastructure and security support. Stock-Based Compensation Total stock-based compensation increased $139.4 million, or 479%, in 2018, as compared to 2017. Of the $168.5 million in stock-based compensation for 2018, approximately $139.1 million was related to one-time employee grant of RSUs that were issued at the time of our IPO and that have a two-year vesting period. These RSUs provided us with a market equity employee retention vehicle necessary to compete for talent across our peer group. In addition, the stock-based compensation included some previously granted RSUs that vested upon completion of our IPO. Other Income and Expense Total Other Expense Total other expense decreased $14.6 million in 2018, as compared to 2017. This decrease was primarily due to the decrease in interest expense following the conversion of a portion of our debt into equity at the time of the IPO. Interest Income Interest income increased $3.6 million in 2018, as compared to 2017. This increase was primarily due to the increase in interest on the short-term investment balances which increased from proceeds from the IPO. Interest Expense Interest expense decreased $15.0 million in 2018, as compared to 2017. This decrease was primarily due to lower amortization expense of our debt derivatives and due to the conversion of a portion of our debt into equity at the time of the IPO. Interest Expense, Related Parties Interest expense, related parties decreased $3.4 million due to the conversion of $40.1 million of our 8% Notes from related parties into equity at the time of the IPO. Other Income (Expense), net Other expense decreased $0.5 million in 2018, as compared to 2017. This change was primarily due to an increase in interest income, partially offset by foreign currency translation. Revaluation of Warrant Liabilities and Embedded Derivatives For 2018, we recognized net loss of $22.1 million primarily due to an increase in the value of our derivatives of $31.2 million, which was partially offset by gains recognized from the revaluation of the preferred warrant liability of $9.1 million. The loss on revaluation of warrant liabilities and embedded derivatives increased $6.9 million when compared to 2017. Provision for Income Taxes Income tax provision increased in 2018, as compared to 2017 and was primarily due to fluctuations in the effective tax rates on income earned by international entities. Net Loss Attributable to Noncontrolling Interests and Redeemable Noncontrolling Interests Total loss attributable to noncontrolling interests decreased $0.9 million, or 5.0%, in 2018, as compared to 2017. The net loss decreased due to the allocation of our lower net loss using HLBV allocation methodology. Liquidity and Capital Resources As of December 31, 2019, we had an accumulated deficit of approximately $2.9 billion. We have financed our operations, including the costs of acquisition and installation of Energy Servers, mainly through a variety of financing arrangements and PPA Entities, credit facilities from banks, sales of our common stock, debt financings and cash generated from our operations. As of December 31, 2019, we had $401.4 million of total outstanding recourse debt, $235.4 million of non-recourse debt and $28.0 million other long term liabilities. See Note 7, Outstanding Loans and Security Agreements for a complete description of our outstanding debt. As of December 31, 2019 and 2018, we had cash and cash equivalents and short-term investments of $202.8 million and $325.1 million, respectively. In July 2018, we successfully completed an initial public offering ("IPO") of our securities with the sale of 20,700,000 shares of our Class A common stock at a price of 15.00 per share, resulting in cash proceeds of $282.3 million, net of underwriting discounts, commissions and estimated offering costs. We believe that our existing cash and cash equivalents will be sufficient to meet our operating and capital cash flow requirements and other cash flow needs for at least the next 12 months from the date of this Annual Report on Form 10-K. As of December 31, 2019, the current portion of our total debt is $337.6 million, which would require cash payments of $353.5 million in the next 12 months. On March 31, 2020, we extended the maturity for all but $70.0 million of current debt as follows: We entered into an Amendment Support Agreement (the “Amendment Support Agreement”) with the beneficial owners (the “Noteholders”) of our outstanding 6.0% Convertible Notes due 2020 (the “Convertible Notes”) pursuant to which such Noteholders have agreed, subject to certain conditions set forth therein, to consent to, among other things, certain amendments to the indenture (the “Proposed Amendments”) dated as of December 15, 2015, as supplemental by the First Supplemental Indenture dated as of September 20, 2016, the Second Supplemental Indenture dated as of June 29, 2017 and the Third Supplemental Indenture dated as of January 18, 2018, each among us, the guarantor party thereto and U.S. Bank National Association, as trustee and collateral agent (as so supplemented, the “Original Indenture”), pursuant to which the Convertible Notes were issued to extend the maturity date of the Convertible Notes to December 1, 2021. In connection with the execution and delivery of the Amendment Documents, on March 31, 2020, we entered into an Amended and Restated Subordinated Secured Convertible Note Modification Agreement (the “Constellation Note Modification Agreement”) with Constellation NewEnergy, Inc. (“Constellation”) pursuant to which certain terms of our outstanding Amended and Restated Subordinated Secured Convertible Note issued to Constellation were modified to extend the maturity date to December 31, 2021. Furthermore, on March 31, 2020, we entered into a note purchase agreement and convertible note purchase agreement, as follows: We entered into a note purchase agreement (the “Note Purchase Agreement”) with certain investors pursuant to which such investors have agreed to purchase, and we have agreed to issue, $70.0 million of 10.25% Senior Secured Notes due 2027 (the “Senior Secured Notes”) in a private placement (the “Senior Secured Notes Private Placement”). The funding of the Note Purchase Agreement is subject to certain conditions including obtaining a rating from a rating agency. We entered into a convertible note purchase agreement (the “Convertible Note Purchase Agreement”) with Foris Ventures, LLC and New Enterprise Associates 10, Limited Partnership (together, the “Purchasers”), pursuant to which such Purchasers were issued $30.0 million aggregate principal amount of additional Convertible Notes (the “Additional Convertible Notes”) under the Amended and Restated Indenture. The combination of our existing cash and cash equivalents, the extension of the Convertible Notes and Constellation Note Modification to December 2021, the proceeds from the convertible note agreement and operating cash flows are expected to be sufficient to meet our operational and capital cash flow requirements and other cash flows for the next 12 months from the date of this Annual Report on Form 10-K, including the current portion of our total debt. Our future cash flow requirements may vary materially from those currently planned and will depend on many factors, including our rate of revenue growth, the timing and extent of spending on research and development efforts and other business initiatives, the rate of growth in the volume of system builds, the expansion of sales and marketing activities, market acceptance of our products, the timing of receipt by us of distributions from our PPA Entities and overall economic conditions including the impact of COVID-19 on our future operations. We do not expect to receive significant cash distributions from our PPA Entities. During June 2019, we completed a transaction for the PPA II upgrade of Energy Servers and we repaid all the PPA II outstanding debt of $76.8 million. During November 2019, we completed a transaction for the PPA IIIb upgrade of Energy Servers and we repaid all the PPA IIIb outstanding debt of $23.9 million. For additional information refer to Note 13, Power Purchase Agreement Programs. Cash Flows A summary of our sources and uses of cash, cash equivalents and restricted cash is as follows (in thousands): Net cash provided by (used in) our variable interest entities (the PPA Entities) which are incorporated into the consolidated statements of cash flows for December 31, 2019, 2018 and 2017, is as follows (in thousands): 1 The PPA Entities' operating and financing cash flows are a subset of our consolidated cash flows and represents the stand-alone cash flows prepared in accordance with U.S. GAAP. Operating activities consist principally of cash used to run the operations of the PPA Entities, the purchase of Energy Servers from us and principal reductions in loan balances. Financing activities consist primarily of changes in debt carried by our PPAs, and payments from and distributions to noncontrollling partnership interests. We believe this presentation of net cash provided by (used in) PPA activities is useful to provide the reader with the impact to consolidated cash flows of the PPA Entities in which we have only a minority interest. Operating Activities Net cash provided by operating activities for the twelve months ended December 31, 2019 was $163.8 million and was primarily the result of net cash earnings of $67.3 million plus the net decrease in working capital of $96.5 million. Net cash earnings is primarily comprised of a net loss of $323.5 million, adjusted for non-cash benefit items including: (i) depreciation and amortization of $78.6 million; (ii) PPA II and PPA IIIb decommissioning costs of $70.5 million; (iii) write-off of property, plant and equipment net of $3.1 million; (iv) impairment of assets of $11.3 million; (v) a loss on revaluation of derivative contracts of $2.8 million; (vi) stock-based compensation of $196.3 million; (vii) amortization of debt issuance cost of $22.1 million, plus (viii) an expense reclass to financing activities related to a debt make-whole expense of $5.9 million. Net cash provided from changes in working capital consisted primarily of decreases in: (i) accounts receivable of $52.0 million; (ii) inventories of $18.4 million; (iii) customer financing receivable of $5.5 million; (iv) prepaid expenses and other current assets of $8.6 million; and (v) other long-term assets of $3.6 million; plus increases in: (vi) accrued expenses and other current liabilities of $6.7 million; and (vii) other long-term liabilities of $4.4 million, and (viii) deferred revenue and contract liabilities of $37.1 million. These sources of cash from working capital were partially offset by increases in: (i) deferred cost of revenue of $22.0 million; and (ii) decreases in: accounts payable of $11.3 million and (iii) accrued warranty of $6.6 million. Net cash used in operating activities for the twelve months ended December 31, 2018 was $91.9 million and was the result of net cash loss of $22.4 million and the net increase in working capital of $69.5 million. Net cash loss is primarily comprised of a net loss of $291.3 million, adjusted for non-cash benefit items including: (i) depreciation and amortization of approximately $53.9 million; (ii) write-off of property, plant and equipment net of $0.9 million; (iii) a loss on revaluation of derivative contracts of $29.0 million; (iv) stock-based compensation of $168.5 million; and (v) amortization of debt issuance cost of $25.4 million; partially offset by (vi) a gain on revaluation of stock warrants of $9.1 million. Net cash used by changes in working capital consisted primarily of increases in: (i) accounts receivable of $55.0 million; (ii) inventory of $37.0 million; and (iii) prepaid expenses and other current assets of $8.0 million; plus a decrease in: (iv) accrued expenses and other current liabilities of $6.0 million; and (v) deferred revenue and contract liabilities of $21.8 million. These uses of cash for working capital were partially offset by decreases in: (i) deferred cost of revenue of $14.2 million; and (ii) customer financing receivable and other of $4.9 million; plus increases in: (iv) accounts payable of $18.3 million; (v) accrued warranty of $1.5 million; and (vi) other long term liabilities of $19.6 million. Net cash used in operating activities for the twelve months ended December 31, 2017 was $92.0 million and was the result of net cash loss of $152.2 million partially offset by the net increase in working capital of $60.2 million. Net cash loss is primarily comprised of a net loss of $295.0 million, adjusted for non-cash benefit items including: (i) depreciation and amortization of approximately $54.4 million; (ii) a loss on revaluation of derivative contracts of $15.0 million; (iii) stock-based compensation of $29.1 million; and (iv) amortization of debt issuance cost of $47.3 million; partially offset by (v) a gain on revaluation of stock warrants of $3.0 million. Net cash provided by changes in working capital consisted primarily of decreases in: (i) accounts receivable of $3.2 million; (ii) customer financing receivable and other of $5.5 million, and (iii) other long-term assets of $0.8 million; plus an increase in: (iv) accrued expenses and other current liabilities of $8.0 million; (v) deferred revenue and contract liabilities of $48.3 million; and (vi) other long term liabilities of $37.6 million. These sources of cash from working capital were partially offset by increases in: (i) inventory of $10.6 million; (ii) deferred cost of revenue of $31.3 million; and (iii) prepaid expenses and other current assets of $1.0 million; plus decrease in: (iv) accrued warranty of $7.4 million. Investing Activities Net cash provided by investing activities in the twelve months ended December 31, 2019 was $53.4 million which included proceeds from maturity of marketable securities of $104.5 million, partially offset by $51.1 million used for the purchase of long-lived assets. Our use of cash in the twelve months ended December 31, 2019 for the purchase of property, plant and equipment increased, as compared to the same period in 2018, due to completing a move to our new corporate headquarters which is used for administration, research and development, and sales and marketing. Net cash used in investing activities in the twelve months ended December 31, 2018 was $125.4 million which was primarily the result of net purchase of marketable securities of $76.9 million, plus $48.5 million used for the purchase of long-lived assets. Net cash used in investing activities in the twelve months ended December 31, 2017 was $88.2 million which was primarily the result of net purchase of marketable securities of $26.8 million, plus $61.5 million used for the purchase of long-lived assets. Financing Activities Net cash used in financing activities in the twelve months ended December 31, 2018 was $120.3 million which included payments to noncontrolling and redeemable noncontrolling interest of $56.5 million, distributions paid to our PPA Equity Investors of $12.5 million, repayments of debt of $121.5 million, and a debt make-whole payment of $5.9 million related to our PPA II upgrade of Energy Servers, partially offset by proceeds from issuance of common stock of $12.7 million. Net cash provided by financing activities in the twelve months ended December 31, 2018 was $317.2 million resulted primarily from our initial public offering netting $292.5 million plus proceeds from the issuance of common stock of $1.5 million, partially offset by distributions paid to our PPA Equity Investors of $15.3 million, repayments of long-term debt of $20.2 million, and payments of initial public offering issuance costs of $5.5 million. Net cash provided by financing activities in the twelve months ended December 31, 2017 was $142.9 million resulted from net proceeds from the issuance of debt of $93.9 million and net proceeds from noncontrolling and redeemable noncontrolling interests of $13.7 million, partially offset by distributions paid to our PPA Equity Investors of $23.7 million, repayments of long-term debt of $21.4 million, and costs related to our initial public offering of $1.1 million. Outstanding Loans and Security Agreements The following is a summary of our debt as of December 31, 2019 (in thousands): Recourse debt refers to debt that Bloom Energy Corporation has an obligation to pay. Non-recourse debt refers to debt that is recourse to only specified assets or our subsidiaries. The differences between the unpaid principal balances and the net carrying values are due to debt discounts and deferred financing costs. We were in compliance with all of our financial covenants as of December 31, 2019 and 2018. Recourse Debt Facilities LIBOR + 4% Term Loan due November 2020 - In May 2013, we entered into a $5.0 million credit agreement and a $12.0 million financing agreement to help fund the building of a new facility in Newark, Delaware. The $5.0 million credit agreement expired in December 2016. The $12.0 million financing agreement has a term of 90 months, payable monthly at a variable rate equal to one month LIBOR plus the applicable margin. The year-to-date weighted average interest rate as of December 31, 2019 and 2018 was 6.3% and 5.9%, respectively. The loan requires monthly payments and is secured by the manufacturing facility. In addition, the credit agreement includes a cross-default provision which provides that the remaining balance of borrowing under the agreement will be due and payable immediately if a lien is placed on the Newark facility in the event we default on any indebtedness in excess of $100,000 individually or $300,000 in the aggregate. Under the terms of the financing agreement, we are required to comply with various restrictive covenants. As of December 31, 2019 and 2018, the debt outstanding was $1.6 million and $3.3 million, respectively. 5% Convertible Promissory Notes due 2020 (Originally 8% Convertible Promissory Notes due December 2018) - Between December 2014 and June 2016, we issued $193.2 million of three-year convertible promissory notes ("8% Notes") to certain investors. The 8% Notes had a fixed interest rate of 8% compounded monthly, due at maturity or at the election of the investor with accrued interest due in December of each year. On January 18, 2018, amendments were finalized to extend the maturity dates for all the 8% Notes to December 2019. At the same time, the portion of the notes that was held by Constellation NewEnergy, Inc. ("Constellation") was extended to December 2020 and the interest rate decreased from 8% to 5% ("5% Notes"). Investors held the right to convert the unpaid principal and accrued interest of both the 8% Notes and 5% Notes to Series G convertible preferred stock at any time at the price of $38.64 per share. In July 2018, upon our IPO, the $221.6 million of principal and accrued interest of outstanding 8% Notes automatically converted into additional paid-in capital, the conversion of which included all the related-party noteholders. The 8% Notes converted to shares of Series G convertible preferred stock and, concurrently, each such share of Series G convertible preferred stock converted automatically into one share of Class B common stock. Upon our IPO, 5,734,440.0 shares of Class B common stock were issued from conversions and the 8% Notes were retired. Constellation, the holder of the 5% Notes, has not elected to convert as of December 31, 2019. The outstanding unpaid principal and accrued interest debt balance of the 5% Notes of $36.5 million was classified as current as of December 31, 2019, and the outstanding unpaid principal and accrued interest debt balance of the 5% Notes of $36.5 million was classified as non-current as of December 31, 2018. 6% Convertible Promissory Notes due December 2020 - Between December 2015 and September 2016, we issued $260.0 million convertible promissory notes due December 2020, ("6% Notes") to investors. The 6% Notes bore a 5% fixed interest rate, payable monthly either in cash or in kind, at our election. We amended the terms of the 6% Notes in June 2017 to reduce the collateral securing the notes and to increase the interest rate from 5% to 6%. As of December 31, 2019 and 2018, the amount outstanding on the 6% Notes, which includes interest paid in kind through the IPO date, was $289.3 million and $296.2 million, respectively. Upon the IPO, the debt was convertible at the option of the holders at the conversion price of $11.25 per share into common stock at any time through the maturity date. In January 2018, we amended the terms of the 6% Notes to extend the convertible put option, which investors could elect only if the IPO did not occur prior to December 2019. After the IPO, we paid the interest in cash when due and no additional interest accrued on the consolidated balance sheet on the 6% Notes. In November 2019, one note holder exchanged a portion of their 6% Notes at the conversion price of $11.25 per share into 616,302 shares of common stock. On or after July 27, 2020, we may redeem, at our option, all or part of the 6% Notes if the last reported sale price of our common stock has been at least $22.50 for at least 20 trading days (whether or not consecutive) during a period of 30 consecutive trading days ending within the three trading days immediately preceding the date on which we provide written notice of redemption In certain circumstances, the 6% Notes are also redeemable at our option in connection with a change of control. Under the terms of the indenture governing the 6% Notes, we are required to comply with various restrictive covenants, including meeting reporting requirements, such as the preparation and delivery of audited consolidated financial statements, and restrictions on investments. In addition, we are required to maintain collateral which secures the 6% Notes in an amount equal to 200% of the principal amount of and accrued and unpaid interest on the outstanding notes. This minimum collateral test is not a negative covenant and does not result in a default if not met. However, the minimum collateral test does restrict us with respect to investing in non-PPA subsidiaries. If we do not meet the minimum collateral test, we cannot invest cash into any non-PPA subsidiary that is not a guarantor of the notes. The 6% Notes also include a cross-acceleration provision which provides that the holders of at least 25% of the outstanding principal amount of the 6% Notes may cause such notes to become immediately due and payable if we or any of our subsidiaries default on any indebtedness in excess of $15.0 million such that the repayment of such indebtedness is accelerated. In connection with the issuance of the 6% Notes, we agreed to issue to J.P. Morgan and CPPIB, upon the occurrence of certain conditions, warrants to purchase our common stock up to a maximum of 146,666 shares and 166,222 shares, respectively. On August 31, 2017, J.P. Morgan transferred its rights to CPPIB. Upon completion of the IPO, the 312,888 warrants were net exercised for 312,575 shares of Class B Common stock. 10% Notes due July 2024 - In June 2017, we issued $100.0 million of senior secured notes ("10% Notes"). The 10% Notes mature in 2024 and bear a 10.0% fixed rate of interest and with principal amortization started July 2019, payable semi-annually. The 10% Notes have a continuing security interest in the cash flows payable to us as servicing, operations and maintenance fees and administrative fees from certain active power purchase agreements. Under the terms of the indenture governing the notes, we are required to comply with various restrictive covenants including, among other things, to maintain certain financial ratios such as debt service coverage ratios, to incur additional debt, issue guarantees, incur liens, make loans or investments, make asset dispositions, issue or sell share capital of our subsidiaries and pay dividends, meet reporting requirements, including the preparation and delivery of audited consolidated financial statements, or maintain certain restrictions on investments and requirements in incurring new debt. As of December 31, 2019, we were in compliance with all of such covenants. In addition, we are required to maintain collateral which secures the 10% Notes based on debt ratio analyses. This minimum collateral test is not a negative covenant and does not result in a default if not met. However, the minimum debt service coverage ratio test does restrict our access to the excess cash escrowed in a collection account which would otherwise be released to us on a bi-annual basis after principal amortization and interest payment. The outstanding unpaid principal and accrued interest debt balance of the 10% Notes of $14.0 million and $7.0 million were classified as current as of December 31, 2019 and 2018, respectively and the outstanding unpaid principal and accrued interest debt balances of the 10% Notes of $76.0 million and $88.6 million were classified as non-current as of December 31, 2019 and 2018, respectively. Non-recourse Debt Facilities 5.22% Senior Secured Term Notes - In March 2013, PPA Company II refinanced its existing debt by issuing 5.22% Senior Secured Notes due March 30, 2025 (the "5.22% Notes"). During the year ended December 31, 2019, there was a decommissioning in PPA II, including the retirement of the 5.22% Notes outstanding unpaid debt and interest of $77.6 million, which included the accumulated unpaid interest on the debt. See Note 13, Power Purchase Agreement Programs - PPA II Upgrade of Energy Servers for additional information. 7.5% Term Loan due September 2028 - In December 2012 and later amended in August 2013, PPA IIIa entered into a $46.8 million credit agreement to help fund the purchase and installation of Energy Servers. The loan bears a fixed interest rate of 7.5% payable quarterly. The loan requires quarterly principal payments which began in March 2014. The credit agreement requires us to maintain a debt service reserve for all funded systems, the balance of which was $3.8 million and $3.7 million as of December 31, 2019 and 2018, respectively, and which was included as part of long-term restricted cash in the consolidated balance sheets. The loan is secured by all assets of PPA IIIa. LIBOR + 5.25% Term Loan due October 2020 - In September 2013, PPA IIIb entered into a credit agreement to help fund the purchase and installation of Energy Servers. The aggregate amount of the debt facility was $32.5 million. During the year ended December 31, 2019, there was a decommissioning in PPA IIIb, including the retirement of this outstanding unpaid debt of $24.2 million, which included the accumulated unpaid interest on the debt. See Note 13, Power Purchase Agreement Programs - PPA IIIb Upgrade of Energy Servers for additional information. 6.07% Senior Secured Notes - In July 2014, PPA IV issued senior secured notes amounting to $99.0 million to third parties to help fund the purchase and installation of Energy Servers. The notes bear a fixed interest rate of 6.07% payable quarterly which began in December 2015 and ends in March 2030. The notes are secured by all the assets of the PPA IV. The Note Purchase Agreement requires us to maintain a debt service reserve, the balance of which was $8.0 million as of December 31, 2019 and $6.5 million as of December 31, 2018, and which was included as part of long-term restricted cash in the consolidated balance sheets. LIBOR + 2.5% Term Loan due December 2021 - In June 2015, PPA V entered into a $131.2 million credit agreement to fund the purchase and installation of Energy Servers. The lenders are a group of five financial institutions and the terms included commitments to a letter of credit (LC) facility (see below). The loan was initially advanced as a construction loan during the development of the PPA V Project and converted into a term loan on February 28, 2017 (the “Term Conversion Date”). As part of the term loan’s conversion, the LC facility commitments were adjusted. In accordance with the credit agreement, PPA V was issued a floating rate debt based on LIBOR plus a margin, paid quarterly. The applicable margins used for calculating interest expense are 2.25% for years 1-3 following the Term Conversion Date and 2.5% thereafter. The loan is secured by all the assets of the PPA V and requires quarterly principal payments which began in March 2017. In connection with the floating-rate credit agreement, in July 2015 the PPA V entered into pay-fixed, receive-float interest rate swap agreements to convert its floating-rate loan into a fixed-rate loan. Letters of credit due December 2021 - In June 2015, PPA V entered into a $131.2 million term loan due December 2021. The agreement also included commitments to a letter of credit ("LC") facility, with the characteristics of a line of credit, with the aggregate principal amount of $6.4 million, later adjusted down to $6.2 million. The amount reserved under the letter of credit as of December 31, 2019 and 2018 was $5.0 million. The unused capacity as of December 31, 2019 and 2018 was $1.2 million. Contractual Obligations and Other Commitments The following table summarizes our contractual obligations and the debt of our consolidated PPA entities that is non-recourse to Bloom as of December 31, 2019: Our 6% Notes and our credit agreements related to the building of our facility in Newark, Delaware each contain cross-default or cross-acceleration provisions. See “Recourse Debt Facilities” above for more details. Each of the debt facilities entered into by PPA IIIa, PPA IV and PPA V contain cross-default provisions. See “Non-recourse Debt Facilities” above for more details. Off-Balance Sheet Arrangements We include in our consolidated financial statements all assets and liabilities and results of operations of our PPA Entities that we have entered into and over which we have substantial control. For additional information, see Note 13, Power Purchase Agreement Programs. We have not entered into any other transactions that have generated relationships with unconsolidated entities or financial partnerships or special purpose entities. Accordingly, as of December 31, 2019 and 2018, we had no off-balance sheet arrangements.
-0.108697
-0.108555
0
<s>[INST] You should read the following discussion of our financial condition and results of operations in conjunction with the consolidated financial statements and the notes thereto included elsewhere in this Annual Report on Form 10K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10K, including information with respect to our plans and strategy for our business, includes forwardlooking statements that involve risks and uncertainties as described under the heading Special Note Regarding ForwardLooking Statements following the Table of Contents of this Annual Report on Form 10K. You should review the disclosure under Item 1A Risk Factors in this Annual Report on Form 10K for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forwardlooking statements contained in the following discussion and analysis. Overview The following discussion should be read in conjunction with the other sections of this Annual Report on Form 10K, including the consolidated financial statements and related notes contained in Item 8 Financial Statements and Supplementary Data. Restatement and Revision of Previously Issued Consolidated Financial Statements In this Annual Report on Form 10K, we have restated our previously issued consolidated financial statements as of and for the year ended December 31, 2018 and revised our previously issued consolidated financial statements as of and for the year ended December 31, 2017. Refer to the “Explanatory Note” preceding Item 1, Business for background on the restatement and revision, the fiscal periods impacted, control considerations, and other information. As a result, we have also restated certain previously reported financial information as of and for the year ended December 31, 2018 and revised certain previously reported financial information as of and for the year ended December 31, 2017 in this Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, including but not limited to information within the Results of Operations and Liquidity and Capital Resources sections to conform the discussion with the appropriate restated and/or revised amounts. See Note 2, Restatement and Revision of Previously Issued Consolidated Financial Statements, in Item 8 Financial Statements and Supplementary Data, for additional information related to the restatement and revision, including descriptions of the misstatements and the impacts on our consolidated financial statements. Description of Bloom Energy Our solution, the Bloom Energy Server, is a stationary power generation platform built for the digital age and capable of delivering highly reliable, uninterrupted, 24x7 constant power that is also clean and sustainable. The Bloom Energy Server converts standard lowpressure natural gas, biogas or hydrogen into electricity through an electrochemical process without combustion, resulting in very high conversion efficiencies and lower harmful emissions than conventional fossil fuel generation. A typical configuration produces 250 kilowatts of power in a footprint roughly equivalent to that of half of a standard thirtyfoot shipping container, or approximately 125 times more spaceefficient than solar power generation. 250 kilowatts of power is roughly equivalent to the constant power requirement of a typical big box retail store. Any number of our Energy Server systems can be clustered together in various configurations to form solutions from hundreds of kilowatts to many tens of megawatts. We currently primarily target commercial and industrial customers. We market and sell our Energy Servers primarily through our direct sales organization in the United States, and also have direct and indirect sales channels internationally. Recognizing that deploying our solutions requires a material financial commitment, we have developed a number of financing options to support sales of our Energy Servers to customers who lack the financial capability to purchase our Energy Servers directly, who prefer to finance the acquisition using third party financing or who prefer to contract for our services on a payasyougo model. Our typical target commercial or industrial customer has historically been either an investmentgrade entity or a customer with investmentgrade attributes such as size, assets and revenue, liquidity, geographically diverse operations and general financial stability. We have recently expanded our product and financing options to the belowinvestmentgrade customers and have also expanded internationally to target customers with deployments on a wholesale grid. Given that our customers are typically large institutions with multilevel decision making processes, [/INST] Negative. </s>
2,020
23,048
1,711,675
Nightstar Therapeutics plc
2019-03-18
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 historical financial statements and the related notes thereto included elsewhere in this Annual Report on Form 10-K. The following discussion contains, in addition to historical information, forward-looking statements that include risks and uncertainties. Our actual results may differ materially from those expressed or contemplated in those forward-looking statements as a result of certain factors, including those set forth under the headings “Forward-Looking Statements” and “Risk Factors” elsewhere in this Annual Report on Form 10-K. Overview We are a leading clinical-stage gene therapy company focused on developing and commercializing novel one-time treatments for patients suffering from rare inherited retinal diseases that would otherwise progress to blindness. Leveraging our expertise in ophthalmology, gene therapy and drug development, we are developing a pipeline of proprietary product candidates that are designed to substantially modify or halt the progression of inherited retinal diseases for which there are no currently approved treatments. Our lead product candidate, NSR-REP1, for the treatment of choroideremia, or CHM, is in Phase 3 clinical development and represents the most clinically advanced product candidate for this indication worldwide. In data from 32 patients treated with NSR-REP1 across four open-label clinical trials, over 90% of treated patients maintained their visual acuity over a two-year follow-up period. In some cases, we also observed substantial improvements in visual acuity. We are also conducting a Phase 2/3 clinical trial with our second product candidate, NSR-RPGR, for the treatment of X-linked retinitis pigmentosa, or XLRP. We also have product candidates in preclinical development for a number of inherited retinal diseases for which there are no approved treatments such as Stargardt disease. Since our inception in May 2013, we have devoted substantially all our resources to conducting preclinical studies and clinical trials, organizing and staffing our company, business planning, raising capital and establishing our intellectual property portfolio. 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 with proceeds from the sale of our ADSs and ordinary shares. Through December 31, 2018, we had received net cash proceeds of $255.2 million from sales of our ADSs and ordinary shares. Since our inception, we have incurred significant operating losses. Our net losses were $36.9 million, $29.7 million and $12.2 million for the years ended December 31, 2018, 2017 and 2016, respectively. As of December 31, 2018, we had an accumulated deficit of $98.9 million. We expect to continue to incur significant expenses for the foreseeable future as we advance our product candidates through preclinical and clinical development, seek regulatory approval and pursue commercialization of any approved product candidates. In addition, if we obtain marketing approval for any of our product candidates, we expect to incur significant commercialization expenses related to product manufacturing, marketing, sales and distribution. As of December 31, 2018, we held cash, cash equivalents and marketable securities of $164.2 million. On March 4, 2019, we entered into an implementation agreement, or the Implementation Agreement, with Biogen Switzerland Holdings GmbH and its wholly-owned subsidiary, Tungsten Bidco Limited, which we collectively refer to as Biogen. Pursuant to the terms of the Implementation Agreement, Biogen has agreed to acquire the entire issued and to be issued share capital of our company for $25.50 in cash per ordinary share, nominal value of GBP 0.01 per share, or the Company Shares, excluding any treasury shares, any Company Shares held by Biogen or its subsidiaries, and certain pre-initial public offering equity awards deferred upon the termination of the holder’s employment, which we refer to as the Deferred Shares. Under the terms of the Implementation Agreement, the proposed acquisition would be implemented by means of a scheme of arrangement to be undertaken by us under Part 26 of the UK Companies Act 2006. Biogen reserves the right under the Implementation Agreement to effect the proposed acquisition by way of a takeover offer, with our consent. The completion of the proposed acquisition is subject to the satisfaction or waiver of specified conditions and certain shareholder and regulatory approvals. At this stage, subject to the approval and availability of the Court (which is subject to change), and subject to the satisfaction (or, where applicable, waiver) of the conditions to the Implementation Agreement, we expect the acquisition will become effective by mid-year 2019. If the transaction is completed, we expect that the ADSs will be removed from listing on the Nasdaq Stock Market and that registration of the ADSs under Section 12(b) of the Securities Exchange Act of 1934, as amended, will be terminated. Components of Our Results of Operations Revenues To date, we have not generated any revenue from product sales and do not expect to generate any revenue from the sale of products in the near future. If our development efforts for our product candidates are successful and result in regulatory approval, we may generate revenue in the future from product sales. Operating Expenses Research and Development Expenses Research and development expenses consist primarily of costs incurred in connection with the research and development of our product candidates, which are partially offset by research and development tax credits provided by Her Majesty's Revenue & Customs, or HMRC, and other government grants. We expense research and development costs as incurred. These expenses consist of: ▪ expenses incurred under agreements with contract research organizations, or CROs, contract manufacturing organizations, or CMOs, as well as investigative sites and consultants that conduct our clinical trials, preclinical studies and other scientific development services; ▪ manufacturing scale-up expenses and the cost of acquiring and manufacturing preclinical studies and clinical trial materials; ▪ employee-related expenses, including salaries, related benefits, travel and share-based compensation expense for employees engaged in research and development functions; ▪ costs related to compliance with regulatory requirements; ▪ facilities costs, depreciation and other expenses, which include rent and utilities; and ▪ fees for maintaining our third-party licensing agreements. We recognize external development costs based on an evaluation of the progress to completion of specific tasks using information provided to us by our service providers. Our direct research and development expenses are tracked on a program-by-program basis for our product candidates and consist primarily of external costs, such as fees paid to outside consultants, CROs and CMOs in connection with our preclinical development, manufacturing and clinical development activities. Our direct research and development expenses by program also include fees incurred under our license agreements. We do not allocate employee costs or facility expenses, including depreciation or other indirect costs, to specific programs because these costs are deployed across multiple programs and, as such, are not separately classified. We use internal resources primarily to oversee the research and discovery as well as to manage our preclinical development, process development, manufacturing and clinical development activities. These employees work across multiple programs and, therefore, we do not track their costs by program. The table below summarizes our research and development expenses incurred by program: Prior to the year ended December 31, 2016, substantially all our direct research and development expenses were related to our NSR-REP1 development program. 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 and related product manufacturing expenses. As a result, we expect that our research and development expenses will continue to increase over the next several years as we increase personnel costs and prepare for regulatory filings related to our product candidates. We also expect to incur additional expenses related to milestone, royalty payments and maintenance fees payable to third parties with whom we have entered into license agreements to acquire the rights related to our product candidates. The successful development and commercialization of our product candidates is highly uncertain. At this time, we cannot reasonably estimate or know the nature, timing and costs of the efforts that will be necessary to complete the preclinical and clinical development of any of our product candidates or when, if ever, material net cash inflows may commence from any of our product candidates. This uncertainty is due to the numerous risks and uncertainties associated with development and commercialization, including the uncertainty of: ▪ the scope, progress, outcome and costs of our preclinical development activities, clinical trials and other research and development activities; ▪ establishing an appropriate safety profile with IND- and CTA-enabling studies; ▪ successful patient enrollment in, and the initiation and completion of, clinical trials; ▪ the timing, receipt and terms of any marketing approvals from applicable regulatory authorities and reimbursement and market access from third-party payors; ▪ establishing commercial manufacturing capabilities or making arrangements with third-party manufacturers; ▪ development and timely delivery of commercial-grade drug formulations that can be used in our clinical trials and for commercial launch; ▪ obtaining, maintaining, defending and enforcing patent claims and other intellectual property rights; ▪ significant and changing government regulation; ▪ launching commercial sales of our product candidates, if and when approved, whether alone or in collaboration with others; and ▪ maintaining a continued acceptable safety profile of the product candidates following approval. We may never succeed in achieving regulatory approval for any of our product candidates. We may obtain unexpected results from our clinical trials. We may elect to discontinue, delay or modify clinical trials of some product candidates or focus on others. Any changes in the outcome of any of these variables with respect to the development of our product candidates in preclinical and clinical development could mean a significant change in the costs and timing associated with the development of these product candidates. For example, if the FDA, EMA or another regulatory authority were to delay our planned start of clinical trials or require us to conduct clinical trials or other testing beyond those that we currently expect, or if we experience significant delays in enrollment in any of our planned clinical trials, we could be required to expend significant additional financial resources and time on the completion of clinical development of that product candidate. General and Administrative Expenses General and administrative expenses consist primarily of salaries, related benefits, travel and share-based compensation expense for personnel in executive, finance and administrative functions. These expenses include professional fees for legal, consulting, accounting and audit services, insurance costs, and investor and public relations expenses associated with being a public company. We anticipate that our general and administrative expenses will increase in the future as we increase our headcount to support our continued research activities and development of our product candidates. We anticipate that our general and administrative expenses will increase in the future as we increase our headcount to support our continued development and commercialization of our product candidates. We also anticipate we will continue to incur increased accounting, audit, legal, regulatory, compliance, director and officer insurance costs as well as investor and public relations expenses associated with being a public company and a domestic filer. Other Income (Expense) Interest and Other Income Interest income consists of interest on cash, cash equivalents and marketable securities. Other income includes funds received from government grants. Foreign Currency Translation We currently maintain our financial statements in the functional currency pounds sterling. Monetary assets and liabilities denominated in currencies other than the functional currency are remeasured into the functional currency at rates of exchange prevailing at the balance sheet dates. Non-monetary assets and liabilities denominated in foreign currencies are remeasured into the functional currency at the exchange rates prevailing at the date of the transaction. Exchange gains or losses arising from foreign currency transactions are included in the determination of net loss for the respective periods. For financial reporting purposes, our financial statements, which are currently prepared using the functional currency of pounds sterling, have been translated into the U.S. dollar. Assets and liabilities are translated at the exchange rates at the balance sheet dates, revenue and expenses are translated at the average exchange rates for the corresponding period and shareholders’ equity is translated based on historical exchange rates at the time of the transaction. The resulting currency translation adjustments are not included in determining net loss but are included as foreign exchange translation adjustments in accumulated other comprehensive income (loss), a component of shareholders’ equity. 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 activities were $31.6 million for the year ended December 31, 2018, compared to $20.5 million for the year ended December 31, 2017. The increase of $11.1 million mainly resulted from increases in program-related expenses of $7.4 million for NSR-RPGR and $5.1 million for NSR-REP1, an increase in personnel-related costs of $5.0 million and a $2.4 million increase in indirect expenses. The increase was partially offset by an increase in research and development tax credits from the HMRC of $8.5 million. Research and development personnel-related costs increased due to an increase of headcount in fiscal 2018 to support our growing company and to assist in the further development of our product candidates. The increase in research and development personnel-related costs includes $1.1 million of additional non-cash share-based compensation when compared to 2017. General and Administrative Expenses General and administrative expenses were $12.6 million for the year ended December 31, 2018 compared to $7.0 million for the ended December 31, 2017. The increase of $5.6 million in 2018 when compared to 2017, is mainly due to an increase of $4.8 million in general and administrative personnel-related costs to support our increased research and development activities. We added headcount in areas such as legal, finance and investor relations. Professional and consulting fees increased by $0.8 million in legal, accounting and audit fees to support growing activities of the organization. The increase in general and administrative personnel-related costs includes $1.7 million of additional non-cash share-based compensation when compared to 2017. Other Income (Expense), Net Other income was $6.9 million for the year ended December 31, 2018, compared to an expense of $2.1 million for the year ended December 31, 2017. The increase between periods of $9.0 million mainly resulted from $6.7 million in realized foreign currency exchange rate fluctuations on securities maturing during the year ended December 31, 2018, an increase of $2.0 million in interest income due to investment in marketable securities of the proceeds from our public offerings in October 2017 and 2018, $0.5 million in government grants, and a decrease of $0.1 million in non-cash loss on foreign currency exchange due to exchange rate fluctuations between the pound sterling, our functional currency, and the U.S. dollar, our reporting currency. (Benefit from) provision for income taxes For the year ended December 31, 2018, we recognized $0.4 million in benefit from income taxes. The benefit from income taxes recognized for the year ended December 31, 2018 resulted from foreign currency gains on maturing marketable securities and changes in the unrealized gains on those securities. 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 $20.5 million for the year ended December 31, 2017, compared to $10.2 million for the year ended December 31, 2016. The increase of $10.3 million resulted primarily from increases in program-related expenses of $3.4 million for NSR-REP1, and $1.5 million for NSR-RPGR, as well as a $1.9 million increase in personnel-related costs, and a $1.3 million expense to reduce research and development tax relief claims receivable in accordance with correspondence with HMRC in 2017, compared to a credit of $2.5 million in 2016. Research and development personnel-related costs increased due to an increase in headcount in 2017, to support our growing company and to assist in the further development of our product candidates and pipeline. The increase in research and development personnel-related costs includes $0.5 million of additional non-cash share-based compensation compared to 2016. General and Administrative Expenses General and administrative expenses were $7.0 million for the year ended December 31, 2017, compared to $2.1 million for the year ended December 31, 2016. The increase of $4.9 million is mainly due to a $2.1 million increase in consulting and professional fees, including increased legal, accounting and audit fees associated with our corporate reorganization and non-capitalizable costs incurred in connection with our initial public offering, or IPO, and a $1.8 million increase in personnel-related costs. General and administrative personnel-related costs increased due to an increase in employees to support our increased research and development activities and our status as a public company. The increase in general and administrative personnel-related costs includes $0.7 million of additional non-cash share-based compensation compared to 2016. Other Income (Expense), Net Other expense was $2.1 million for the year ended December 31, 2017, compared to income of $22,000 for the year ended December 31, 2016. The increase of $2.2 million mainly consisted of an increase in non-cash loss on foreign currency exchange of $2.9 million due to the strengthening of the pound sterling, our functional currency, compared to the U.S. dollar, our reporting currency and an increase in USD cash balances held at December 31, 2017. The increase in the non-cash loss was partially offset by an increase of $0.7 million in interest and other income. Provision for income taxes The provision for income taxes results from activities of our U.S. subsidiary, which increased operations during the year ended December 31, 2017. Liquidity and Capital Resources Since our inception, we have not generated any revenue and have incurred operating losses and negative cash flows from our operations. We have funded our operations to date primarily with proceeds from the sale of ADSs and ordinary shares. Through December 31, 2018, we had received net cash proceeds of $255.2 million from sales of our ADSs and ordinary shares. As of December 31, 2018, we held cash, cash equivalents and marketable securities of $164.2 million. Cash Flows The following table summarizes our cash flows for each of the periods presented: Net Cash Used in Operating Activities Our use of cash in operating activities for the year ended December 31, 2018 resulted primarily from our net losses, adjusted for non-cash charges and changes in components of working capital. Net cash used in operating activities of $45.6 million during the year ended December 31, 2018 increased by $19.8 million compared to the year ended December 31, 2017. The increase in net cash used in operating activities was primarily due to increases of $11.1 million in research and development expenses and $5.6 million in general and administrative expenses offset by an increase in non-cash share-based compensation expense and working capital movements totaling $4.1 million. Our use of cash in operating activities for the year ended December 31, 2017 resulted primarily from our net losses, adjusted for non-cash charges and changes in components of working capital. Net cash used in operating activities of $25.8 million during the year ended December 31, 2017 increased by $15.7 million compared to the year ended December 31, 2016. The increase in net cash used in operating activities was primarily due to increases of $10.3 million in research and development expenses and $4.9 million in general and administrative expenses offset by favorable working capital movements totaling $0.5 million. Our use of cash in operating activities for the year ended December 31, 2016 resulted primarily from our net losses, adjusted for non-cash charges and changes in components of working capital. Net Cash Used in Investing Activities In 2018, net cash used in investing activities increased due to the investment in marketable securities of the funds raised in our public offerings in October 2018 and October 2017. For the years ended December 31, 2018, 2017 and 2016, we also used $0.7 million, $0.2 million and $0.3 million of cash for the purchases of property and equipment. Net Cash Provided by Financing Activities During the years ended December 31, 2018, 2017 and 2016, net cash provided by financing activities was $77.2 million, $141.1 million and $11.3 million, respectively, consisting of net cash proceeds from our sale and issuance of ordinary shares in 2018, 2017 and 2016. These sale proceeds included our IPO in October 2017 and our offering in October 2018. Contractual Obligations Our contractual obligations as of December 31, 2018, relate to our non-cancellable leased office space in the United States and the United Kingdom. Our fixed contractual obligations as of December 31, 2018 are: We enter into contracts in the normal course of business with CROs and other third vendors for clinical trials, clinical and commercial supply manufacturing, support for precommercial activities, research and development activities and other services and products for our operations. Our agreements generally provide for termination within 90 days of notice. Such agreements are cancelable contracts and not included in the table of contractual obligations and commitments. We have included as purchase obligations our commitments under agreements to the extent they are quantifiable and are not cancelable. We may incur potential contingent payments upon our achievement of clinical, regulatory and commercial milestones, as applicable, or that we may be required to make royalty payments under license agreements we have entered into with various entities pursuant to which we have in-licensed certain intellectual property, including our license agreements with the University of Oxford and Oxford BioMedica plc. Due to the uncertainty of the achievement and timing of the events requiring payment under these agreements, the amounts to be paid by us are not fixed or determinable at this time and have not been included in the table above. Funding Requirements We expect our expenses to increase substantially in connection with our ongoing activities as a public company, particularly as we advance the preclinical activities, manufacturing and clinical trials of our product candidates. Our expenses will also increase as we: ▪ seek regulatory approvals for any product candidates that successfully complete clinical trials; ▪ establish a sales, marketing and distribution infrastructure in anticipation of commercializing any product candidates for which we may obtain marketing approval and intend to commercialize on our own or jointly; ▪ hire additional clinical, medical and development personnel; ▪ expand our infrastructure and facilities to accommodate our growing employee base; ▪ continue our operations as a public company; and ▪ maintain, expand and protect our intellectual property portfolio. We believe our existing cash, cash equivalents and marketable securities of $164.2 million at December 31, 2018, will enable us to fund our operating expenses and capital expenditure requirements for at least the next 12 months from the filing date of the Annual Report. We have based these estimates on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we expect. As we progress with our development programs and the regulatory review process, we expect to incur significant commercialization expenses related to product manufacturing, pre-commercial activities and commercialization. Because of the numerous risks and uncertainties associated with research, development and commercialization of pharmaceutical product candidates, we are unable to estimate the exact amount of our working capital requirements. Our future funding requirements will depend on and could increase significantly as a result of many factors, including: ▪ the scope, progress, results and costs of laboratory testing, manufacturing, and preclinical and clinical development for our current and future product candidates; ▪ the costs, timing and outcome of regulatory review of our product candidates; ▪ our ability to establish and maintain collaborations and license agreements on favorable terms, if at all; ▪ the costs of expanding our facilities to accommodate our expected growth in personnel; ▪ the extent to which we acquire or in-license other product candidates and technologies or establish collaboration, distribution or other marketing arrangements for our product candidates; ▪ the costs, timing and outcome of potential future commercialization activities, including manufacturing, marketing, sales and distribution for our product candidates for which we receive marketing approval; ▪ the costs of preparing, filing and prosecuting patent applications, maintaining and enforcing our intellectual property rights and defending intellectual property-related claims; ▪ the extent to which we acquire technologies; ▪ the sales price and availability of adequate third-party coverage and reimbursement for our product candidates, if and when approved; and ▪ the costs of operating as a public company in the United States. Until such time, if ever, that we can generate product revenue sufficient to achieve profitability, we expect to finance our cash needs through equity offerings, debt financings, government or other third-party funding, marketing and distribution arrangements and other collaborations, strategic alliances and licensing arrangements. To the extent that we raise additional capital through the sale of equity, current ownership interests will be diluted. If we raise additional funds through government or third-party funding, collaboration agreements, strategic alliances, licensing arrangements or marketing and distribution arrangements, 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. 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 are unable to raise additional funds 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 products or product candidates that we would otherwise prefer to develop and market ourselves. Critical Accounting Policies and Significant Judgments and Estimates Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States (U.S. GAAP). The preparation of our consolidated financial statements and related disclosures requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, costs and expenses, and the disclosure of contingent assets and liabilities in our consolidated financial statements. We base our estimates on historical experience, known trends and events and various other factors that we believe are 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. We evaluate our estimates and assumptions on an ongoing basis. Our 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 included in this Annual Report, 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 Expenses As part of the process of preparing our consolidated financial statements, we are required to estimate our accrued research and development expenses. 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 actual costs. We make estimates of our accrued expenses as of each balance sheet date in the consolidated financial statements based on facts and circumstances known to us at that time. We periodically confirm the accuracy of these estimates with the service providers and make adjustments if necessary. Examples of estimated accrued research and development expenses include fees paid to: ▪ vendors in connection with preclinical development activities; ▪ CROs and investigative sites in connection with preclinical studies and clinical trials; and ▪ CMOs in connection with drug substance and drug product formulation of preclinical study and clinical trial materials. We base our expenses related to preclinical studies and clinical trials on our estimates of the services received and efforts expended pursuant to quotes and contracts with multiple research institutions and CROs that conduct and manage preclinical studies and clinical trials 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 expense. Payments under some of these contracts depend on factors such as the successful enrollment of patients and the completion of clinical trial milestones. 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 the estimate, we adjust the accrual or the amount of prepaid expenses 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 may result in reporting amounts that are too high or too low in any particular period. To date, there have not been any material adjustments to our prior estimates of accrued research and development expenses. Valuation of Share-Based Compensation We grant equity awards under our share-based compensation programs, which may include share options, restricted share awards, or RSAs, restricted share units, or RSUs, and other share-based awards. To date, the share-based awards granted to our employees and directors have been in the form of RSAs, RSUs and share options. We recognize compensation expense for equity awards based on the grant date fair value of the award. For equity awards that vest based on a service condition, the share-based compensation expense is recognized on a straight-line basis over the requisite service period. For equity awards that contain both performance and service conditions, we recognize share-based compensation expense ratably over the requisite service period when the achievement of a performance-based milestone is probable based on the relative satisfaction of the performance condition as of the reporting date. We use the fair value of our ordinary shares to determine the fair value of RSAs. Share-based compensation is recognized as an expense in the financial statements based on the grant date fair value over the requisite service period. For awards granted to our employees and directors that vest based on service conditions, we use the straight-line method to allocate compensation expense to reporting periods. Beginning in the first quarter of 2017, we do not adjust share-based compensation for estimated forfeitures and account for forfeitures when they occur, which did not result in a material change in expense. We use the Black-Scholes option pricing model to estimate the fair value of share options. This option-pricing model requires the input of various subjective assumptions, including the option’s expected life and the price volatility of the underlying stock. Due to the lack of history, our estimated expected ADS price volatility is based on using an average of a comparable market index or of a comparable company in the same industry. Our expected term of options granted represents the weighted average period of time that options granted are expected to be outstanding giving consideration to vesting schedules and our historical exercise patterns. The risk-free rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of grant. The dividend yield of zero is based on the fact that we have never paid cash dividends and have no present intention to pay cash dividends. Share-based compensation has been reported in our consolidated statements of operations as follows (in thousands): The grant date fair value of RSAs and RSUs is calculated based on the grant date fair value of the underlying ordinary shares. Prior to the IPO, the fair value of the underlying ordinary shares has historically been determined by our board of directors based upon information available to us at the time of grant. Our board of directors considered numerous objective and subjective factors in the assessment of fair value, including reviews of our business and financial condition, the conditions of the industry in which we operate and the markets that we serve and general economic and market conditions, the lack of marketability of our ordinary shares, the likelihood of achieving a liquidity event for the ordinary shares, the status of the preclinical studies and clinical trials relating to our product candidates and third-party valuations of our ordinary shares. Our board of directors has generally considered the most persuasive evidence of fair value to be the prices at which our securities were sold in arms’-length transactions. We expect the impact of our share-based compensation expense for equity awards granted to employees, directors and other service providers to grow in future periods due to the potential increases in the value of our ordinary shares and our staffing levels. Income Taxes We account for income taxes using the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the consolidated financial statements or in our tax returns. Deferred tax assets and liabilities are determined on the basis of the differences between the consolidated financial statements and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Changes in deferred tax assets and liabilities are recorded in the provision for income taxes. We assess the likelihood that our deferred tax assets will be recovered in the future to the extent we believe, based upon the weight of available evidence, that it is more likely than not that all or a portion of the deferred tax assets will not be realized, a valuation allowance is established through a charge to income tax expense. Potential for recovery of deferred tax assets is evaluated by estimating the future taxable profits expected and considering prudent and feasible tax planning strategies. We account for uncertainty in income taxes by recognizing in the consolidated financial statements by applying a two-step process to determine the amount of tax benefit to be recognized. First, the tax position must be evaluated to determine the likelihood that it will be sustained upon external examination by the taxing authorities. If the tax position is deemed more-likely-than-not to be sustained, the tax position is then assessed as the amount of benefit to recognize in the consolidated financial statements. The amount of benefits that may be used is the largest amount that has a greater than 50% likelihood of being realized upon ultimate settlement. The provision for income taxes includes the effects of any resulting tax reserves, or unrecognized tax benefits, that are considered appropriate, as well as the related net interest and penalties. A full valuation allowance is recorded against our net deferred tax asset position. As a company that carries out extensive research and development activities, we seek to benefit from one or the other of two U.K. research and development tax credit cash rebate regimes, the Small and Medium-sized Enterprises R&D Tax Credit Scheme or SME Scheme and the and the Research and Development Expenditure scheme or RDEC Scheme. Under the SME Scheme, our principal research subsidiary company, NightstaRx Limited, may be eligible to surrender the trading losses that arise from its research and development activities for a payable tax credit of up to approximately 33.4% of eligible research and development expenditures. Qualifying expenditures largely comprise employment costs for research staff, consumables and certain internal overhead costs incurred as part of research projects for which we do not receive income. Subcontracted research expenditures are eligible for a cash rebate of up to approximately 21.7%. For certain periods where NightstaRx Limited is not eligible for the SME Scheme, NightstaRx Limited is eligible for the RDEC Scheme, whereby tax relief is given at 11% of allowable research and development costs, increasing to 12% from January 1, 2018. The RDEC scheme is more restrictive with qualifying expenditures mainly comprising of employment cost for research staff. Based on criteria established by HMRC, we expect a proportion of expenditures being carried out by NightstaRx Limited in relation to its pipeline research, clinical trials management and manufacturing development activities is likely to be eligible for inclusion within one of these two tax credit cash rebate regimes. For the years ended December 31, 2018 and 2016, we recorded $7.2 million and $2.2 million respectively, in research and development tax credits as an offset to research and development expenses. For the year ended December 31, 2017, we recorded an expense of $1.3 million, as a change in estimate, to reduce research and development claims payable in accordance with correspondence with HRMC. Recently Issued Accounting Pronouncements A description of recently issued accounting pronouncements that may potentially impact our financial position and results of operations is disclosed in Note 2, “Summary of Significant Accounting Policies,” to our consolidated financial statements included in this Annual Report. Emerging Growth Company Status On April 5, 2012, the Jumpstart Our Business Startups Act, or the JOBS Act, was enacted. The JOBS Act provides that, among other things, an “emerging growth company” can take advantage of an extended transition period for complying with new or revised accounting standards. As an emerging growth company, we have irrevocably elected not to take advantage of the extended transition period afforded by the JOBS Act for the implementation of new or revised accounting standards and, as a result, we will comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth public companies. We intend to rely on certain of the other exemptions and reduced reporting requirements provided by the JOBS Act. As an emerging growth company, 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), (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 for a period of five years following the completion of our IPO that occurred in October 2017, or until we no longer meet the other requirements of being an emerging growth company, whichever is earlier. Smaller Reporting Company Status In June 2018 the U.S Securities and Exchange Commission amended the thresholds for the definition of the smaller reporting company, or SRC, definition thereby expanding the number of companies that qualify for certain existing scaled disclosure accommodations. As of December 31, 2018, companies meeting the expanded revenue and unaffiliated market capitalization qualify for these reduced SRC disclosure accommodations. For example, companies with annual revenues under $100 million can maintain the SRC status until their unaffiliated market capitalization exceeds $700 million. A company will maintain the SRC status until its revenue and unaffiliated market capitalization exceed the eligibility criteria. As an SRC, we are permitted to take advantage of many of the same exemptions from disclosure requirements as an emerging growth company described above. In addition to the reduced disclosure requirements described above, as a smaller reporting company, we are permitted to rely on exemptions from certain disclosure requirements that are applicable to other public companies that are not smaller reporting companies. These exemptions include: • being permitted to provide only two years of audited consolidated financial statements in this Annual Report on Form 10-K, with correspondingly reduced “Management's Discussion and Analysis of Financial Condition and Results of Operations” disclosure; • not being required to provide selected financial data in this Annual Report on Form 10-K; • not being required to furnish a contractual obligations table in “Management's Discussion and Analysis of Financial Condition and Results of Operations”; and • not being required to furnish a stock performance graph in our annual report. Off-Balance Sheet Arrangements As of December 31, 2018, 2017 and 2016, we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K, such as the use of unconsolidated subsidiaries, structured finance, special purpose entities or variable interest entities.
-0.012013
-0.011936
0
<s>[INST] Overview We are a leading clinicalstage gene therapy company focused on developing and commercializing novel onetime treatments for patients suffering from rare inherited retinal diseases that would otherwise progress to blindness. Leveraging our expertise in ophthalmology, gene therapy and drug development, we are developing a pipeline of proprietary product candidates that are designed to substantially modify or halt the progression of inherited retinal diseases for which there are no currently approved treatments. Our lead product candidate, NSRREP1, for the treatment of choroideremia, or CHM, is in Phase 3 clinical development and represents the most clinically advanced product candidate for this indication worldwide. In data from 32 patients treated with NSRREP1 across four openlabel clinical trials, over 90% of treated patients maintained their visual acuity over a twoyear followup period. In some cases, we also observed substantial improvements in visual acuity. We are also conducting a Phase 2/3 clinical trial with our second product candidate, NSRRPGR, for the treatment of Xlinked retinitis pigmentosa, or XLRP. We also have product candidates in preclinical development for a number of inherited retinal diseases for which there are no approved treatments such as Stargardt disease. Since our inception in May 2013, we have devoted substantially all our resources to conducting preclinical studies and clinical trials, organizing and staffing our company, business planning, raising capital and establishing our intellectual property portfolio. 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 with proceeds from the sale of our ADSs and ordinary shares. Through December 31, 2018, we had received net cash proceeds of $255.2 million from sales of our ADSs and ordinary shares. Since our inception, we have incurred significant operating losses. Our net losses were $36.9 million, $29.7 million and $12.2 million for the years ended December 31, 2018, 2017 and 2016, respectively. As of December 31, 2018, we had an accumulated deficit of $98.9 million. We expect to continue to incur significant expenses for the foreseeable future as we advance our product candidates through preclinical and clinical development, seek regulatory approval and pursue commercialization of any approved product candidates. In addition, if we obtain marketing approval for any of our product candidates, we expect to incur significant commercialization expenses related to product manufacturing, marketing, sales and distribution. As of December 31, 2018, we held cash, cash equivalents and marketable securities of $164.2 million. On March 4, 2019, we entered into an implementation agreement, or the Implementation Agreement, with Biogen Switzerland Holdings GmbH and its whollyowned subsidiary, Tungsten Bidco Limited, which we collectively refer to as Biogen. Pursuant to the terms of the Implementation Agreement, Biogen has agreed to acquire the entire issued and to be issued share capital of our company for $25.50 in cash per ordinary share, nominal value of GBP 0.01 per share, or the Company Shares, excluding any treasury shares, any Company Shares held by Biogen or its subsidiaries, and certain preinitial public offering equity awards deferred upon the termination of the holder’s employment, which we refer to as the Deferred Shares. Under the terms of the Implementation Agreement, the proposed acquisition would be implemented by means of a scheme of arrangement to be undertaken by us under Part 26 of the UK Companies Act 2006. Biogen reserves the right under the Implementation Agreement to effect the proposed acquisition by way of a takeover offer, with our consent. The completion of the proposed acquisition is subject to the satisfaction or waiver of specified conditions and certain shareholder and regulatory approvals. At this stage, subject to the approval and availability of the Court (which is subject to change), and subject to the satisfaction (or, where applicable, waiver) of the conditions to the Implementation Agreement, we expect the acquisition will become effective [/INST] Negative. </s>
2,019
6,768
1,739,445
Arcosa, Inc.
2019-02-28
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 (“MD&A”) is intended to provide a reader of our financial statements with a narrative from the perspective of our management on our financial condition, results of operations, liquidity, and certain other factors that may affect our future results. Our MD&A is presented in the following sections: •Separation from Trinity •Basis of Historical Presentation •Executive Overview •Results of Operations •Liquidity and Capital Resources •Contractual Obligations and Commercial Commitments •Critical Accounting Policies and Estimates •Recent Accounting Pronouncements •Forward-Looking Statements Our MD&A should be read in conjunction with our Consolidated and Combined Financial Statements and related Notes in Item 8, "Financial Statements and Supplementary Data," of this Annual Report on Form 10-K. Separation from Trinity Arcosa is a Delaware corporation and was incorporated in 2018 in connection with the Separation of Arcosa from Trinity on November 1, 2018 as an independent, publicly-traded company, listed on the New York Stock Exchange. At the time of the Separation, Arcosa consisted of certain of Trinity’s former construction products, energy equipment, and transportation products businesses. The Separation was effectuated through a pro rata dividend distribution on November 1, 2018 of all of the then-outstanding shares of common stock of Arcosa to the holders of common stock of Trinity as of October 17, 2018, the record date for the distribution. Trinity stockholders received one share of Arcosa common stock for every three shares of Trinity common stock held as of the record date. The transaction was structured to be tax-free to both Trinity and Arcosa stockholders for U.S. federal income tax purposes. Basis of Historical Presentation The accompanying Consolidated and Combined Financial Statements present our historical financial position, results of operations, comprehensive income/loss, and cash flows in accordance with accounting principles generally accepted in the U.S. (“GAAP”). The combined financial statements for periods prior to the Separation were derived from Trinity’s consolidated financial statements and accounting records and prepared in accordance with GAAP for the preparation of carved-out combined financial statements. Through the date of the Separation, all revenues and costs as well as assets and liabilities directly associated with Arcosa have been included in the combined financial statements. Prior to the Separation, the combined financial statements also included allocations of certain selling, engineering, and administrative expenses provided by Trinity to Arcosa and allocations of related assets, liabilities, and the Former Parent’s net investment, as applicable. The allocations were determined on a reasonable basis; however, the amounts are not necessarily representative of the amounts that would have been reflected in the financial statements had the Company been an entity that operated independently of Trinity during the applicable periods. Related party allocations prior to the Separation, including the method for such allocation, are described further in Note 1, “Overview and Summary of Significant Accounting Policies” to the Consolidated and Combined Financial Statements. Following the Separation, the consolidated financial statements include the accounts of Arcosa and those of our wholly-owned subsidiaries and no longer include any allocations from Trinity. Trinity will continue to provide some general and administrative functions on a transitional basis for a fee following the Separation. Executive Overview Financial Operations and Highlights The Company’s revenues for the year ended December 31, 2018 were $1.5 billion, essentially flat compared to the year ended December 31, 2017. Operating profit for year ended December 31, 2018 totaled $94.9 million, representing a decrease of 27.9% compared to the year ended December 31, 2017 primarily due to lower volumes in our Energy Equipment Group combined with an impairment charge of $23.2 million recognized in the third quarter in our Energy Equipment Group on businesses that were subsequently divested. Revenues in our Construction Products Group increased for the year ended December 31, 2018 primarily due to increased volumes driven by 2017 and 2018 acquisitions. Operating profit in our Construction Products Group decreased for the year ended December 31, 2018 primarily due to lower volumes in our legacy construction aggregates businesses and increased costs related to the fair value markup of acquired inventory. The Energy Equipment Group recorded lower revenues and operating profit for the year ended December 31, 2018 resulting primarily from a planned reduction in volumes in our wind towers product line, partially offset by an increase in revenues from our other product lines, and the impact of the $23.2 million impairment charge. Revenues and operating profit from the Transportation Products Group were higher for the year ended December 31, 2018 when compared to the year ended December 31, 2017 primarily related to increased volumes in both our inland barge and steel components product lines. The effect of the required adoption of new revenue accounting rules effective January 1, 2018 was to increase revenues and operating profit by $24.1 million and $6.2 million, respectively, for the year ended December 31, 2018 within our Energy Equipment Group. See Note 1 of the Consolidated and Combined Financial Statements. Selling, engineering, and administrative expenses decreased by 5.6% for the year ended December 31, 2018, when compared to the prior year primarily due to lower compensation related expenses Acquisition of ACG Materials In December 2018, we completed the stock acquisition of ACG Materials ("ACG"), a producer of specialty materials and aggregates, which is included in our Construction Products Group. The purchase price of $309.1 million was funded with a combination of cash on-hand and a $180 million borrowing under the Company's credit facility. See Note 2 of the Consolidated and Combined Financial Statements. Revolving Credit Facility On November 1, 2018, the Company entered into a $400.0 million unsecured revolving credit facility that matures in November 2023. The revolving credit facility requires the maintenance of certain ratios related to leverage and interest coverage. Borrowings under the credit facility bear interest at a defined index rate plus a margin and are guaranteed by certain wholly-owned subsidiaries of the Company. As of December 31, 2018, we had $180.0 million of outstanding loans borrowed under the facility and there were approximately $47.7 million in letters of credit issued, leaving $172.3 million available for borrowing. See Note 7 of the Consolidated and Combined Financial Statements. Other Acquisitions and Divestitures In October and November 2018, the Company completed the divestiture of certain businesses whose revenues, approximately $20 million for the year ended December 31, 2018, are included in the Other component of the Energy Equipment Group. The net proceeds from these divestitures were not significant. Prior to the sale, the Company recognized a pre-tax impairment charge of $23.2 million on these businesses. See Note 2 of the Consolidated and Combined Financial Statements. In March 2018, we completed the acquisition of certain assets of an inland barge business. Unsatisfied Performance Obligations (Backlog) As of December 31, 2018 and 2017 our backlog of firm orders was as follows: * Prior to January 2018, contracts within the Other businesses of the Energy Equipment Group did not meet the Company's historical definition of backlog, which was firm, non-cancellable orders. With the adoption in January 2018 of ASU 2014-09, Revenue from Contracts with Customers, these amounts are now included in backlog due to the fact that they contain substantive cancellation penalties. Approximately 64% percent of unsatisfied performance obligations for our wind towers and utility structures in our Energy Equipment Group are expected to be delivered during the year ending December 31, 2019 with the remainder to be delivered through 2020. All of the unsatisfied performance obligations for our other business lines in our Energy Equipment Group are expected to be delivered during the year ending December 31, 2019. Approximately 94% percent of unsatisfied performance obligations for barges in our Transportation Products Group are expected to be delivered during the year ending December 31, 2019 with the remainder to be delivered through 2020. Results of Operations The following discussion of Arcosa’s results of operations should be read in connection with “Forward-Looking Statements” and “Risk Factors”. These items provide additional relevant information regarding the business of Arcosa, its strategy and various industry conditions which have a direct and significant impact on Arcosa’s results of operations, as well as the risks associated with Arcosa’s business. Years Ended December 31, 2018, 2017, and 2016 Overall Summary Revenues Our revenues for the year ended December 31, 2018, decreased by 0.1% from the previous year primarily as a result of reduced volumes in our Energy Equipment Group which were largely offset by increased volumes in both the Construction Products and Transportation Products Groups. Revenues from our Construction Products Group increased for the year ended December 31, 2018 primarily due the impact of acquisitions in 2018 and 2017 in both our construction aggregates and other product lines. In our Energy Equipment Group, revenues for the year ended December 31, 2018 decreased when compared to the prior year primarily due to a planned reduction in volumes in our wind towers product line partially offset by an increase in revenues from our other product lines. Revenues from our Transportation Products Group increased for the year ended December 31, 2018 when compared to the prior year primarily due to increased volumes in both our inland barge and steel components product lines. Our revenues for the year ended December 31, 2017, decreased by 14.2% from the previous year primarily as a result of reduced volumes in our Transportation Products Group. Revenues from our Construction Products Group increased for the year ended December 31, 2017 primarily as a result of an acquisition in our trench shoring products business partially offset by lower volumes in the construction aggregates business. In our Energy Equipment Group, revenues for the year ended December 31, 2017 increased when compared to the prior year primarily as a result of an increase in revenues from our utility structures product line partially offset by lower delivery volumes in our wind towers product line. Operating Costs Operating costs are comprised of cost of revenues; selling, engineering, and administrative expenses; impairment charges; and gains or losses on property disposals. Operating costs for the year ended December 31, 2018 increased by 2.6% over the previous year. The increase in operating costs in our Construction Products Group was primarily due to the impact of acquisitions in 2018 and 2017 in both our construction aggregates and other product lines. Operating costs for the Energy Equipment Group were lower primarily due to a planned reduction in volumes in our wind tower product line, partially offset by the impact of an impairment charge of $23.2 million on businesses that were subsequently divested. Operating costs for the Transportation Products Group were higher than the previous year due to increased deliveries in our inland barge and steel components product lines. Total selling, engineering, and administrative expenses decreased for the year ended December 31, 2018 by 5.6%, primarily due to lower compensation-related expenses. Operating costs for the year ended December 31, 2017 decreased by 11.5% over the previous year primarily due to lower shipment levels in our Transportation Products Group. Total selling, engineering, and administrative expenses for the year ended December 31, 2017, increased by 10.7%, primarily due to higher performance-related compensation. Operating Profit (Loss) Our operating profit for the year ended December 31, 2018 decreased by 27.9% when compared to the prior year. Operating profit in the Construction Products Group decreased compared to the prior period primarily due to lower volumes in our legacy construction aggregates businesses and increased costs related to the fair value markup of acquired inventory. Operating profit in our Energy Equipment Group decreased for the year ended December 31, 2018 when compared to the prior year as a result of a planned reduction in volumes in our wind towers product line and the impact of an impairment charge of $23.2 million on businesses that were subsequently divested. Operating profit in our Transportation Products Group increased compared to the prior year due to increased deliveries in our inland barge and steel components product lines. Our operating profit for the year ended December 31, 2017 decreased by 34.4% when compared to the prior year primarily as a result of lower shipment levels in our Transportation Products Group. Operating profit in the Construction Products Group decreased for the year ended December 31, 2017 when compared to the prior year primarily due to lower volumes in our construction aggregates business partially offset by higher volumes in the Group’s other businesses as a result of an acquisition in our trench shoring products business. Operating profit in our Energy Equipment Group decreased for the year ended December 31, 2017 when compared to the prior year as a result of lower delivery volumes in our wind towers business partially offset by an increase in revenues from our utility structures product line and other businesses. For a further discussion of revenues, costs, and the operating results of individual segments, see Segment Discussion below. Other Income and Expense Other, net (income) expense consists of the following items: Income Taxes The income tax provision for the years ended December 31, 2018, 2017, and 2016 was $19.3 million, $40.4 million, and $74.2 million, respectively. The effective tax rate for the years ended December 31, 2018, 2017, and 2016 was 20.3%, 31.1%, and 37.6%, respectively. The effective tax rates differ from the federal tax rates of 21.0%, 35.0%, and 35.0%, respectively, due to the impact of the Act, state income taxes, excess tax deficiencies (benefits) related to equity compensation, and changes in valuation allowances on certain deferred tax assets. See Note 9 of the Notes to the Consolidated and Combined Financial Statements for a further discussion of income taxes. Segment Discussion Construction Products Group Revenues and cost of revenues increased by 12.9% and 19.0%, respectively, for the year ended December 31, 2018, when compared to the same period in 2017. The increases in revenues and cost of revenues resulted primarily from 2018 revenues attributable to the 2017 acquisitions in both the lightweight and the trench shoring products businesses and the December 2018 acquisition of ACG. Selling, engineering, and administrative expenses increased by 10.2% for the year ended December 31, 2018 compared to the same period in 2017 primarily due to acquisitions. Operating profit decreased by 6.1% primarily due to lower volumes in our legacy construction aggregates businesses and increased costs related to the fair value markup of acquired inventory. Revenues and cost of revenues increased by 2.8% and 4.6%, respectively, for the year ended December 31, 2017, when compared to the same period in 2016. Approximately 65% of the increase in revenues from other businesses and substantially all of the increase in segment cost of revenues was a result of the acquisition in our trench shoring business in the third quarter of 2017. The decrease in revenues in our construction aggregates business was primarily due to lower volumes. Selling, engineering, and administrative expenses increased by 22.0% for the year ended December 31, 2017 compared to the same period in 2016, approximately 30% of which related to increased compensation-related costs from the newly acquired shoring business and approximately 65% of which related to increased compensation-related costs of existing businesses. Energy Equipment Group Revenues for the year ended December 31, 2018 decreased by 7.6% compared to the same period in 2017. Revenues from our wind towers and utility structures product lines decreased by 10.6% for the year ended December 31, 2018 driven primarily by a planned reduction in volume in our wind towers product line. Other revenues include results primarily from our storage and distribution containers. Revenues from other product lines for the year ended December 31, 2018 increased by 2.7% when compared to 2017 as a result of increased shipping volumes in our storage tanks product line. Cost of revenues decreased by 4.8% for the year ended December 31, 2018 compared to 2017, due to lower volumes in our wind tower product line, partially offset by a $6.1 million finished goods inventory write-off related to an order for a single customer in our utility structures business. Declines in revenues and cost of revenues on our wind towers and utility structures product lines were also partially offset by the required adoption of ASU 2014-09. See Note 1 of the Notes to the Combined and Consolidated Financial Statements for further discussion of the impact of this required change in accounting policy. Selling, engineering, and administrative costs decreased by 5.4% for the year ended December 31, 2018 primarily due to bad debt expense related to a single customer recognized in 2017. Operating profit for the year ended December 31, 2018 was also negatively impacted by an impairment charge of $23.2 million on businesses that were subsequently divested. Revenues for the year ended December 31, 2017 increased by 2.0% compared to the same period in 2016. Revenues from our wind towers and utility structures product lines increased by 1.7% for the year ended December 31, 2017 driven by an approximately 10% increase in revenues in our utility structures product line due largely to improved pricing, partially offset by an approximately 5% decrease in revenues in our wind towers product line due to lower shipping volumes and pricing. Revenues from other product lines for the year ended December 31, 2017 increased by 3.1% when compared to 2016 as a result of increased shipping volumes. Cost of revenues increased by 3.2% for the year ended December 31, 2017, compared to 2016, due to higher volumes in our utility structures and other product lines. Selling, engineering, and administrative costs increased by 6.6% for the year ended December 31, 2017 approximately 60% of which related to increased bad debt expense primarily related to a single customer and approximately 20% of which related to increased compensation-related expenses. As of December 31, 2018, the backlog for wind towers and utility structures was $633.1 million compared to $899.0 million as of December 31, 2017. Approximately 64% of our structural wind towers and utility structures backlog is expected to be delivered during the year ending December 31, 2019 with the remainder to be delivered through 2020. Future wind tower orders are subject to uncertainty following the phase-out of the PTC. As of December 31, 2018, the backlog for our other business lines in our Energy Equipment Group was $55.1 million, all of which is expected to be delivered during the year ending December 31, 2019. Transportation Products Group Revenues and cost of revenues increased for the year ended December 31, 2018 by 7.7% and 6.4%, respectively, compared to the same period in 2017 primarily from higher deliveries in both the inland barge and steel components product lines. Selling, engineering, and administrative costs decreased for the year ended December 31, 2018 compared to the same period in 2017. Revenues and cost of revenues decreased for the year ended December 31, 2017 by 42.1% and 41.6%, respectively, compared to the same period in 2016 primarily from lower barge deliveries and steel components deliveries. Selling, engineering, and administrative costs decreased for the year ended December 31, 2017 compared to the same period in 2016. As of December 31, 2018, the backlog for the Transportation Products Group was $230.5 million compared to $98.2 million as of December 31, 2017. Approximately 94% percent of backlog for barges in our Transportation Products Group is expected to be delivered during the year ending December 31, 2019 with the remainder to be delivered through 2020. Corporate Corporate overhead costs prior to the Separation consist of costs not previously allocated to Trinity’s business units and have been allocated to Arcosa based on an analysis of each cost function and the relative benefits received by Arcosa for each of the periods using methods management believes are consistent and reasonable. See Note 1 of the Notes to the Consolidated and Combined Financial Statements for further information. The decrease in corporate overhead costs of 18.3% for the year ended December 31, 2018 compared to 2017 is primarily due to lower compensation related expenses. The increase in corporate overhead costs for the year ended December 31, 2017 compared to 2016 is primarily due to higher corporate level infrastructure costs and performance-based compensation-related expenses. Liquidity and Capital Resources Arcosa’s liquidity requirements are primarily to fund our business operations, including capital expenditures, working capital requirements, and disciplined acquisitions. Our primary sources of liquidity are cash flows from operations, our existing cash balance and, as necessary, borrowings under the revolving credit facility and issuance of long-term debt or equity. To the extent we generate discretionary cash flow, we may consider using this additional cash flow to undertake new capital investment projects, execute strategic acquisitions, return capital to stockholders, or for general corporate purposes. Pursuant to the separation and distribution agreement, on October 31, 2018, Trinity contributed $200 million of cash to Arcosa in connection with the Separation. Revolving Credit Faciltiy On November 1, 2018, the Company entered into a $400.0 million unsecured revolving credit facility that matures in November 2023. The interest rates under the facility are variable based on LIBOR or an alternate base rate plus a margin that is determined based on Arcosa’s leverage as measured by a consolidated total indebtedness to consolidated EBITDA ratio, which is currently set at LIBOR plus 1.25%. A commitment fee accrues on the average daily unused portion of the revolving facility at the current rate of 0.20%. Borrowings under the credit facility are guaranteed by certain wholly-owned subsidiaries of the Company. As of December 31, 2018, we had $180.0 million of outstanding loans borrowed under the facility and there were approximately $47.7 million in letters of credit issued, leaving $172.3 million available for borrowing. The Company's revolving credit facility requires the maintenance of certain ratios related to leverage and interest coverage. As of December 31, 2018, we were in compliance with all such financial covenants. Cash Flows The following table summarizes our cash flows from operating, investing, and financing activities for each of the last three years: 2018 compared with 2017 Operating Activities. Net cash provided by operating activities for the year ended December 31, 2018 was $118.5 million compared to net cash provided by operating activities of $162.0 million for the same period in 2017. Cash flow provided by operating activities decreased primarily due to lower operating profit. Receivables at December 31, 2018 increased by $80.9 million, or 48.9%, from December 31, 2017. While most of this increase relates to the timing of payments from trade receivables, approximately 10% of the increase is due to the recognition of receivables from the Former Parent which had previously been deemed settled in the period incurred in the historical combined financial statements. Raw materials inventory at December 31, 2018 increased by $37.1 million, or 40.6%, since December 31, 2017, while work in process inventory decreased by $13.9 million, or 29.4%. Finished goods inventory decreased by $17.5 million, or 16.2%, since December 31, 2017. Accounts payable increased by $20.6 million, while accrued liabilities increased by $20.2 million from December 31, 2017. We continually review reserves related to collectability as well as the adequacy of lower of cost or net realizable value with regard to accounts receivable and inventory. Certain amounts above may not be able to be recalculated from the information provided in the Consolidated and Combined Balance Sheets due to, among others, the impact of acquisitions. Investing Activities. Net cash required by investing activities for the year ended December 31, 2018 was $364.5 million compared to $126.4 million for the year ended December 31, 2017. Capital expenditures for the year ended December 31, 2018 were $44.8 million. This compares to $82.4 million of capital expenditures for the same period in 2017. Full-year capital expenditures for 2019 are expected to range between $70 million and $80 million. We expect maintenance capital expenditures to be in the range of $60 million to $65 million and capital expenditures related to additional growth to be in the range of $10 million and $15 million. Proceeds from the sale of property, plant, and equipment and other assets totaled $10.2 million for the year ended December 31, 2018 compared to $3.5 million for the same period in 2017. Net cash required related to acquisitions amounted to $333.2 million for the year ended December 31, 2018 compared to $47.5 million for the same period in 2017. Net cash provided related to divestitures totaled $3.3 million for the year ended December 31, 2018. There was no divestiture activity for the year ended December 31, 2017. Financing Activities. Net cash provided by financing activities during the year ended December 31, 2018 was $338.6 million compared to $42.8 million of net cash required by financing activities for the same period in 2017. During the year ended December 31, 2018, we borrowed $180.0 million and retired $0.3 million in debt. During the year ended December 31, 2017, we borrowed $0.6 million and retired $0.1 million in debt. We received a capital contribution of $200.0 million from Trinity during the year ended December 31, 2018. Net transfers to Trinity totaled $34.5 million for the year ended December 31, 2018 compared with $43.0 million for the year ended December 31, 2017. 2017 compared with 2016 Operating Activities. Net cash provided by operating activities for the year ended December 31, 2017 was $162.0 million compared to net cash provided by operating activities of $227.8 million for the same period in 2016. Cash flow provided by operating activities decreased primarily due to lower operating profit. Receivables at December 31, 2017 increased by $26.4 million, or 19.9%, from December 31, 2016. Raw materials inventory at December 31, 2017 decreased by $2.5 million, or 2.7%, since December 31, 2016, while work in process inventory decreased by $16.5 million, or 25.9%. Finished goods inventory increased by $2.1 million, or 2.0%, since December 31, 2016. Accounts payable increased by $7.1 million, while accrued liabilities decreased by $4.9 million from December 31, 2016. Investing Activities. Net cash required by investing activities for the year ended December 31, 2017 was $126.4 million compared to $79.8 million for the year ended December 31, 2016. Capital expenditures for the year ended December 31, 2017 were $82.4 million. This compares to $84.8 million of capital expenditures for the same period in 2016. Proceeds from the sale of property, plant, and equipment and other assets totaled $3.5 million for the year ended December 31, 2017 compared to $5.0 million for the same period in 2016. Net cash required related to acquisitions amounted to $47.5 million for the year ended December 31, 2017. There was no divestiture activity for the year ended December 31, 2017. There was no acquisition or divestiture activity for the year ended December 31, 2016. Financing Activities. Net cash required by financing activities during the year ended December 31, 2017 was $42.8 million compared to $144.2 million of net cash required by financing activities for the same period in 2016. During the year ended December 31, 2017, we borrowed $0.6 million and retired $0.1 million in debt. During the year ended December 31, 2016, we retired $0.5 million in debt as scheduled. Net transfers to Trinity totaled $43.0 million for the year ended December 31, 2017 compared with $141.7 million for the year ended December 31, 2016. Other Investing and Financing Activities Dividends and Repurchase Program In December 2018, the Company declared a quarterly dividend of $0.05 per share paid in January 2019. In December 2018, the Company’s Board of Directors authorized a $50.0 million share repurchase program effective December 5, 2018 through December 31, 2020. During December 2018, the Company repurchased 124,272 shares at a cost of $3.0 million. See Note 1 of the Notes to the Consolidated and Combined Financial Statements. Off-Balance Sheet Arrangements As of December 31, 2018, we had letters of credit issued under our revolving credit facility in an aggregate principal amount of $47.7 million, all of which are expected to expire in 2019. The majority of our letters of credit obligations support the Company’s various insurance programs and warranty claims and generally renew by their terms each year. See Note 7 of the Notes to the Consolidated and Combined Financial Statements. Derivative Instruments In December 2018, the Company entered into an interest rate swap instrument, effective as of January 2, 2019 and expiring in 2023, to reduce the effect of changes in the variable interest rates associated with borrowings under the revolving credit facility. The instrument carried an initial notional amount of $100 million, thereby hedging the first $100 million of borrowings under the credit facility. The instrument effectively fixes the LIBOR component of the credit facility borrowings at 2.71%. As of December 31, 2018, the Company has recorded a liability of $1.2 million for the fair value of the instrument, all of which is recorded in accumulated other comprehensive loss. See Note 3 and Note 7 of the Notes to the Consolidated and Combined Financial Statements. Stock-Based Compensation We have a stock-based compensation plan covering our employees and our Board of Directors. See Note 12 of the Notes to the Consolidated and Combined Financial Statements. Employee Retirement Plans We sponsor an employee savings plan under the existing 401(k) plan that covers substantially all employees and includes both a company matching contribution and an annual retirement contribution of up to 3% each of eligible compensation based on our performance, as well as a Supplemental Profit Sharing Plan. Both the annual retirement contribution and the company matching contribution are discretionary, requiring board approval, and made annually with the investment of the funds directed by the participants.The Company also contributes to a multiemployer defined benefit pension plan under the terms of a collective-bargaining agreement that covers certain union-represented employees at one of our facilities. See Note 10 of the Notes to the Consolidated and Combined Financial Statements. Contractual Obligations and Commercial Commitments As of December 31, 2018, we had the following contractual obligations and commercial commitments: As of December 31, 2018 and 2017, we had $0.5 million and $2.2 million, respectively, of tax liabilities, including interest and penalties, related to uncertain tax positions. Because of the high degree of uncertainty regarding the timing of future cash outflows associated with these liabilities, we are unable to estimate the years in which settlement will occur with the respective taxing authorities. See Note 14 of the Notes to the Consolidated and Combined Financial Statements. Critical Accounting Policies and Estimates MD&A discusses our Consolidated and Combined Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the U.S. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, management evaluates its estimates and judgments, including those related to bad debts, inventories, property, plant, and equipment, goodwill, income taxes, warranty obligations, insurance, contingencies, and litigation. 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. We believe the following critical accounting policies, among others, affect our more significant judgments and estimates used in the preparation of our Consolidated and Combined Financial Statements. Revenue Recognition Revenue is measured based on the allocation of the transaction price in a contract to satisfied performance obligations. The transaction price does not include any amounts collected on behalf of third parties. The Company recognizes revenue when it satisfies a performance obligation by transferring control over a product or service to a customer. The following is a description of principal activities from which the Company generates its revenue, separated by reportable segments. Payments for our products and services are generally due within normal commercial terms. Construction Products Group The Construction Products Group recognizes revenue when the customer has accepted the product and legal title of the product has passed to the customer. Energy Equipment Group Within the Energy Equipment Group, revenue is recognized for our wind tower and certain utility structure product lines over time as the products are manufactured using an input approach based on the costs incurred relative to the total estimated costs of production. We recognize revenue over time for these products as they are highly customized to the needs of an individual customer resulting in no alternative use to the Company if not purchased by the customer after the contract is executed, and we have the right to bill the customer for our work performed to date plus at least a reasonable profit margin for work performed. For all other products, revenue is recognized when the customer has accepted the product and legal title of the product has passed to the customer. Transportation Products Group The Transportation Products Group recognizes revenue when the customer has accepted the product and legal title of the product has passed to the customer. Inventory Inventories are valued at the lower of cost or net realizable value. Our policy related to excess and obsolete inventory requires an analysis of inventory at the business unit level on a quarterly basis and the recording of any required adjustments. In assessing the ultimate realization of inventories, we are required to make judgments as to future demand requirements and compare that with the current or committed inventory levels. It is possible that changes in required inventory reserves may occur in the future due to then current market conditions. Long-lived Assets We periodically evaluate the carrying value of long-lived assets to be held and used for potential impairment. The carrying value of long-lived assets to be held and used is considered impaired only when the carrying value is not recoverable through undiscounted future cash flows and the fair value of the assets is less than their carrying value. Fair value is determined primarily using the anticipated cash flows discounted at a rate commensurate with the risks involved or market quotes as available. Impairment losses on long-lived assets held for sale are determined in a similar manner, except that fair values are reduced by the estimated cost to dispose of the assets. Goodwill Goodwill is required to be tested for impairment annually, or on an interim basis whenever events or circumstances change, indicating that the carrying amount of the goodwill might be impaired. The quantitative goodwill impairment test is a two-step process with step one requiring the comparison of the reporting unit’s estimated fair value with the carrying amount of its net assets. If necessary, step two of the impairment test determines the amount of goodwill impairment to be recorded when the reporting unit’s recorded net assets exceed its fair value. Impairment is assessed at the “reporting unit” level by applying a fair value-based test for each unit with recorded goodwill. The estimates and judgments that most significantly affect the fair value calculations are assumptions, consisting of level three inputs, related to revenue and operating profit growth, discount rates, and exit multiples. Based on the Company's annual goodwill impairment test, performed at the reporting unit level as of December 31, 2018, the Company concluded that no impairment charges were determined to be necessary and that none of the reporting units evaluated was at risk of failing the first step of the goodwill impairment test. A reporting unit is considered to be at risk if its estimated fair value does not exceed the carrying value of its net assets by 10% or more. See Note 1 and Note 6 of the Notes to the Consolidated and Combined Financial Statements for further explanation. Given the uncertainties of the economy and its potential impact on our businesses, there can be no assurance that our estimates and assumptions regarding the fair value of our reporting units, made for the purposes of the long-lived asset and goodwill impairment tests, will prove to be accurate predictions of the future. If our assumptions regarding forecasted cash flows are not achieved, it is possible that impairments of goodwill and long-lived assets may be required. Warranties The Company provides various express, limited product warranties that generally range from one to five years depending on the product. The warranty costs are estimated using a two-step approach. First, an engineering estimate is made for the cost of all claims that have been asserted by customers. Second, based on historical, accepted claims experience, a cost is accrued for all products still within a warranty period for which no claims have been filed. The Company provides for the estimated cost of product warranties at the time revenue is recognized related to products covered by warranties and assesses the adequacy of the resulting reserves on a quarterly basis. Insurance We are effectively self-insured for workers’ compensation claims. A third-party administrator processes all such claims. We accrue our workers’ compensation liability based upon independent actuarial studies. To the extent actuarial assumptions change and claims experience rates differ from historical rates, our liability may change. Contingencies and Litigation The Company is involved in claims and lawsuits incidental to our business. Based on information currently available with respect to such claims and lawsuits, including information on claims and lawsuits as to which the Company is aware but for which the Company has not been served with legal process, it is management’s opinion that the ultimate outcome of all such claims and litigation, including settlements, in the aggregate will not have a material adverse effect on the Company’s financial condition for purposes of financial reporting. However, resolution of certain claims or lawsuits by settlement or otherwise, could impact the operating results of the reporting period in which such resolution occurs. Environmental We are involved in various proceedings related to environmental matters. We have provided reserves to cover probable and estimable liabilities with respect to such proceedings, taking into account currently available information and our contractual recourse. However, estimates of future response costs are necessarily imprecise. Accordingly, there can be no assurance that we will not become involved in future environmental litigation or other proceedings or, if we were found to be responsible or liable in any litigation or proceeding, that such costs would not be material to us. Income Taxes Income taxes as presented herein attribute current and deferred income taxes of Trinity to Arcosa’s standalone financial statements in a manner that is systematic, rational, and consistent with the asset and liability method prescribed by the Accounting Standards Codification Topic 740 - Income Taxes (“ASC 740”). Accordingly, Arcosa’s income tax provision has been prepared following the separate return method. The separate return method applies ASC 740 to the standalone financial statements of each member of the consolidated group as if the group member were a separate taxpayer and a standalone enterprise. As a result, actual tax transactions included in the consolidated financial statements of Trinity may not be included in the separate financial statements of Arcosa. Similarly, the tax treatment of certain items reflected in the separate financial statements of Arcosa may not be reflected in the consolidated financial statements and tax returns of Trinity; therefore, such items as net operating losses, credit carryforwards, and valuation allowances may exist in the standalone financial statements that may or may not exist in Trinity’s consolidated financial statements. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amount of existing assets and liabilities and their respective tax bases and other tax attributes using currently enacted tax rates. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in the provision for income taxes in the period that includes the enactment date. Management is required to estimate the timing of the recognition of deferred tax assets and liabilities, make assumptions about the future deductibility of deferred tax assets, and assess deferred tax liabilities based on enacted law and tax rates for the appropriate tax jurisdictions to determine the amount of such deferred tax assets and liabilities. Changes in the calculated deferred tax assets and liabilities may occur in certain circumstances including statutory income tax rate changes, statutory tax law changes, or changes in the structure or tax status of the Company. The Company assesses whether a valuation allowance should be established against its deferred tax assets based on consideration of all available evidence, both positive and negative, using a more likely than not standard. This assessment considers, among other matters, the nature, frequency, and severity of recent losses; a forecast of future profitability; the duration of statutory carryback and carryforward periods; the Company’s experience with tax attributes expiring unused; and tax planning alternatives. At December 31, 2018, the Company had $105.0 million federal consolidated net operating loss carryforwards and $2.7 million of tax-effected state loss carryforwards remaining. In addition, the Company had $23.9 million of foreign net operating loss carryforwards that will begin to expire in the year 2034. We have established a valuation allowance for state and foreign tax operating losses and credits that we have estimated may not be realizable. At times, we may claim tax benefits that may be challenged by a tax authority. We recognize tax benefits only for tax positions more likely than not to be sustained upon examination by tax authorities. The amount recognized is measured as the largest amount of benefit that is greater than 50 percent likely to be realized upon settlement. A liability for “unrecognized tax benefits” is recorded for any tax benefits claimed in our tax returns that do not meet these recognition and measurement standards. The Act was enacted on December 22, 2017. The Act reduced the U.S. federal corporate income tax rate from 35% to 21%, required companies to pay a one-time transition tax on earnings of certain foreign subsidiaries that were previously tax deferred, and created new taxes on certain foreign-sourced earnings. For the year ended December 31, 2017, we recognized a provisional benefit of $6.2 million. During the year ended December 31, 2018, we finalized the accounting for the enactment of the Act and recorded an additional $1.5 million benefit, primarily as a result of the true up of our deferred taxes. Recent Accounting Pronouncements See Note 1 of the Notes to the Consolidated and Combined Financial Statements for information about recent accounting pronouncements. Forward-Looking Statements This annual report on Form 10-K (or statements otherwise made by the Company or on the Company’s behalf from time to time in other reports, filings with the Securities and Exchange Commission (“SEC”), news releases, conferences, internet postings or otherwise) contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Any statements contained herein that are not historical facts are forward-looking statements and involve risks and uncertainties. These forward-looking statements include expectations, beliefs, plans, objectives, future financial performances, estimates, projections, goals, and forecasts. Arcosa uses the words “anticipates,” “assumes,” “believes,” “estimates,” “expects,” “intends,” “forecasts,” “may,” “will,” “should,” and similar expressions to identify these forward-looking statements. Potential factors, which could cause our actual results of operations to differ materially from those in the forward-looking statements include, among others: • market conditions and customer demand for our business products and services; • the cyclical nature of the industries in which we compete; • variations in weather in areas where our construction products are sold, used, or installed; • naturally-occurring events and disasters causing disruption to our manufacturing, product deliveries, and production capacity, thereby giving rise to an increase in expenses, loss of revenue, and property losses; • our ability to identify, consummate, or integrate acquisition of new businesses or products; • the timing of introduction of new products; • the timing and delivery of customer orders or a breach of customer contracts; • the credit worthiness of customers and their access to capital; • product price changes; • changes in mix of products sold; • the costs incurred to align manufacturing capacity with demand and the extent of its utilization; • the operating leverage and efficiencies that can be achieved by our manufacturing businesses; • availability and costs of steel, component parts, supplies, and other raw materials; • competition and other competitive factors, including U.S. and foreign trade practices; • changing technologies; • surcharges and other fees added to fixed pricing agreements for steel, component parts, supplies and other raw materials; • interest rates and capital costs; • counter-party risks for financial instruments; • long-term funding of our operations; • taxes; • the stability of the governments and political and business conditions in certain foreign countries, particularly Mexico; • changes in import and export quotas and regulations; • business conditions in emerging economies; • costs and results of litigation; • changes in accounting standards or inaccurate estimates or assumptions in the application of accounting policies; • legal, regulatory, and environmental issues, including compliance of our products with mandated specifications, standards, or testing criteria and obligations to remove and replace our products following installation or to recall our products and install different products manufactured by us or our competitors; • actions by the executive and legislative branches of the U.S. government relative to federal government budgeting, taxation policies, government expenditures, U.S. borrowing/debt ceiling limits, and trade policies, including NAFTA and the USMCA; • the use of social or digital media to disseminate false, misleading and/or unreliable or inaccurate information; • the inability to sufficiently protect our intellectual property rights; • if the Company does not realize some or all of the benefits expected to result from the Separation, or if such benefits are delayed; • the Company's ongoing businesses may be adversely affected and subject to certain risks and consequences as a result of the Separation; • if the distribution does not qualify as a transaction that is generally tax-free for U.S. federal income tax purposes, the Company's stockholders at the time of the distribution and the Company could be subject to significant tax liability; and • if the Separation does not comply with state and federal fraudulent conveyance laws and legal dividend requirements. Any forward-looking statement speaks only as of the date on which such statement is made. Arcosa undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made. For a discussion of risks and uncertainties which could cause actual results to differ from those contained in the forward-looking statements, see Item 1A, "Risk Factors" included elsewhere herein.
0.060069
0.06041
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<s>[INST] Separation from Trinity Basis of Historical Presentation Executive Overview Results of Operations Liquidity and Capital Resources Contractual Obligations and Commercial Commitments Critical Accounting Policies and Estimates Recent Accounting Pronouncements ForwardLooking Statements Our MD&A should be read in conjunction with our Consolidated and Combined Financial Statements and related Notes in Item 8, "Financial Statements and Supplementary Data," of this Annual Report on Form 10K. Separation from Trinity Arcosa is a Delaware corporation and was incorporated in 2018 in connection with the Separation of Arcosa from Trinity on November 1, 2018 as an independent, publiclytraded company, listed on the New York Stock Exchange. At the time of the Separation, Arcosa consisted of certain of Trinity’s former construction products, energy equipment, and transportation products businesses. The Separation was effectuated through a pro rata dividend distribution on November 1, 2018 of all of the thenoutstanding shares of common stock of Arcosa to the holders of common stock of Trinity as of October 17, 2018, the record date for the distribution. Trinity stockholders received one share of Arcosa common stock for every three shares of Trinity common stock held as of the record date. The transaction was structured to be taxfree to both Trinity and Arcosa stockholders for U.S. federal income tax purposes. Basis of Historical Presentation The accompanying Consolidated and Combined Financial Statements present our historical financial position, results of operations, comprehensive income/loss, and cash flows in accordance with accounting principles generally accepted in the U.S. (“GAAP”). The combined financial statements for periods prior to the Separation were derived from Trinity’s consolidated financial statements and accounting records and prepared in accordance with GAAP for the preparation of carvedout combined financial statements. Through the date of the Separation, all revenues and costs as well as assets and liabilities directly associated with Arcosa have been included in the combined financial statements. Prior to the Separation, the combined financial statements also included allocations of certain selling, engineering, and administrative expenses provided by Trinity to Arcosa and allocations of related assets, liabilities, and the Former Parent’s net investment, as applicable. The allocations were determined on a reasonable basis; however, the amounts are not necessarily representative of the amounts that would have been reflected in the financial statements had the Company been an entity that operated independently of Trinity during the applicable periods. Related party allocations prior to the Separation, including the method for such allocation, are described further in Note 1, “Overview and Summary of Significant Accounting Policies” to the Consolidated and Combined Financial Statements. Following the Separation, the consolidated financial statements include the accounts of Arcosa and those of our whollyowned subsidiaries and no longer include any allocations from Trinity. Trinity will continue to provide some general and administrative functions on a transitional basis for a fee following the Separation. Executive Overview Financial Operations and Highlights The Company’s revenues for the year ended December 31, 2018 were $1.5 billion, essentially flat compared to the year ended December 31, 2017. Operating profit for year ended December 31, 2018 totaled $94.9 million, representing a decrease of 27.9% compared to the year ended December 31, 2017 primarily due to lower volumes in our Energy Equipment Group combined with an impairment charge of $23.2 million recognized in the third quarter in our Energy Equipment Group on businesses that were subsequently divested. Revenues in our Construction Products Group increased for the year ended December 31, 2018 primarily due to increased volumes driven by 2017 and 2018 acquisitions. Operating profit in our Construction Products Group decreased for the year ended December 31, 2018 primarily due to lower volumes in our legacy construction aggregates businesses and increased costs related to the fair value markup of acquired inventory. The Energy Equipment Group recorded lower revenues and [/INST] Positive. </s>
2,019
7,737
1,739,445
Arcosa, Inc.
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 (“MD&A”) is intended to provide a reader of our financial statements with a narrative from the perspective of our management on our financial condition, results of operations, liquidity, and certain other factors that may affect our future results. Our MD&A is presented in the following sections: •Separation from Trinity •Basis of Historical Presentation •Executive Overview •Results of Operations •Liquidity and Capital Resources •Contractual Obligations and Commercial Commitments •Critical Accounting Policies and Estimates •Recent Accounting Pronouncements •Forward-Looking Statements Our MD&A should be read in conjunction with our Consolidated and Combined Financial Statements and related Notes in Item 8, "Financial Statements and Supplementary Data," of this Annual Report on Form 10-K. Separation from Trinity Arcosa, Inc. (“Arcosa,” the “Company,” “we,” or “our”) is a Delaware corporation and was incorporated in 2018 in connection with the separation of Arcosa from Trinity Industries, Inc. (“Trinity” or “Former Parent”) on November 1, 2018 as an independent, publicly-traded company, listed on the New York Stock Exchange (the “Separation”). At the time of the Separation, Arcosa consisted of certain of Trinity’s former construction products, energy equipment, and transportation products businesses. The Separation was effectuated through a pro rata dividend distribution on November 1, 2018 of all of the then-outstanding shares of common stock of Arcosa to the holders of common stock of Trinity as of October 17, 2018, the record date for the distribution. Trinity stockholders received one share of Arcosa common stock for every three shares of Trinity common stock held as of the record date. The transaction was structured to be tax-free to both Trinity and Arcosa stockholders for U.S. federal income tax purposes. Basis of Historical Presentation The accompanying Consolidated and Combined Financial Statements present our historical financial position, results of operations, comprehensive income/loss, and cash flows in accordance with accounting principles generally accepted in the U.S. (“GAAP”). The combined financial statements for periods prior to the Separation were derived from Trinity’s consolidated financial statements and accounting records and prepared in accordance with GAAP for the preparation of carved-out combined financial statements. Through the date of the Separation, all revenues and costs as well as assets and liabilities directly associated with Arcosa have been included in the combined financial statements. Prior to the Separation, the combined financial statements also included allocations of certain selling, general, and administrative expenses provided by Trinity to Arcosa and allocations of related assets, liabilities, and the Former Parent’s net investment, as applicable. The allocations were determined on a reasonable basis; however, the amounts are not necessarily representative of the amounts that would have been reflected in the financial statements had the Company been an entity that operated independently of Trinity during the applicable periods. Related party allocations prior to the Separation, including the method for such allocation, are described further in Note 1, “Overview and Summary of Significant Accounting Policies” to the Consolidated and Combined Financial Statements. Following the Separation, the consolidated financial statements include the accounts of Arcosa and those of our wholly-owned subsidiaries and no longer include any allocations from Trinity. Trinity continues to provide some general and administrative functions on a transitional basis for a fee following the Separation. Such functions were minimal as of December 31, 2019. Executive Overview Financial Operations and Highlights • Revenues for the year ended December 31, 2019 grew 18.9% to $1.7 billion compared to the year ended December 31, 2018 primarily due to the impact of the ACG acquisition in our Construction Products Group, higher unit volumes and prices in our Energy Equipment Group, and higher tank barge volumes in our Transportation Products Group. • Operating profit for year ended December 31, 2019 totaled $152.9 million, representing an increase of 61.1% compared to the year ended December 31, 2018 primarily driven by increased revenues in all segments, operating improvements in our Energy Equipment Group, and certain other charges recognized in the prior period including an impairment charge of $23.2 million related to divested businesses. • Selling, general, and administrative expenses increased by 16.6% for the year ended December 31, 2019, when compared to the prior year largely due to additional costs from the acquired ACG business, incremental standalone costs related to the replacement of services and fees previously provided or incurred by Trinity, as well as other standalone public company costs. • The effective tax rate for the year ended December 31, 2019 was 22.8% compared to 20.3% for the year ended December 31, 2018. See Note 10, “Income Taxes” to the Consolidated and Combined Financial Statements. • Net income for the year ended December 31, 2019 was $113.3 million compared with $75.7 million for the year ended December 31, 2018. Recent Developments On January 6, 2020, Arcosa completed the acquisition of Cherry, a leading producer of natural and recycled aggregates in the Houston, Texas market for approximately $298 million. The acquisition of Cherry broadens our geographic presence, adding 12 Houston locations to Arcosa’s existing 20 active aggregate and specialty materials locations in Texas, provides us a new complementary product line of recycled aggregates, a growing product category due to resource scarcity and ESG benefits, and offers a platform for additional growth in natural and recycled aggregates. The purchase was funded with a combination of cash on-hand and advances under a new $150 million five-year term loan. See Note 2 and Note 7 to the Consolidated and Combined Financial Statements. Unsatisfied Performance Obligations (Backlog) As of December 31, 2019 and 2018 our backlog of firm orders was as follows: Approximately 86% percent of unsatisfied performance obligations for our wind towers and utility structures in our Energy Equipment Group are expected to be delivered during the year ending 2020 with the remainder to be delivered in 2021. All of the unsatisfied performance obligations for our other business lines in our Energy Equipment Group are expected to be delivered during the year ending 2020. All of the unsatisfied performance obligations for barges in our Transportation Products Group are expected to be delivered during the year ending 2020. Results of Operations The following discussion of Arcosa’s results of operations should be read in connection with “Forward-Looking Statements” and “Risk Factors”. These items provide additional relevant information regarding the business of Arcosa, its strategy and various industry conditions which have a direct and significant impact on Arcosa’s results of operations, as well as the risks associated with Arcosa’s business. Overall Summary Revenues 2019 versus 2018 • Revenues grew by 18.9% with all segments contributing to the increase. • Revenues from our Construction Products Group increased primarily due to the impact of the ACG acquisition. • In our Energy Equipment Group, revenues increased primarily driven by higher volumes in wind towers and higher pricing levels in utility structures. • Revenues from our Transportation Products Group increased primarily due to higher tank barge volumes partially offset by lower contractual pricing and decreased volumes in steel components. 2018 versus 2017 • Revenues were essentially flat in 2018 as lower volumes in our Energy Equipment Group were largely offset by increased volumes in both the Construction Products and Transportation Products Groups. • Revenues from our Construction Products Group increased primarily due to the impact of acquisitions completed in 2018 and 2017 in both our construction aggregates and other product lines. • In our Energy Equipment Group, revenues decreased primarily due to a planned reduction of volumes in our wind towers product line partially offset by an increase in revenues from our other product lines. • Revenues from our Transportation Products Group increased primarily due to increased volumes in both our inland barge and steel components product lines. Operating Costs Operating costs are comprised of cost of revenues; selling, general, and administrative expenses; impairment charges; and gains or losses on property disposals. 2019 versus 2018 • Operating costs increased 16.0%. • The increase in our Construction Products Group was primarily due to the acquired ACG business as well as increased volumes in our legacy businesses. • Operating costs for the Energy Equipment Group decreased primarily due to an impairment charge and the elimination of operating losses from divested businesses in 2018, partially offset by higher volumes in 2019. • Operating costs for the Transportation Products Group increased due to higher tank barge volumes and start-up costs incurred related to the re-opening of a previously idled barge facility, partially offset by lower steel component volumes. • Total selling, general, and administrative expenses increased 16.6% largely due to additional costs from the acquired ACG business, incremental standalone costs related to the replacement of services and fees previously provided or incurred by Trinity, and other standalone public company costs. As a percentage of revenue, selling, general, and administrative expenses for the year ended December 31, 2019 was 10.3% compared to 10.5% for the year ended December 31, 2018. 2018 versus 2017 • Operating costs increased 2.6%. • The increase in operating costs in our Construction Products Group was primarily due to the impact of businesses acquired in 2018 and 2017 in both our construction aggregates and other product lines. • Operating costs for the Energy Equipment Group were lower primarily due to a planned reduction in volumes in our wind tower product line, partially offset by an impairment charge of $23.2 million recorded in 2018 on businesses that were subsequently divested. • Operating costs for the Transportation Products Group were higher due to increased volumes in our inland barge and steel components product lines. • Total selling, general, and administrative expenses decreased 5.6%, primarily due to lower compensation-related expenses. Operating Profit (Loss) 2019 versus 2018 • Operating profit increased 61.1%. • Operating profit in the Construction Products Group increased 4.6% primarily due to higher volumes from the acquired ACG business. • Operating profit in our Energy Equipment Group increased significantly due to higher unit volumes in wind towers and higher pricing levels in utility structures as well as the elimination of operating losses from, and the incurrence of an impairment charge related to, businesses divested in 2018. • Operating profit in our Transportation Products Group decreased 3.3% primarily due to reduced volumes and lower contractual pricing for steel components as well as start-up costs incurred toward the re-opening of a previously idled barge facility, partially offset by higher tank barge volumes. 2018 versus 2017 • Our operating profit decreased 27.9%. • Operating profit in the Construction Products Group decreased primarily due to lower volumes in our legacy construction aggregates businesses and increased costs related to the fair value markup of acquired inventory. • Operating profit in our Energy Equipment Group decreased as a result of a planned reduction in volumes in our wind towers product line and the impact of a $23.2 million impairment charge on businesses that were subsequently divested. • Operating profit in our Transportation Products Group increased due to increased volumes in our inland barge and steel components product lines. For a further discussion of revenues, costs, and the operating results of individual segments, see Segment Discussion below. Other Income and Expense Other, net (income) expense consists of the following items: Income Taxes The income tax provision for the years ended December 31, 2019, 2018, and 2017 was $33.5 million, $19.3 million, and $40.4 million, respectively. The effective tax rate for the years ended December 31, 2019, 2018, and 2017 was 22.8%, 20.3%, and 31.1%, respectively. The effective tax rates differ from the federal tax rates of 21.0%, 21.0%, and 35.0%, respectively, due to the impact of the Act, state income taxes, excess tax deficiencies (benefits) related to equity compensation, and the impact of foreign tax benefits. See Note 10 of the Notes to Consolidated and Combined Financial Statements for a further discussion of income taxes. Segment Discussion Construction Products Group 2019 versus 2018 • Revenues increased 50.4%, driven by the acquisition of ACG, which increased revenues by approximately 50%. In our legacy construction aggregates businesses, increased volumes were substantially offset by lower average selling prices, largely in our natural aggregates business in the Dallas-Fort Worth, Texas market area. • Cost of revenues increased 61.0%, primarily due to the acquired ACG business as well as increased volumes in our legacy construction aggregates businesses. • Selling, general, and administrative expenses increased 52.9% primarily due to additional costs from the acquired ACG business. • Operating profit increased primarily due to the acquired ACG business. Operating margin decreased reflecting the change in product mix as a result of the addition of the ACG business, which has lower margins than the legacy businesses, as well as lower average selling prices in the legacy natural aggregates business. • Depreciation, depletion, and amortization expense increased primarily due to the acquired ACG business. 2018 versus 2017 • Revenues and cost of revenues increased 12.9% and 19.0%, respectively, primarily due to revenues attributable to acquisitions completed in 2017 in both the lightweight aggregates and the trench shoring businesses and the December 2018 acquisition of ACG. • Selling, general, and administrative expenses increased 10.2% primarily due to the acquired businesses. • Operating profit and margin decreased primarily due to lower volumes in our legacy construction aggregates businesses and increased costs related to the fair value markup of acquired inventory. Energy Equipment Group 2019 versus 2018 • Revenues increased 7.2%, driven primarily by higher unit volumes in wind towers and higher pricing levels in utility structures. Revenues from other product lines, which include results primarily from our storage and distribution tanks, also increased due to higher volumes and pricing levels, partially offset by the elimination of revenues from businesses divested in 2018. • Cost of revenues increased 1.9%, due primarily to higher overall volumes. The increase was partially offset by the elimination of costs from divested businesses, as well as a $6.1 million finished goods inventory write-off recognized in 2018 related to an order for a single customer in our utility structures business. • Selling, general, and administrative expenses decreased 6.7% primarily due to the elimination of costs from divested businesses and a $2.9 million recovery of bad debt related to a single customer in our utility structures business. 2018 versus 2017 • Revenues decreased 7.6% primarily due to a planned reduction of volumes in our wind towers product line, partially offset by an increase in revenues from other product lines as a result of higher volumes in our storage tanks business. • Cost of revenues decreased 4.8% due to lower volumes in our wind tower product line, partially offset by a $6.1 million finished goods inventory write-off related to an order for a single customer in our utility structures business. • Decreases in revenues and cost of revenues were also partially offset by the required adoption of ASU 2014-09, which impacts the timing of revenue recognition in our wind towers and certain utility structures product lines. See Note 1 of the Notes to Consolidated and Combined Financial Statements for further discussion of the impact of this required change in accounting policy. • Selling, general, and administrative expenses decreased 5.4% primarily due to bad debt expense related to a single customer recognized in 2017. • Operating profit in 2018 was also negatively impacted by a $23.2 million impairment charge on businesses that were subsequently divested. Unsatisfied Performance Obligations (Backlog) As of December 31, 2019, the backlog for wind towers and utility structures was $596.8 million compared to $633.1 million as of December 31, 2018. Approximately 86% of our structural wind towers and utility structures backlog is expected to be delivered during the year ending December 31, 2020 with the remainder to be delivered in 2021. Future wind tower orders are subject to uncertainty as PTC eligibility for new wind farm projects is scheduled to expire at the end of 2020 and the level of credit phases out after 2024. Pricing of orders and individual order quantities reflect a market transitioning from PTC incentives. As of December 31, 2019, the backlog for our other business lines in our Energy Equipment Group was $36.2 million, all of which is expected to be delivered during the year ending December 31, 2020. Transportation Products Group 2019 versus 2018 • Revenues increased 19.0%, primarily driven by higher tank barge volumes but partially offset by lower contractual pricing and decreased volumes in steel components. Railcar component demand has declined as the North American industry outlook for new railcar builds has softened. The Company expects the decline to continue into 2020 unless the industry backlog for new railcars recovers. • Cost of revenues increased 23.8%, driven by higher tank barge volumes, partially offset by lower steel component volumes. Cost of revenues also increased $2.6 million due to start-up costs related to the re-opening of a previously idled barge manufacturing facility, which began delivering barges in the third quarter of 2019. • Selling, general, and administrative expenses were substantially unchanged. 2018 versus 2017 • Revenues and cost of revenues increased 7.7% and 6.4%, respectively, primarily from higher volumes in both the inland barge and steel components product lines. • Selling, general, and administrative expenses decreased 2.6%. Unsatisfied Performance Obligations (Backlog) As of December 31, 2019, the backlog for inland barges was $346.9 million compared to $230.5 million as of December 31, 2018. All of the backlog for inland barges is expected to be delivered during the year ending December 31, 2020. Corporate The increase in corporate overhead costs of 47.4% for the year ended December 31, 2019 compared to 2018 is primarily due to incremental standalone costs related to the replacement of services and fees previously provided or incurred by Trinity as well as other standalone public company costs. The 18.3% decrease in corporate overhead costs for the year ended December 31, 2018 compared to 2017 is primarily due to lower compensation related expenses. Corporate overhead costs prior to the Separation consist of costs not previously allocated to Trinity’s business units and have been allocated to Arcosa based on an analysis of each cost function and the relative benefits received by Arcosa for each of the periods using methods management believes are consistent and reasonable. See Note 1 of the Notes to Consolidated and Combined Financial Statements for further information. Liquidity and Capital Resources Arcosa’s primary liquidity requirement consists of funding our business operations, including capital expenditures, working capital investment, and disciplined acquisitions. Our primary sources of liquidity include cash flow from operations, our existing cash balance, availability under the revolving credit facility, and, as necessary, the issuance of additional long-term debt or equity. To the extent we have available liquidity, we may also consider undertaking new capital investment projects, executing additional strategic acquisitions, returning capital to stockholders, or funding other general corporate purposes. Revolving Credit Facility On November 1, 2018, the Company entered into a $400.0 million unsecured revolving credit facility that matures in November 2023. The interest rates under the facility are variable based on LIBOR or an alternate base rate plus a margin. A commitment fee accrues on the average daily unused portion of the revolving facility. The margin for borrowing and commitment fee rate are determined based on Arcosa’s leverage as measured by a consolidated total indebtedness to consolidated EBITDA ratio. The margin for borrowing ranges from 1.25% to 2.00% and was set at LIBOR plus 1.25% as of December 31, 2019. The commitment fee rate ranges from 0.20% to 0.35% and was set at 0.20% at December 31, 2019. Borrowings under the credit facility are guaranteed by certain wholly-owned subsidiaries of the Company. As of December 31, 2019, we had $100.0 million of outstanding loans borrowed under the facility and there were approximately $42.5 million in letters of credit issued, leaving $257.5 million available for borrowing. The Company's revolving credit facility requires the maintenance of certain ratios related to leverage and interest coverage. As of December 31, 2019, we were in compliance with all such financial covenants. On January 2, 2020, the Company entered into an Amended and Restated Credit Agreement to increase the revolving credit facility from $400.0 million to $500.0 million and add a term loan facility of $150.0 million, in each case with a maturity date of January 2, 2025. The leverage-based mechanism for determining and the applicable ranges for both the interest rate margin and commitment fee rate are unchanged. The interest rate on the revolving credit facility was initially set at one-month LIBOR plus 1.50% and the interest rate on the term loan facility was initially set at three-month LIBOR plus 1.50%. The commitment fee rate on both facilities was initially set at 0.25%. The entire term loan was advanced on January 2, 2020 in connection with the closing of the acquisition of Cherry, leaving $357.5 million available for borrowing under the facility. Cash Flows The following table summarizes our cash flows from operating, investing, and financing activities for each of the last three years: 2019 versus 2018 Operating Activities. Net cash provided by operating activities for the year ended December 31, 2019 was $358.8 million compared to $118.5 million for the year ended December 31, 2018. • The increase in cash flow provided by operating activities was primarily driven by increased earnings for the year ended December 31, 2019 and changes in current assets and liabilities. • The changes in current assets and liabilities resulted in a net source of cash of $132.6 million for the year ended December 31, 2019 compared to a net use of cash of $80.8 million for the year ended December 31, 2018. The increase was primarily driven by a reduction in receivables and increase in advance billings for our Energy Equipment and Transportation Products Groups. Investing Activities. Net cash required by investing activities for the year ended December 31, 2019 was $109.4 million compared to $364.5 million for the year ended December 31, 2018. • Capital expenditures for the year ended December 31, 2019 were $85.4 million compared to $44.8 million for the year ended December 31, 2018. • Proceeds from the sale of property, plant, and equipment and other assets totaled $8.9 million for the year ended December 31, 2019 compared to $10.2 million for the year ended December 31, 2018. • Cash paid for acquisitions, net of cash acquired, was $32.9 million for the year ended December 31, 2019 compared to $333.2 million for the year ended December 31, 2018. Financing Activities. Net cash required by financing activities for the year ended December 31, 2019 was $108.4 million compared to $338.6 million of net cash provided by financing activities for the same period in 2018. • During the year ended December 31, 2019, the Company had repayments of advances under the Company's revolving credit facility of $80 million. During the year ended December 31, 2018, the Company had borrowings under the revolving credit facility of $180 million. • Dividends paid during the year ended December 31, 2019 were $9.9 million. • The Company paid $11.0 million during the year ended December 31, 2019 to repurchase common stock under the current share repurchase program compared to $3.0 million repurchased during the year ended December 31, 2018. 2018 versus 2017 Operating Activities. Net cash provided by operating activities for the year ended December 31, 2018 was $118.5 million compared to $162.0 million for the year ended December 31, 2017. • The decrease in cash flow provided by operating activities was primarily driven by lower operating profit. • The changes in current assets and liabilities resulted in a net use of cash of $80.8 million for the year ended December 31, 2018 compared to a net use of cash of $0.5 million for the year ended December 31, 2017. The change was primarily driven by the increase in receivables. While most of this increase relates to the timing of payments from trade receivables, approximately 10% of the increase is due to the recognition of receivables from the Former Parent which had previously been deemed settled in the period incurred in the historical combined financial statements. Investing Activities. Net cash required by investing activities for the year ended December 31, 2018 was $364.5 million compared to $126.4 million for the year ended December 31, 2017. • Capital expenditures for the year ended December 31, 2018 were $44.8 million compared to $82.4 million for the year ended December 31, 2017. • Proceeds from the sale of property, plant, and equipment and other assets totaled $10.2 million for the year ended December 31, 2018 compared to $3.5 million for the year ended December 31, 2017. • Cash paid for acquisitions, net of cash acquired, was $333.2 million for the year ended December 31, 2018 compared to $47.5 million during for the year ended December 31, 2017. There was $3.3 million of divestiture activity for the year ended December 31, 2018. There was no divestiture activity for the year ended December 31, 2017. Financing Activities. Net cash provided by financing activities during the year ended December 31, 2018 was $338.6 million compared to $42.8 million of net cash required by financing activities for the same period in 2017. • During the year ended December 31, 2018, we borrowed $180.0 million and retired $0.3 million in debt. During the year ended December 31, 2017, we retired $0.1 million in debt as scheduled. • We received a capital contribution of $200.0 million from Trinity during the year ended December 31, 2018. • Net transfers to Trinity totaled $34.5 million for the year ended December 31, 2018 compared with $43.0 million for the year ended December 31, 2017. Other Investing and Financing Activities Repurchase Program In December 2018, the Company’s Board of Directors authorized a $50.0 million share repurchase program effective December 5, 2018 through December 31, 2020. For the year ended December 31, 2019, the Company repurchased 361,442 shares at a cost of $11.0 million. As of December 31, 2019, the Company had a remaining authorization of $36.0 million under the program. See Note 1 of the Notes to Consolidated and Combined Financial Statements. Off-Balance Sheet Arrangements As of December 31, 2019, we had letters of credit issued under our revolving credit facility in an aggregate principal amount of $42.5 million, all of which are expected to expire in 2020. The majority of our letters of credit obligations support the Company’s various insurance programs and warranty claims and generally renew by their terms each year. See Note 7 of the Notes to Consolidated and Combined Financial Statements. Derivative Instruments In December 2018, the Company entered into an interest rate swap instrument, effective as of January 2, 2019 and expiring in 2023, to reduce the effect of changes in the variable interest rates associated with borrowings under the revolving credit facility. The instrument carried an initial notional amount of $100 million, thereby hedging the first $100 million of borrowings under the credit facility. The instrument effectively fixes the LIBOR component of the credit facility borrowings at a monthly rate of 2.71%. As of December 31, 2019, the Company has recorded a liability of $4.3 million for the fair value of the instrument, all of which is recorded in accumulated other comprehensive loss. See Note 3 and Note 7 of the Notes to Consolidated and Combined Financial Statements. Stock-Based Compensation We have a stock-based compensation plan for our directors, officers, and employees. See Note 13 of the Notes to Consolidated and Combined Financial Statements. Employee Retirement Plans In 2019, we sponsored an employee savings plan under the 401(k) plan that covered substantially all employees and included both a company matching contribution and an annual retirement contribution of up to 3% each of eligible compensation based on our performance, as well as a Supplemental Profit Sharing Plan. Both the annual retirement contribution and the company matching contribution are discretionary, requiring board approval, and made annually with the investment of the funds directed by the participants. The Company also contributed to a multiemployer defined benefit pension plan under the terms of a collective-bargaining agreement that covered certain union-represented employees at one of our facilities. See Note 11 of the Notes to Consolidated and Combined Financial Statements. Contractual Obligations and Commercial Commitments As of December 31, 2019, we had the following contractual obligations and commercial commitments: As of December 31, 2019 and 2018, we had $0.0 million and $0.5 million, respectively, of tax liabilities, including interest and penalties, related to uncertain tax positions. Because of the high degree of uncertainty regarding the timing of future cash outflows associated with these liabilities, we are unable to estimate the years in which settlement will occur with the respective taxing authorities. See Note 15 of the Notes to Consolidated and Combined Financial Statements. Critical Accounting Policies and Estimates MD&A discusses our Consolidated and Combined Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the U.S. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, management evaluates its estimates and judgments, including those related to bad debts, inventories, property, plant, and equipment, goodwill, income taxes, warranty obligations, insurance, contingencies, and litigation. 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. We believe the following critical accounting policies, among others, affect our more significant judgments and estimates used in the preparation of our Consolidated and Combined Financial Statements. Revenue Recognition Revenue is measured based on the allocation of the transaction price in a contract to satisfied performance obligations. The transaction price does not include any amounts collected on behalf of third parties. The Company recognizes revenue when it satisfies a performance obligation by transferring control over a product or service to a customer. The following is a description of principal activities from which the Company generates its revenue, separated by reportable segments. Payments for our products and services are generally due within normal commercial terms. Construction Products Group The Construction Products Group recognizes revenue when the customer has accepted the product and legal title of the product has passed to the customer. Energy Equipment Group Within the Energy Equipment Group, revenue is recognized for our wind tower, certain utility structure, and certain storage tank product lines over time as the products are manufactured using an input approach based on the costs incurred relative to the total estimated costs of production. We recognize revenue over time for these products as they are highly customized to the needs of an individual customer resulting in no alternative use to the Company if not purchased by the customer after the contract is executed, and we have the right to bill the customer for our work performed to date plus at least a reasonable profit margin for work performed. For all other products, revenue is recognized when the customer has accepted the product and legal title of the product has passed to the customer. Transportation Products Group The Transportation Products Group recognizes revenue when the customer has accepted the product and legal title of the product has passed to the customer. Inventory Inventories are valued at the lower of cost or net realizable value. Our policy related to excess and obsolete inventory requires an analysis of inventory at the business unit level on a quarterly basis and the recording of any required adjustments. In assessing the ultimate realization of inventories, we are required to make judgments as to future demand requirements and compare that with the current or committed inventory levels. It is possible that changes in required inventory reserves may occur in the future due to then current market conditions. Long-lived Assets We periodically evaluate the carrying value of long-lived assets to be held and used for potential impairment. The carrying value of long-lived assets to be held and used is considered impaired only when the carrying value is not recoverable through undiscounted future cash flows and the fair value of the assets is less than their carrying value. Fair value is determined primarily using the anticipated cash flows discounted at a rate commensurate with the risks involved or market quotes as available. Impairment losses on long-lived assets held for sale are determined in a similar manner, except that fair values are reduced by the estimated cost to dispose of the assets. Goodwill Goodwill is required to be tested for impairment annually, or on an interim basis whenever events or circumstances change indicating that the carrying amount of the goodwill might be impaired. The quantitative goodwill impairment test is a two-step process with step one requiring the comparison of the reporting unit’s estimated fair value with the carrying amount of its net assets. If necessary, step two of the impairment test determines the amount of goodwill impairment to be recorded when the reporting unit’s recorded net assets exceed its fair value. Impairment is assessed at the “reporting unit” level by applying a fair value-based test for each unit with recorded goodwill. The estimates and judgments that most significantly affect the fair value calculations are assumptions, consisting of level three inputs, related to revenue and operating profit growth, discount rates, and exit multiples. Based on the Company's annual goodwill impairment test, performed at the reporting unit level as of December 31, 2019, the Company concluded that no impairment charges were determined to be necessary and that none of the reporting units evaluated were at risk of failing the first step of the goodwill impairment test. A reporting unit is considered to be at risk if its estimated fair value does not exceed the carrying value of its net assets by 10% or more. See Note 1 and Note 6 of the Notes to Consolidated and Combined Financial Statements. Given the uncertainties of the economy and its potential impact on our businesses, there can be no assurance that our estimates and assumptions regarding the fair value of our reporting units, made for the purposes of the long-lived asset and goodwill impairment tests, will prove to be accurate predictions of the future. If our assumptions regarding forecasted cash flows are not achieved, it is possible that impairments of goodwill and long-lived assets may be required. Warranties The Company provides various express, limited product warranties that generally range from one to five years depending on the product. The warranty costs are estimated using a two-step approach. First, an engineering estimate is made for the cost of all claims that have been asserted by customers. Second, based on historical, accepted claims experience, a cost is accrued for all products still within a warranty period for which no claims have been filed. The Company provides for the estimated cost of product warranties at the time revenue is recognized related to products covered by warranties and assesses the adequacy of the resulting reserves on a quarterly basis. Workers' Compensation We are effectively self-insured for workers’ compensation claims. A third-party administrator processes all such claims. We accrue our workers’ compensation liability based upon independent actuarial studies. To the extent actuarial assumptions change and claims experience rates differ from historical rates, our liability may change. Contingencies and Litigation The Company is involved in claims and lawsuits incidental to our business. Based on information currently available with respect to such claims and lawsuits, including information on claims and lawsuits as to which the Company is aware but for which the Company has not been served with legal process, it is management’s opinion that the ultimate outcome of all such claims and litigation, including settlements, in the aggregate will not have a material adverse effect on the Company’s financial condition for purposes of financial reporting. However, resolution of certain claims or lawsuits by settlement or otherwise, could impact the operating results of the reporting period in which such resolution occurs. Environmental We are involved in various proceedings related to environmental matters. We have provided reserves to cover probable and estimable liabilities with respect to such proceedings, taking into account currently available information and our contractual recourse. However, estimates of future response costs are inherently imprecise. Accordingly, there can be no assurance that we will not become involved in future environmental litigation or other proceedings or, if we were found to be responsible or liable in any litigation or proceeding, that such costs would not be material to us. Income Taxes Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amount of existing assets and liabilities and their respective tax bases and other tax attributes using currently enacted tax rates. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in the provision for income taxes in the period that includes the enactment date. Management is required to estimate the timing of the recognition of deferred tax assets and liabilities, make assumptions about the future deductibility of deferred tax assets, and assess deferred tax liabilities based on enacted law and tax rates for the appropriate tax jurisdictions to determine the amount of such deferred tax assets and liabilities. Changes in the calculated deferred tax assets and liabilities may occur in certain circumstances including statutory income tax rate changes, statutory tax law changes, or changes in the structure or tax status of the Company. The Company assesses whether a valuation allowance should be established against its deferred tax assets based on consideration of all available evidence, both positive and negative, using a more likely than not standard. This assessment considers, among other matters, the nature, frequency, and severity of recent losses; a forecast of future profitability; the duration of statutory carryback and carryforward periods; the Company’s experience with tax attributes expiring unused; and tax planning alternatives. At December 31, 2019, the Company had $22.0 million federal consolidated net operating loss carryforwards, primarily from businesses acquired, and $0.6 million of tax-effected state loss carryforwards remaining. In addition, the Company had $36.9 million of foreign net operating loss carryforwards that will begin to expire in the year 2022. We have established a valuation allowance for state and foreign tax operating losses and credits that we have estimated may not be realizable. At times, we may claim tax benefits that may be challenged by a tax authority. We recognize tax benefits only for tax positions more likely than not to be sustained upon examination by tax authorities. The amount recognized is measured as the largest amount of benefit that is greater than 50 percent likely to be realized upon settlement. A liability for “unrecognized tax benefits” is recorded for any tax benefits claimed in our tax returns that do not meet these recognition and measurement standards. The Act was enacted on December 22, 2017. The Act reduced the U.S. federal corporate income tax rate from 35% to 21%, required companies to pay a one-time transition tax on earnings of certain foreign subsidiaries that were previously tax deferred, and created new taxes on certain foreign-sourced earnings. For the year ended December 31, 2017, we recognized a provisional benefit of $6.2 million. During the year ended December 31, 2018, we finalized the accounting for the enactment of the Act and recorded an additional $1.5 million benefit, primarily as a result of the true-up of our deferred taxes. For periods prior to and including the Separation, income taxes as presented herein attribute current and deferred income taxes of the Company's standalone financial statements in a manner that is systematic, rational, and consistent with the asset and liability method prescribed by the Accounting Standards Codification Topic 740 - Income Taxes (“ASC 740”). Accordingly, Arcosa’s income tax provision has been prepared following the separate return method. The separate return method applies ASC 740 to the standalone financial statements of each member of the consolidated group as if the group member were a separate taxpayer and a standalone enterprise. As a result, actual tax transactions included in the consolidated financial statements of Trinity may not be included in the separate financial statements of Arcosa. Similarly, the tax treatment of certain items reflected in the separate financial statements of Arcosa may not be reflected in the consolidated financial statements and tax returns of Trinity; therefore, such items as net operating losses, credit carryforwards, and valuation allowances may exist in the standalone financial statements that may or may not exist in Trinity’s consolidated financial statements. Recent Accounting Pronouncements See Note 1 of the Notes to Consolidated and Combined Financial Statements for information about recent accounting pronouncements. Forward-Looking Statements This annual report on Form 10-K (or statements otherwise made by the Company or on the Company’s behalf from time to time in other reports, filings with the Securities and Exchange Commission (“SEC”), news releases, conferences, internet postings or otherwise) contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Any statements contained herein that are not historical facts are forward-looking statements and involve risks and uncertainties. These forward-looking statements include expectations, beliefs, plans, objectives, future financial performances, estimates, projections, goals, and forecasts. Arcosa uses the words “anticipates,” “assumes,” “believes,” “estimates,” “expects,” “intends,” “forecasts,” “may,” “will,” “should,” and similar expressions to identify these forward-looking statements. Potential factors, which could cause our actual results of operations to differ materially from those in the forward-looking statements include, among others: • market conditions and customer demand for our business products and services; • the cyclical nature of the industries in which we compete; • variations in weather in areas where our construction products are sold, used, or installed; • naturally-occurring events and other events and disasters causing disruption to our manufacturing, product deliveries, and production capacity, thereby giving rise to an increase in expenses, loss of revenue, and property losses; • competition and other competitive factors; • our ability to identify, consummate, or integrate acquisitions of new businesses or products, including the Cherry acquisition; • the timing of introduction of new products; • the timing and delivery of customer orders or a breach of customer contracts; • the credit worthiness of customers and their access to capital; • product price changes; • changes in mix of products sold; • the costs incurred to align manufacturing capacity with demand and the extent of its utilization; • the operating leverage and efficiencies that can be achieved by our manufacturing businesses; • availability and costs of steel, component parts, supplies, and other raw materials; • changing technologies; • surcharges and other fees added to fixed pricing agreements for steel, component parts, supplies and other raw materials; • interest rates and capital costs; • counter-party risks for financial instruments; • long-term funding of our operations; • taxes; • the stability of the governments and political and business conditions in certain foreign countries, particularly Mexico; • changes in import and export quotas and regulations; • business conditions in emerging economies; • costs and results of litigation; • changes in accounting standards or inaccurate estimates or assumptions in the application of accounting policies; • legal, regulatory, and environmental issues, including compliance of our products with mandated specifications, standards, or testing criteria and obligations to remove and replace our products following installation or to recall our products and install different products manufactured by us or our competitors; • actions by the executive and legislative branches of the U.S. government relative to federal government budgeting, taxation policies, government expenditures, U.S. borrowing/debt ceiling limits, and trade policies, including tariffs and border closures; • the inability to sufficiently protect our intellectual property rights; • if the Company does not realize some or all of the benefits expected to result from the Separation, or if such benefits are delayed; • the Company's ongoing businesses may be adversely affected and subject to certain risks and consequences as a result of the Separation; • if the distribution of shares of Arcosa resulting from the Separation, together with certain related transactions, does not qualify as a transaction that is generally tax-free for U.S. federal income tax purposes, the Company's stockholders at the time of the distribution and the Company could be subject to significant tax liability; and • if the Separation does not comply with state and federal fraudulent conveyance laws and legal dividend requirements. Any forward-looking statement speaks only as of the date on which such statement is made. Arcosa undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made. For a discussion of risks and uncertainties which could cause actual results to differ from those contained in the forward-looking statements, see Item 1A, "Risk Factors" included elsewhere herein.
0.138302
0.138618
0
<s>[INST] Separation from Trinity Basis of Historical Presentation Executive Overview Results of Operations Liquidity and Capital Resources Contractual Obligations and Commercial Commitments Critical Accounting Policies and Estimates Recent Accounting Pronouncements ForwardLooking Statements Our MD&A should be read in conjunction with our Consolidated and Combined Financial Statements and related Notes in Item 8, "Financial Statements and Supplementary Data," of this Annual Report on Form 10K. Separation from Trinity Arcosa, Inc. (“Arcosa,” the “Company,” “we,” or “our”) is a Delaware corporation and was incorporated in 2018 in connection with the separation of Arcosa from Trinity Industries, Inc. (“Trinity” or “Former Parent”) on November 1, 2018 as an independent, publiclytraded company, listed on the New York Stock Exchange (the “Separation”). At the time of the Separation, Arcosa consisted of certain of Trinity’s former construction products, energy equipment, and transportation products businesses. The Separation was effectuated through a pro rata dividend distribution on November 1, 2018 of all of the thenoutstanding shares of common stock of Arcosa to the holders of common stock of Trinity as of October 17, 2018, the record date for the distribution. Trinity stockholders received one share of Arcosa common stock for every three shares of Trinity common stock held as of the record date. The transaction was structured to be taxfree to both Trinity and Arcosa stockholders for U.S. federal income tax purposes. Basis of Historical Presentation The accompanying Consolidated and Combined Financial Statements present our historical financial position, results of operations, comprehensive income/loss, and cash flows in accordance with accounting principles generally accepted in the U.S. (“GAAP”). The combined financial statements for periods prior to the Separation were derived from Trinity’s consolidated financial statements and accounting records and prepared in accordance with GAAP for the preparation of carvedout combined financial statements. Through the date of the Separation, all revenues and costs as well as assets and liabilities directly associated with Arcosa have been included in the combined financial statements. Prior to the Separation, the combined financial statements also included allocations of certain selling, general, and administrative expenses provided by Trinity to Arcosa and allocations of related assets, liabilities, and the Former Parent’s net investment, as applicable. The allocations were determined on a reasonable basis; however, the amounts are not necessarily representative of the amounts that would have been reflected in the financial statements had the Company been an entity that operated independently of Trinity during the applicable periods. Related party allocations prior to the Separation, including the method for such allocation, are described further in Note 1, “Overview and Summary of Significant Accounting Policies” to the Consolidated and Combined Financial Statements. Following the Separation, the consolidated financial statements include the accounts of Arcosa and those of our whollyowned subsidiaries and no longer include any allocations from Trinity. Trinity continues to provide some general and administrative functions on a transitional basis for a fee following the Separation. Such functions were minimal as of December 31, 2019. Executive Overview Financial Operations and Highlights Revenues for the year ended December 31, 2019 grew 18.9% to $1.7 billion compared to the year ended December 31, 2018 primarily due to the impact of the ACG acquisition in our Construction Products Group, higher unit volumes and prices in our Energy Equipment Group, and higher tank barge volumes in our Transportation Products Group. Operating profit for year ended December 31, 2019 totaled $152.9 million, representing an increase of 61.1% compared to the year ended December 31, 2018 primarily driven by increased revenues in all segments, operating improvements in our Energy Equipment Group, and certain other charges recognized in the prior period including an impairment charge of $23.2 million related to divested businesses. S [/INST] Positive. </s>
2,020
7,475
1,736,946
Arlo Technologies, Inc.
2019-02-22
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 together with the audited consolidated financial statements and notes to the financial statements included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. The forward-looking statements are not historical facts, but rather are based on current expectations, estimates, assumptions and projections about our industry, business and future financial results. Our actual results could differ materially from the results contemplated by these forward-looking statements due to a number of factors, including those discussed under “Risk Factors” in Part I, Item 1A above. Business and Executive Overview Arlo combines an intelligent cloud infrastructure and mobile app with a variety of smart connected devices that transform the way people experience the connected lifestyle. Our cloud-based platform creates a seamless, end-to-end connected lifestyle solution that provides customers with visibility, insight, and a powerful means to help them protect and connect with the people and things that matter most to them. Arlo enables users to monitor their environments and engage in real-time with their families and businesses from any location with a Wi-Fi or a cellular network internet connection. Since the launch of our first product in December 2014, we have shipped over 11.7 million smart connected devices, and, as of December 31, 2018, our smart platform had approximately 2.85 million cumulative registered users across more than 100 countries around the world. On February 6, 2018, NETGEAR announced that its board of directors had unanimously approved the pursuit of a separation of its Arlo business from NETGEAR (the “Separation”) to be effected through an initial public offering (the “IPO”) of newly issued shares of the common stock of Arlo Technologies, Inc., a wholly owned subsidiary of NETGEAR. On August 2, 2018, NETGEAR and Arlo announced the pricing of the IPO of 10,215,000 shares of Arlo’s common stock at a price to the public of $16.00 per share. On August 3, 2018, Arlo’s shares began trading on the New York Stock Exchange under the ticker symbol “ARLO.” On August 7, 2018, we completed the IPO of 11,747,250 shares of common stock (including 1,532,250 shares of common stock pursuant to the underwriters’ option to purchase additional shares, which was exercised in full on August 3, 2018), at $16.00 per share, before underwriting discounts and commissions and estimated offering costs and NETGEAR owned approximately 84.2% of the shares of Arlo’s outstanding common stock. On November 29, 2018, NETGEAR announced that its board of directors had approved a special stock dividend (the “Distribution”) to NETGEAR stockholders of the 62,500,000 shares of Arlo common stock owned by NETGEAR, representing approximately 84.2% of the outstanding shares of Arlo common stock. The Distribution was made on December 31, 2018 (the “Distribution Date”) to all NETGEAR stockholders of record as of the close of business on December 17, 2018 (the “Record Date”). In the Distribution, each NETGEAR stockholder of record on the Record Date received 1.980295 shares of Arlo common stock for every share of NETGEAR common stock held on the Record Date, subject to cash in lieu of fractional shares. The Distribution was intended to qualify as generally tax free to NETGEAR stockholders for U.S. federal income tax purposes. We conduct business across three geographic regions-the Americas; Europe, Middle-East and Africa (“EMEA”); and Asia Pacific (“APAC”) and we primarily generate revenue by selling devices through retail, wholesale distribution and wireless carrier channels and paid subscription services through in-app purchases. International revenue was 22.6%, 24.6% and 23.0% of our revenue for the years ended December 31, 2018, 2017 and 2016, respectively. We plan to replicate our success in the U.S. market elsewhere as we strategically expand into the global market. For the years ended December 31, 2018, 2017 and 2016, we generated revenue of $464.9 million, $370.7 million and $184.6 million, respectively, representing year-over-year growth of 25.4% and 100.8%, respectively. Loss from operations was $74.8 million for the year ended December 31, 2018 compared with Income from operations of $5.7 million for the year ended December 31, 2017 and Loss from operations of $13.1 million for the year ended December 31, 2016. Loss from operations for the year ended December 31, 2018 included separation expense of $27.3 million. Our goal is to continue to develop innovative, world-class connected lifestyle solutions to expand and further monetize our current and future user and subscriber bases. We believe that the growth of our business is dependent on many factors, including our ability to innovate and grow our installed base, to increase subscription-based recurring revenue, to invest in brand awareness and channel partnerships and to continue our global expansion. We expect to increase our investment in research and development as we continue to introduce new and innovative products and services to enhance the Arlo platform. Key Business Metrics In addition to the measures presented in our consolidated financial statements, we use the following key metrics to evaluate our business, measure our performance, develop financial forecasts and make strategic decisions. Our key business metrics may be calculated in a manner different from similar key business metrics used by other companies. Cumulative Registered Users. We believe that our ability to increase our user base is an indicator of our market penetration and growth of our business as we continue to expand and innovate our Arlo platform. We define our registered users at the end of a particular period as the number of unique registered accounts on the Arlo app as of the end of such particular period. The number of registered users does not necessarily reflect the number of end-users on the Arlo platform, as one registered account may be used by multiple people. Paid Subscribers. Paid subscribers worldwide measured as subscribers to any paid service subscription plan, excluding prepaid service subscribers. Devices Shipped. Devices shipped represents the number of Arlo cameras, lights, and doorbells that are shipped to our customers during a period. Devices shipped does not include shipments of Arlo accessories and Arlo base stations, nor does it take into account returns of Arlo cameras, lights, and doorbells. The growth rate of our revenue is not necessarily correlated with our growth rate of devices shipped, as our revenue is affected by a number of other variables, including but not limited to returns from customers, end-user customer rebates and other channel sales incentives deemed to be a reduction of revenue per the authoritative guidance for revenue recognition, sales of accessories, and premium services, the types of Arlo products sold during the relevant period and the introduction of new product offerings that have different U.S. manufacturer’s suggested retail prices (“MSRPs”). Service Revenue. Service revenue represents revenue recognized relating to prepaid services and paid service subscriptions. Our prepaid services pertain to devices which are sold with our Arlo prepaid services offering, providing users with the ability to store and access data for up to five cameras for a rolling seven-day period. Our paid subscription services relate to sales of subscription plans to our registered users. Comparability of Historical Results The operating results of Arlo have historically been disclosed as a reportable segment within the consolidated financial statements of NETGEAR, enabling the identification of directly attributable transactional information, functional departments, and headcount. Through July 1, 2018, Revenue and Cost of revenue, with the exception of channel sales incentives, were derived from transactional information specific to Arlo products and services. Directly attributable operating expenses were derived from activities relating to Arlo functional departments and headcount. Arlo employees also historically participated in NETGEAR’s stock-based incentive plans, in the form of restricted stock units (“RSUs”), stock options, and purchase rights issued pursuant to NETGEAR’s employee stock purchase plan. Stock-based compensation expense has been either directly reported by or allocated to Arlo based on the awards and terms previously granted to NETGEAR’s employees. The combined statements of operations of the Company as presented reflect the directly attributable transactional information specific to Arlo and certain additional allocated costs through July 1, 2018. The allocated costs for corporate functions included, but were not limited to, allocations of general corporate expenses from NETGEAR including expenses related to corporate services, such as executive management, information technology, legal, finance and accounting, human resources, tax, treasury, research and development, sales and marketing, shared facilities and other shared services. These costs were allocated based on revenue, headcount, or other measures the Company has determined as reasonable. Following July 1, 2018, the consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. The amount of these allocations from NETGEAR reflected within operating expenses in the consolidated statements of operations was $30.6 million from January 1, 2018 to the date of the completion of the IPO, which included $9.4 million for research and development, $10.0 million for sales and marketing, and $11.2 million for general and administrative expense. For the year ended December 31, 2017, allocations amounted to $40.0 million, which included $11.8 million for research and development, $13.1 million for sales and marketing and $15.1 million for general and administrative expense. For the year ended December 31, 2016, allocations amounted to $20.6 million, which included $5.9 million for research and development, $6.4 million for sales and marketing and $8.3 million for general and administrative expense. The management of Arlo believes the assumptions underlying the consolidated financial statements, including the assumptions regarding the allocated expenses, reasonably reflect the utilization of services provided, or the benefit received by Arlo during the periods presented. Nevertheless, the consolidated financial statements may not be indicative of Arlo’s future performance and do not necessarily reflect Arlo’s results of operations, financial position, and cash flows had Arlo been a standalone company during the periods presented. Our Relationship with NETGEAR NETGEAR has agreed to continue to provide certain of the services described above on a transitional basis following the Distribution pursuant to the transition services agreement. We generally expect to use the vast majority of these services for less than a year following the completion of the IPO, depending on the type of the service and the location at which such service is provided. However, we may agree with NETGEAR to extend the service periods for a limited amount of time (which period will not extend past the first anniversary of the Distribution) or may terminate such service periods by providing prior written notice. Pursuant to the transition services agreement, NETGEAR will charge a fee that is consistent with our historical allocation for such services. During the year ended December 31, 2018, we incurred $6.3 million in transition services agreement-related costs, which included $0.4 million for research and development, $1.6 million for sales and marketing, and $4.3 million for general and administrative expense. As we reduce our reliance on these services and build such functions as executive management, information technology, legal, finance and accounting, human resources, tax, treasury, research and development, sales and marketing, shared facilities, and other services, the actual expenses we will incur in the future may differ from the costs that were historically allocated to us by NETGEAR. In addition, to operate as a standalone company, we incurred costs to replace certain services that were previously provided by NETGEAR, which were higher than those reflected in our historical combined financial statements. The most significant component of these costs was IT-related costs, including capital expenditures, to implement certain new systems, including infrastructure and an enterprise resource planning system. As of December 31, 2018, we have fully completed the implementation of these new systems. We are subject to the reporting requirements of the Exchange Act, and we are required to establish procedures and practices as a standalone public company in order to comply with our obligations under the Exchange Act and related rules and regulations, as well as rules of the New York Stock Exchange. As a result, we will continue to incur additional costs, including internal audit, investor relations, stock administration, and regulatory compliance costs. These additional costs may differ from the costs that were historically allocated to us by NETGEAR. Components of Our Operating Results Revenue Our gross revenue consists primarily of sales of devices, and to a much lesser extent, prepaid and paid subscription service revenue. We generally recognize revenue from product sales at the time the product is shipped. Our prepaid services primarily pertain to devices which are sold with our Arlo prepaid services offering, providing users with the ability to store and access data for up to five cameras for a rolling seven-day period. Upon device shipment, we attribute a portion of the sales price to the prepaid service, deferring this revenue at the outset and subsequently recognizing it ratably over the estimated useful life of the device. Our paid subscription services relate to sales of subscription plans to our registered users. Our revenue consists of gross revenue, less end-user customer rebates and other channel sales incentives deemed to be a reduction of revenue per the authoritative guidance for revenue recognition, allowances for estimated sales returns, price protection, and net changes in deferred revenue. A significant portion of our marketing expenditure is with customers and is deemed to be a reduction of revenue under authoritative guidance for revenue recognition. Our revenue can vary based on a number of factors, including changes in average selling prices, end-user customer rebates and other channel sales incentives, uncertainties surrounding demand for our products and allowances for estimated sales returns, including future pricing and/or potential discounts as a result of competition or in response to fluctuations of the U.S. dollar in our international markets, and related production level variances; changes in technology; and market adoption of our current and future paid subscription service offerings. We continue to experience user demand across all regions for our Arlo products. We believe this demand will lead to an increase in absolute dollars in prepaid and paid subscription service revenues as our number of registered users continues to grow. Furthermore, we expect that as we introduce more features in our subscription services, the rate of adoption of our paid subscription services will increase, which we expect to increase revenue. While we expect prepaid and paid subscription service revenue to grow, we anticipate revenue from device sales will continue to generate the majority of our revenue for the foreseeable future. Cost of Revenue Cost of revenue consists of both product costs and costs of service. Product costs primarily consist of: the cost of finished products from our third-party manufacturers; overhead costs, including purchasing, product planning, inventory control, warehousing and distribution logistics, third-party software licensing fees, inbound freight, warranty costs associated with returned goods, write-downs for excess and obsolete inventory, royalties to third parties; and amortization expense of certain acquired intangibles. Cost of service consists of costs attributable to the provision and maintenance of our cloud-based platform, including personnel, storage, security, and computing. Our cost of revenue as a percentage of revenue can vary based upon a number of factors, including those that may affect our revenue set forth above and factors that may affect our cost of revenue, including, without limitation: product mix, sales channel mix, registered user acceptance of paid subscription service offerings, fluctuation in foreign exchange rates and changes in our cost of goods sold due to fluctuations in prices paid for components, net of vendor rebates, cloud platform costs, warranty and overhead costs, inbound freight and duty product conversion costs, charges for excess or obsolete inventory, and amortization of acquired intangibles. We outsource our manufacturing, warehousing, and distribution logistics. We also outsource certain components of the required infrastructure to support our cloud-based back-end IT infrastructure. We believe this outsourcing strategy allows us to better manage our product and services costs and gross margin. We expect that revenue derived from paid subscription service plans will increase as a percentage of our revenue in the future, which may have a positive impact on our gross margin. From time to time, however, we may experience fluctuations in our gross margin as a result of the factors discussed above. Research and Development Research and development expense consists primarily of personnel-related expense, safety, security, regulatory testing, other consulting fees, and IT and facility overhead. We recognize research and development expense as it is incurred. We have invested in and expanded our research and development organization to enhance our ability to introduce innovative products and services. We believe that innovation and technological leadership are critical to our future success, and we are committed to continuing a significant level of research and development to develop new technologies, products, and services, including our hardware devices, cloud-based software, AI-based algorithms, and machine learning capabilities. We expect research and development expense to grow in absolute dollars as we continue to develop new product and service offerings to support the connected lifestyle market. We expect research and development expense to fluctuate depending on the timing and number of development activities in any given period, and such expense could vary significantly as a percentage of revenue, depending on actual revenue achieved in any given period. Sales and Marketing Sales and marketing expense consists primarily of personnel expense for sales and marketing staff; technical support expense; advertising; trade shows; corporate communications and other marketing expense; product marketing expense; IT and facilities overhead; outbound freight costs; and amortization of certain intangibles. We expect our sales and marketing expense to increase in absolute dollars for the foreseeable future as we continue to invest in brand marketing to strengthen our competitive position, to accelerate growth and to raise brand awareness. General and Administrative General and administrative expense consists primarily of personnel-related expense for certain executives, finance and accounting, investor relations, human resources, legal, information technology, professional fees, IT and facility overhead, and other general corporate expense. We expect our general and administrative expense to increase in absolute dollars, primarily as a result of the increased costs associated with being a standalone public company. However, we also expect our general and administrative expense to fluctuate as a percentage of our revenue in future periods based on fluctuations in our revenue and the timing of such expense. Separation Expense Separation expense consists primarily of costs associated with our separation from NETGEAR, including third-party advisory, consulting, legal and professional services, IT-related expenses directly related to our separation from NETGEAR, and other items that are incremental and one-time in nature. To operate as a standalone company, we have incurred separation costs of $27.3 million during the year ended December 31, 2018 to replicate certain services previously provided by NETGEAR. We expect a significant reduction in our separation expense in the fiscal year ending December 31, 2019 as we completed our Separation from NETGEAR on December 31, 2018. Interest Income Interest income represents interest earned on our cash, cash equivalents and short-term investments. Other Income (Expense), Net Other income (expense), net primarily represents gains and losses on transactions denominated in foreign currencies, foreign currency contract gain (loss), net, and other miscellaneous income and expense. Income Taxes Our business has historically been included in NETGEAR’s consolidated U.S. federal income tax return. We have adopted the separate return approach for the purpose of the Arlo financial statements. The income tax provisions and related deferred tax assets and liabilities that have been reflected in our historical consolidated financial statements have been estimated as if we were a separate taxpayer. The historical operations of the Arlo business reflect a separate return approach for each jurisdiction in which Arlo had presence and NETGEAR filed a tax return. We record a provision for income taxes for the anticipated tax consequences of the reported results of operations using the asset and liability method. Under this method, we recognize deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial reporting and tax basis of assets and liabilities, as well as for operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using the tax rates that are expected to apply to taxable income for the years in which those tax assets and liabilities are expected to be realized or settled. We record a valuation allowance to reduce our deferred tax assets to the net amount that we believe is more likely than not to be realized. As a result of the separation of the Arlo business from NETGEAR’s other businesses, there were changes to the organizational structure of the business, which did not impact our historical financial statements. As a result of the spin-off of Arlo from NETGEAR on December 31, 2018, all net operating losses, with the exception of acquired net operating losses, and tax credit carryforwards determined under the separate return approach that were utilized by NETGEAR or will be retained by NETGEAR were eliminated on December 31, 2018, with an offsetting reduction to our valuation allowance. We recognize tax benefits from uncertain tax positions only if we believe that it is more likely than not that the tax position will be sustained on examination by the taxing authorities based on the technical merits of the position. As we expand internationally, we will face increased complexity in determining the appropriate tax jurisdictions for revenue and expense items which may differ from that of NETGEAR. Our policy is to adjust these reserves when facts and circumstances change, such as the closing of a tax audit or refinement of an estimate. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will affect the provision for income taxes in the period in which such determination is made and could have a material impact on our financial condition and operating results. The provision for income taxes includes the effects of any accruals that we believe are appropriate, as well as the related net interest and penalties. As a result of the spin-off of Arlo from NETGEAR on December 31, 2018, all uncertain tax positions that remain the responsibility of NETGEAR as a result of the Tax Sharing Agreement have been eliminated from our December 31, 2018 balance sheet, with a corresponding increase to equity. On December 22, 2017, the Tax Cuts and Jobs Act of 2017 (the “Tax Act”) was signed into law, making significant changes to the Internal Revenue Code of 1986, as amended (the “Code”). Changes include, but are not limited to, a U.S. federal corporate income tax rate decrease from 35% to 21%, effective for tax years beginning after December 31, 2017, the transition of U.S. international taxation from a worldwide tax system to a territorial system and a one-time transition tax on the mandatory deemed repatriation of cumulative foreign earnings. The Tax Act significantly changed how the United States taxes corporations. In addition to the impact of the Tax Act on our federal taxes, the Tax Act may impact our taxation in other jurisdictions, including with respect to state income taxes. In addition, in 2017 we accrued $0.1 million of state income tax expense related to the deemed repatriation resulting from the transition tax. Foreign governing bodies may enact changes to their tax laws in reaction to the Tax Act that could result in changes to our global tax position and materially adversely affect our business, results of operations and financial condition. Results of Operations We operate as one operating and reportable segment. The following table sets forth, for the periods presented, the consolidated statements of operations data, which we derived from the accompanying consolidated financial statements: Revenue by Geographic Region We conduct business across three geographic regions: Americas, EMEA, and APAC. We generally base revenue by geography on the ship-to location of the customer for device sales and device location for service sales. Revenue increased 25.4% across all geographic regions for the year ended December 31, 2018 compared to the prior year. The increase was primarily driven by continued rollout of our Arlo Pro 2 camera, which launched in the fourth quarter of fiscal 2017. Additionally, service revenue increased by $8.7 million, or 30.0%, for the year ended December 31, 2018 compared to the prior year. We experienced a slowdown in end user demand for our cameras in the fourth quarter of 2018 and we anticipate a further slowdown in our revenue growth for the fiscal year ending December 31, 2019 resulting from a slowdown in market demand for connected cameras, increased competition and delays to certain new product introductions. We also anticipate our marketing expenditures that are deemed to be a reduction of revenue will increase in the fiscal year ending December 31, 2019 as we provide discounts on our earlier generation products to stimulate sales of these products. Revenue increased 100.8% for the year ended December 31, 2017 compared to the prior year. The expansion of our sales channels, the rapid expansion of the consumer network connected camera systems market, the continued sales of our Arlo Pro camera launched in the third quarter of 2016 and the launch of our Arlo Pro 2 camera in the fourth quarter of fiscal 2017 contributed significantly to the revenue increase. Additionally, revenue further benefited from an increase in paid subscription service revenue due to the increase in the number of our registered users. Cost of Revenue and Gross Margin The following table presents cost of revenue and gross margin for the periods indicated: Cost of revenue increased for the year ended December 31, 2018, due primarily to revenue growth compared to the prior year. Gross margin decreased for the year ended December 31, 2018 compared to the prior year due primarily to higher channel marketing promotion activities deemed to be a reduction of revenue and due to an increase of $10.2 million in inventory reserves for excess and obsolete products as well as excess materials from our original design manufacturers (“ODMs”). The decrease was partially offset by higher revenue and product margin, mainly from the continued rollout of our Arlo Pro 2 camera. During the fourth quarter of 2018, we experienced a decline in our gross margin mainly from increased marketing expenditures that are deemed to be a reduction in revenue and we expect our gross profit in the fiscal year ending December 31, 2019 to be lower due to lower product revenue, increased competition, delays to certain new product introductions and increased marketing expenditures that are deemed to be a reduction in revenue. Cost of revenue increased for the year ended December 31, 2017, due primarily to revenue growth compared to the prior year. Gross margin increased for the year ended December 31, 2017 compared to the prior year. The improvement in gross margin was achieved by effective product cost reduction and growth in paid subscription service revenue compared to the prior year. Operating Expenses The full year of 2017 and 2016, as well as first and second quarter of 2018, are based on carve-out financials and reflect the transactions which are directly attributable to Arlo and certain allocated costs, whereas third quarter and fourth quarter of 2018 are based on standalone financials which represent our actual results for the period as a standalone public company. For the fiscal year ending December 31, 2019, our operating expenses, which will reflect a full year as a standalone public company, are expected to increase compared to historical periods. Research and Development The following table presents research and development expense for the periods indicated: Research and development expense increased for the year ended December 31, 2018 compared to the prior year due to increases of $11.6 million in personnel-related expenses, $9.2 million in corporate IT and facility overhead, $2.5 million in engineering projects and outside professional services, and $0.4 million in transition services agreement-related expense. The increased expenditures on personnel-related expense, engineering projects and outside professional services were due to continuous investment in strategic focus areas, principally the expansion of our Arlo product and service offerings and the growth of our cloud platform capabilities. We expect our research and development expense will increase as we continue to invest in and expand our Arlo product and service offerings. Research and development expense increased for the year ended December 31, 2017 compared to the prior year due to increases of $5.2 million in allocated personnel-related expense, $3.5 million in corporate IT and facility overhead and $1.6 million in engineering projects and outside professional services. The increased expenditures on personnel-related expense, engineering projects and outside professional services were due to continuous investment in strategic focus areas, such as expanding our Arlo product offerings and services and growing our cloud platform capabilities. Sales and Marketing The following table presents sales and marketing expense for the periods indicated: Sales and marketing expense increased for the year ended December 31, 2018 compared to the prior year, primarily due to an increase in personnel-related expenses of $7.7 million, digital advertising, media and other costs of $7.1 million, IT and facility overhead of $2.3 million, transition services agreement-related expense of $1.6 million, and sales freight out expenses of $0.7 million. The increase was partially offset by a decrease in marketing expenditures of $1.1 million further to the launch of our Arlo Pro 2 camera in fiscal 2017. For the fiscal year ending December 31, 2019, our sales and marketing expense, which will reflect a full year as a standalone public company, is expected to increase compared to historical periods. Sales and marketing expense increased for the year ended December 31, 2017 compared to the prior year, primarily due to an increase in personnel-related expenditures of $6.8 million, marketing expenditures of $5.4 million, outside professional services of $1.3 million, IT and facility overhead of $1.3 million and sales freight out expense of $1.0 million. The increase in allocated personnel and marketing expenditures resulted from the revenue increase described above. The majority of the costs incurred represented allocations from NETGEAR. General and Administrative The following table presents general and administrative expense for the periods indicated: General and administrative expense increased for the year ended December 31, 2018 compared to the prior year, primarily due to higher personnel-related expenditures of $7.0 million, transition services agreement-related expense of $4.3 million, and higher legal and professional services of $1.8 million. Following the completion of the IPO, NETGEAR has agreed to continue to provide certain of the services on a transitional basis pursuant to the transition services agreement. Refer to Overview for further detail about the transition services agreement. For the fiscal year ending December 31, 2019, our general and administrative expense, which will reflect a full year as a standalone public company, is expected to increase compared to historical periods. General and administrative expense increased for the year ended December 31, 2017 compared to the prior year, primarily due to higher allocated personnel-related expenditures of $3.5 million, legal and professional services of $1.7 million, and IT and facility overhead of $1.3 million. Separation Expense The following table presents separation expense for the periods indicated: **Percentage change not meaningful. Separation expense consists primarily of charges for third-party advisory, consulting, legal and professional services, IT-related expenses, and other items that are incremental and one-time in nature related to our separation from NETGEAR. We had no separation expense in fiscal year 2016. We expect a significant reduction in our separation expense in the fiscal year ending December 31, 2019 as we completed our Separation from NETGEAR on December 31, 2018. Interest Income and Other Income (Expense), Net The following table presents other income (expense), net for the periods indicated: **Percentage change not meaningful. During the year ended December 31, 2018, we earned interest income of $1.2 million from our cash proceeds from the IPO and from our cash equivalents and short-term investments. Other income (expense), net decreased for the year ended December 31, 2018 compared to the prior year, due primarily to higher foreign currency transaction losses, mainly as a result of the U.S. dollar strengthening versus transaction currencies. We entered into a foreign currency hedging program during the third quarter of fiscal 2018, which effectively reduced volatility associated with hedged currency exchange rate movements. For a detailed discussion of our hedging program and related foreign currency contracts, refer to Note 7, Derivative Financial Instruments, in Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K. Other income (expense), net increased for the year ended December 31, 2017 compared to the prior year, due primarily to higher foreign currency transaction gains, primarily as a result of the U.S. dollar weakening versus transaction currencies. Provision for Income Taxes **Percentage change not meaningful. The decrease in tax expense for the year ended December 31, 2018 compared to the prior year was primarily caused by the deemed repatriation of foreign earnings in 2017 following the 2017 U.S. Tax Act. The negative 1.0% effective tax rate is a result of losses in the U.S. for which the Company is not recognizing a tax benefit due to its full U.S. federal and state valuation allowance. The increase in tax expense for the year ended December 31, 2017 compared to the prior year primarily resulted from improved earnings in foreign jurisdictions. Additionally, on December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Act. The Tax Act resulted in an increase in U.S. federal and state income tax expense, of which the U.S. federal tax was offset by the utilization of net operating losses and foreign tax credits that were previously subject to a valuation allowance. Liquidity and Capital Resources Arlo was historically funded as part of NETGEAR’s treasury program. Cash and cash equivalents were primarily centrally managed through bank accounts legally owned by NETGEAR. Accordingly, prior to the completion of the IPO, cash and cash equivalents held by NETGEAR at the corporate level were not attributable to Arlo. Cash flows related to financing activities primarily reflect changes in Net parent investment. Only cash amounts legally owned by entities dedicated to the Arlo business are reflected in the consolidated balance sheets. Prior to the IPO, transfers of cash, both to and from NETGEAR’s treasury program, are reflected as a component of Net parent investment in financing activities of the consolidated statements of cash flows. Following the completion of the IPO, our capital structure and sources of liquidity changed significantly from our historical capital structure as we became a standalone public company. We are no longer participating in cash management and funding arrangements managed by NETGEAR. Arlo maintained a separate cash management and financing function for our operations. Our primary sources of liquidity are our expected cash flows to be generated from operations, together with approximately $70.0 million in cash contributed by NETGEAR prior to the completion of the IPO, and the net proceeds of $173.4 million raised from our IPO, net of the portion of the offering cost paid by Arlo, which portion was $1.4 million. Our total offering cost is $4.6 million, of which $3.2 million was paid by NETGEAR. Our principal sources of liquidity are cash, cash equivalents and short-term investments. Short-term investments are marketable government securities with an original maturity or a remaining maturity at the time of purchase of greater than three months and no more than 12 months. The marketable securities are held in our company’s name with a high quality financial institution, which acts as our custodian and investment manager. As of December 31, 2018, we had cash, cash equivalents and short-term investments totaling $201.0 million. As of December 31, 2018, 22.5% of our cash and cash equivalents were held outside of the U.S. Starting in 2018 as a result of the Tax Act due to the one-time transition tax on un-repatriated earnings, the tax impact is generally immaterial should we repatriate our cash from foreign earnings. The cash and cash equivalents balance outside of the U.S. is subject to fluctuation based on the settlement of intercompany balances. Based on our current plans and market conditions, we believe that such sources of liquidity will be sufficient to satisfy our anticipated cash requirements for at least the next 12 months. However, we may require or desire additional funds to support unanticipated growth in our business, our operating expenses and capital requirements or for other purposes, such as acquisitions, and may seek to raise such additional funds through public or private equity or debt financing or from other sources. To preserve the tax-free treatment of our separation from NETGEAR, we have agreed in the tax matters agreement with NETGEAR to certain restrictions on our business, which generally will be effective during the two-year period following the Distribution that could limit our ability to pursue certain transactions including equity issuances. We cannot assure you that additional financing will be available at all or, if available, that such financing would be obtainable on terms favorable to us and would not be dilutive. Our future liquidity and cash requirements will depend on numerous factors, including the introduction of new products and potential acquisitions of related businesses or technology. Cash Flow The following table presents our cash flows for the periods presented. Operating activities Net cash used in operating activities decreased by $21.3 million for the year ended December 31, 2018 compared to the prior year, due primarily to the favorable net working capital changes offset by the net loss incurred. Changes in operating activities also reflected the movements of the balances for Statements of Cash Flows purposes since the balances contributed by NETGEAR on or before the initial public offering reflects the contributed balances to us as per the master separation agreement between Arlo and NETGEAR and related documents governing the Contribution. Our days sales outstanding (“DSO”) increased to 125 days as of December 31, 2018 as compared to 115 days as of December 31, 2017. New to our DSO calculation is the unfavorable impact of the adoption of ASU 2014-09, “Revenue from Contracts with Customers,” as of January 1, 2018. We calculated a 13-day increase in our December 31, 2018 DSO under the new revenue standard compared to the old revenue standard, mainly as a result of changes in the balance sheet presentation of certain reserve balances previously shown net within accounts receivable, which are now presented as liabilities. Refer to Note 3, Revenue Recognition, in Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K for the details on adoption impacts. Inventory increased from $83.0 million as of December 31, 2017 to $124.8 million as of December 31, 2018. Ending inventory turns were 3.8 in the three months ended December 31, 2018 down from 4.6 turns in the three months ended December 31, 2017. Our accounts payable increased from $20.7 million as of December 31, 2017 to $82.5 million as of December 31, 2018, primarily as a result of timing of payments. Investing activities Net cash used in investing activities increased by $67.0 million for the year ended December 31, 2018 compared to the prior year, primarily due to the purchase of short-term investments of $54.6 million and the increased capital expenditures as we implement certain new systems, including infrastructure and an enterprise resource planning system. In the year ended December 31, 2017, we made a $0.7 million payment in connection with our Placemeter acquisition. Financing activities Net cash provided by financing activities was $244.3 million in the year ended December 31, 2018 compared to $43.2 million in the prior year. Cash proceeds from the IPO were $173.4 million, net of the $1.4 million portion of the offering cost paid by Arlo. The total offering cost was $4.6 million, of which $3.2 million was paid by NETGEAR. Net cash provided by financing activities also included a net investment from NETGEAR, of approximately $70.0 million. Backlog Our backlog consists of products for which customer purchase orders have been received and that are scheduled or in the process of being scheduled for shipment. As of December 31, 2018, we had a backlog of $18.9 million, compared to $15.6 million as of December 31, 2017 and $14.2 million as of December 31, 2016. As we typically fulfill orders received within a relatively short period (e.g., within one week for our top three customers) after receipt, our revenue in any fiscal year depends primarily upon orders booked and the availability of supply of our products in that year. In addition, most of our backlog is subject to rescheduling or cancellation with minimal penalties. As a result, our backlog as of any particular date may not be an indicator of revenue for any succeeding period. Similarly, there is a lack of meaningful correlation between year-over-year changes in backlog as compared with year-over-year changes in revenue. Accordingly, we do not believe that backlog information is material to an understanding of our overall business, and backlog as of any particular date should not be considered a reliable indicator of our ability to achieve any particular level of revenue or financial performance. Contractual Obligations The following table summarizes our non-cancelable operating lease commitments, letter of credit, and purchase obligations as of December 31, 2018: Operating leases We entered into several office lease agreements under non-cancelable operating leases with various expiration dates through October 2028. The terms of certain of our facility leases provide for rental payments on a graduated scale. We recognize rent expense on a straight-line basis over the lease period and have accrued for rent expense incurred but not paid. The amounts presented are consistent with contractual terms and are not expected to differ significantly, unless a substantial change in our headcount requires us to exit an office facility early or expand our occupied space. For the years ended December 31, 2017 and 2016 and six months ended July 1, 2018, rent expense reflected allocations from NETGEAR and may not be indicative of our results. Rent expense was $1.4 million after the Separation through December 31, 2018. Build-to-Suit Lease We entered into a 10.5-year lease for our corporate headquarters located in San Jose, California with an expiration date ending in June 2029. During the third quarter of fiscal year 2018, we commenced construction of tenant improvements that are expected to be complete in March 2019. Annual base rent under the terms of the lease is $2.6 million and will increase throughout the lease term. Letters of Credit In connection with the build-to-suit lease agreement for the headquarters located in San Jose, California, we executed a letter of credit with the landlord as the beneficiary. As of December 31, 2018, we had approximately $3.6 million of unused letters of credit outstanding, of which $3.1 million pertains to the build-to-suit lease arrangement. Purchase obligations We enter into various inventory-related purchase agreements with suppliers. Generally, under these agreements, 50% of the orders are cancelable by giving notice 46 to 60 days prior to the expected shipment date and 25% of orders are cancelable by giving notice 31 to 45 days prior to the expected shipment date. Orders are not cancelable within 30 days prior to the expected shipment date. As of December 31, 2018, we had $36.8 million in non-cancelable purchase commitments with suppliers, respectively. We expect to sell all products for which we have committed purchases from suppliers. Uncertain tax position As of December 31, 2018, the total gross unrecognized tax benefits and related interest and penalties was immaterial. The timing of any payments that could result from these unrecognized tax benefits will depend upon a number of factors. The unrecognized tax benefits have been excluded from the contractual obligations table because reasonable estimates cannot be made of whether, or when, any cash payments for such items might occur. We do not expect to reduce our liabilities for uncertain tax positions in any jurisdiction, where the impact would affect the statement of operations, in the next 12 months. We do not estimate any long-term liability related to a one-time transaction tax that resulted from the passage of the Tax Act. 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 SEC Regulation S-K. Critical Accounting Policies and Estimates Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and pursuant to the regulations of the SEC. The preparation of the consolidated financial statements requires management to make assumptions, judgments and estimates that can have a significant impact on the reported amounts of assets, liabilities, revenue and expenses. We base our estimates on historical experience and on various other assumptions believed to be applicable and reasonable under the circumstances. Actual results could differ significantly from these estimates. These estimates may change as new events occur, as additional information is obtained and as our operating environment changes. On a regular basis, we evaluate our assumptions, judgments and estimates and make changes accordingly. We also discuss our critical accounting estimates with the Audit Committee of the Board of Directors. Note 2, Summary of Significant Accounting Policies, in Notes to Consolidated Financial Statements describes the significant accounting policies used in the preparation of the consolidated financial statements. We have listed below our critical accounting policies that we believe to have the greatest potential impact on our consolidated financial statements. Revenue Recognition under ASC 606 Revenue from contracts with customers is recognized when control of the promised goods or services is transferred to the customers in an amount that reflects the consideration we expect to be entitled to in exchange for those goods or services. The majority of revenue comes from sales of hardware products to customers (retailers, distributors, and service providers). Revenue is recognized at a point in time when control of the goods is transferred to the customer, generally occurring upon shipment or delivery dependent upon the terms of the underlying contract. The amount recognized reflects the consideration we expect to be entitled to in exchange for the transferred goods. We sell subscription paid services to its end user customers where it provides customers access to its cloud services. Revenue for subscription sales is generally recognized on a ratable basis over the contract term, beginning on the date that the service is made available to the customers at the time of registration. The subscription contracts are generally 30 days or 12 months in length, billed in advance. All such service or support sales are typically recognized using an output measure of progress by looking at the time elapsed as the contracts generally provide the customer equal benefit throughout the contract period. In addition to selling paid subscriptions, we also sell services bundled with hardware products and accounts for these sales in line with the multiple performance obligations guidance. Revenue from all sales types is recognized at transaction price, the amount we expect to be entitled to in exchange for transferring goods or providing services. Transaction price is calculated as selling price net of variable consideration which may include estimates for future returns, sales incentives, and price protection related to current period product revenue. Our standard obligation to its direct customers generally provides for a full refund in the event that such product is not merchantable or is found to be damaged or defective. In determining estimates for future returns, management analyzes historical data, channel inventory levels, current economic trends, and changes in customer demand for our products. Sales incentives and price protection are determined based on a combination of the actual amounts committed and through estimating future expenditure based upon historical customary business practice. Typically variable consideration does not need to be constrained as estimates are based on predictive historical data or future commitments that are planned and controlled by us. However, we continue to assess variable consideration estimates such that it is probable that a significant reversal of revenue will not occur. Contracts with Multiple Performance Obligations Some of our contracts with customers contain multiple promised goods or services. Such contracts include hardware products with bundled services, various subscription services, and support. For these contracts, we account for the promises separately as individual performance obligations if they are distinct. Performance obligations are determined to be considered distinct if they are both capable of being distinct and distinct within the context of the contract. In determining whether performance obligations meet the criteria for being distinct, we consider a number of factors, such as the degree of interrelation and interdependence between obligations, and whether or not the good or service significantly modifies or transforms another good or service in the contract. The embedded software in most of the hardware products is not considered distinct and therefore the combined hardware and incidental software are treated as one performance obligation and recognized at the point in time when control of product transfers to the customer. Services that are included with certain hardware products are considered distinct and therefore the hardware and service are treated as separate performance obligations. After identifying the separate performance obligations, the transaction price is allocated to the separate performance obligations on a relative standalone selling price basis. Standalone selling prices are generally determined based on the prices charged to customers or using an adjusted market assessment. Standalone selling price of the hardware is directly observable from add-on camera and base station sales. Standalone selling price of the premium services are directly observable from sales direct to end users while the service is estimated using an adjusted market approach. Revenue is then recognized for each distinct performance obligation as control is transferred to the customer. Revenue attributable to hardware is recognized at the time control of the product transfers to the customer. The transaction price allocated to the service is recognized over the specified service period or over the estimated useful life of the hardware, beginning when the customer is expected to activate their account. Useful life of the hardware is determined by industry norms, technical and financial relevance, frequency of new model releases, and user history. Allowances for Warranty Obligations and Returns due to Stock Rotation Our standard warranty obligation to our direct customers generally provides for a right of return of any product for a full refund in the event that such product is not merchantable or is found to be damaged or defective. At the time we recognize revenue, we record an estimate of future warranty returns to reduce revenue in the amount of the expected credit or refund to be provided to our direct customers. At the time we record the reduction to revenue related to warranty returns, we include within cost of revenue a write-down to reduce the carrying value of such products to net realizable value. Our standard warranty obligation to end-users provides for replacement of a defective product for one or more years. Factors that affect the warranty obligation include product failure rates, material usage and service delivery costs incurred in correcting product failures. We record the estimated cost associated with fulfilling the warranty obligation to end-users in cost of revenue. Because our products are manufactured by third-party manufacturers, in certain cases we have recourse to the third-party manufacturer for replacement or credit for the defective products. We give consideration to amounts recoverable from our third-party manufacturers in determining our warranty liability. Our estimated allowances for product warranties can vary from actual results, and we may have to record additional revenue reductions or charges to cost of revenue, which could materially impact our financial position and results of operations. In addition to warranty-related returns, certain distributors and retailers generally have the right to return products for stock rotation purposes. Upon shipment of the product, we reduce revenue by an estimate of potential future stock rotation returns related to the current period product revenue. We analyze historical returns, channel inventory levels, current economic trends and changes in customer demand for our products when evaluating the adequacy of the allowance for stock rotation returns. Our estimated allowances for returns due to stock rotation can vary from actual results, and we may have to record additional revenue reductions, which could materially impact our financial position and results of operations. Sales Incentives We accrue for sales incentives as a marketing expense if we receive an identifiable benefit in exchange and can reasonably estimate the fair value of the identifiable benefit received; otherwise, it is recorded as a reduction to revenue. As a consequence, we record a substantial portion of our channel marketing costs as a reduction of revenue. We record estimated reductions to revenue for sales incentives when the related revenue is recognized or ahead of customer or end customer commitment if customary business practice creates an implied expectation that such activities will occur in the future. Revenue Recognition under ASC 605 We generally recognize revenue from product sales at the time the product is shipped, provided that persuasive evidence of an arrangement exists, title and risk of loss have transferred to the customer, the selling price is fixed or determinable and collection of the related receivable is reasonably assured. Currently, for some of our customers, title passes to the customer upon delivery to the port or country of destination, upon their receipt of the product, or upon the customer’s resale of the product. At the end of each fiscal quarter, we estimate and defer revenue related to product where title has not transferred. The revenue continues to be deferred until such time that title passes to the customer. We assess collectability based on a number of factors, including general economic and market conditions, past transaction history with the customer and the creditworthiness of the customer. If we determine that collection is not reasonably assured, then we defer revenue until receipt of the payment from the customer. A large majority of our product offerings consist of multiple elements. Our multiple-element product offerings include hardware with bundled prepaid services, which are considered separate units of accounting. In general, the hardware is delivered up-front, while the bundled prepaid services are delivered over the stated service period, or the estimated useful life. We allocate revenue to the deliverables based upon their relative selling price. We recognize revenue allocated to each unit of accounting when persuasive evidence of an arrangement exists, title and risk of loss have transferred to the customer, the selling price is fixed or determinable and collection of the related receivable is reasonably assured. When applying the relative selling price method, we determine the selling price for each deliverable using vendor-specific objective evidence (“VSOE”) of fair value of the deliverable, or when VSOE of fair value is unavailable, our best estimate of selling price (“ESP”), as we have determined that we are unable to establish third-party evidence of selling price for the deliverables. In determining VSOE, we require that a substantial majority of the selling prices for a deliverable sold on a stand-alone basis fall within a reasonably narrow pricing range, generally evidenced by approximately 80% of such historical stand-alone transactions falling within +/-15% of the median price. We determine ESP for a deliverable by considering multiple factors including, but not limited to, market conditions, competitive landscape, internal costs, gross margin objectives and pricing practices. The objective of ESP is to determine the price at which we would transact a sale if the deliverable were sold on a stand-alone basis. The determination of ESP is made through consultation with and formal approval by our management, taking into consideration the go-to-market strategy. We accrue for sales incentives as a marketing expense if we receives an identifiable benefit in exchange and can reasonably estimate the fair value of the identifiable benefit received; otherwise, it is recorded as a reduction to revenues. As a consequence, we record a substantial portion of its channel marketing costs as a reduction of revenue. We record estimated reductions to revenues for sales incentives at the later of when the related revenue is recognized or when the program is offered to the customer or end consumer. Valuation of Inventory We value our inventory at the lower of cost or net realizable value, cost being determined using the first-in, first-out method. We continually assess the value of our inventory and will periodically write down its value for estimated excess and obsolete inventory based upon assumptions about future demand and market conditions. On a quarterly basis, we review inventory quantities on hand and on order under non-cancelable purchase commitments, in comparison to our estimated forecast of product demand for the next nine months to determine what inventory, if any, is not saleable. We base our analysis on the demand forecast but take into account market conditions, product development plans, product life expectancy and other factors. Based on this analysis, we write down the affected inventory value for estimated excess and obsolescence charges. At the point of loss recognition, a new, lower cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis. As demonstrated during prior years, demand for our products can fluctuate significantly. If actual demand is lower than our forecasted demand and we fail to reduce our manufacturing accordingly, we could be required to write down the value of additional inventory, which would have a negative effect on our gross profit. Goodwill Goodwill pertained to the acquisitions of Avaak, Inc. (“Avaak”) and Placemeter, Inc. (“Placemeter”). Goodwill represents the purchase price over estimated fair value of net assets of businesses acquired in a business combination. We perform an annual impairment assessment of goodwill at the reporting unit level on the first day of the fourth fiscal quarter. The analysis may include both qualitative and quantitative factors to assess the likelihood of an impairment. Should certain events or indicators of impairment occur between annual impairment tests, we will perform the impairment test as those events or indicators occur. Examples of such events or circumstances include: a significant decline in our expected future cash flows, a sustained, significant decline in our stock price and market capitalization, a significant adverse change in the business climate and slower growth rates. We test goodwill for impairment at the reporting unit level by first performing a qualitative assessment to determine whether it is more likely than not (that is, a likelihood of more than 50%) that the fair value of the reporting unit is less than its carrying amount. The qualitative assessment considers: macroeconomic conditions, industry and market considerations, cost factors, overall company financial performance, events affecting the reporting units and changes in our stock price. If the reporting unit does not pass the qualitative assessment, we estimate its fair value and compare the fair value with the carrying amount of the reporting unit, including goodwill. If the fair value is greater than the carrying amount of the reporting unit, we do not record an impairment. We also test goodwill for impairment by performing a quantitative assessment, which is used to identify both the existence of impairment and the amount of impairment loss. The quantitative assessment compares the fair value of a reporting unit with its carrying amount, including goodwill. If the fair value is less than the carrying amount, an impairment loss shall be recognized in an amount equal to that excess, limited to the total amount of goodwill allocated to that reporting unit. We would record any impairment charge within earnings in the consolidated statements of operations. A quantitative assessment of goodwill was performed on the first day of the fourth quarter of fiscal 2018, October 1, 2018. We identified that we had one reporting unit for the purpose of goodwill impairment testing and the reporting unit is at the same level as the operating segment and reportable segment. We utilized our market capitalization as a proxy for fair value of the business and compared it to the carrying amount as of October 1, 2018. Based on the results of the quantitative assessment, the respective fair value was substantially in excess of the carrying amount by $772 million, or 253%. We updated our quantitative test as of December 31, 2018 at which time the fair value of the business was substantially in excess of the carrying amount by $471 million, or 175%. A qualitative assessment of goodwill was performed on the first day of the fourth quarter of fiscal 2017 or October 2, 2017. We assessed economic conditions and industry and market considerations, in addition to the overall financial performance the reporting unit. Based on the results of the qualitative assessment, the respective fair value was substantially in excess of the carrying amount. We determined that it was more likely than not that the fair value was greater than its carrying amount and therefore performing the next step of impairment testing was unnecessary. No goodwill impairment was recognized for the years ended December 31, 2018 and 2017. We do not believe it is likely that there will be a material change in the estimates or assumptions we use to test for impairment loss on goodwill. However, if the actual result is not consistent with our estimates or assumptions, we may be exposed to an impairment charge that could be material. Refer to Note 16, Subsequent Events, in Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K, for additional considerations for goodwill after year end. Long-Lived Assets Excluding Goodwill Intangibles, net pertained to the acquisitions of Avaak and Placemeter. We amortize purchased intangibles with finite lives using the straight-line method over the estimated economic useful life, which range from three to five years. We state property and equipment at historical cost, less accumulated depreciation. We review long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Examples of such events or circumstances include: a significant decrease in the market price of the asset, a significant decline in our expected future cash flows, significant changes or planned changes in our use of the assets and a significant adverse change in the business climate. We base our determination of recoverability on an estimate of undiscounted future cash flows resulting from the use of the asset and its eventual disposition. If the carrying amount of the asset exceeds its estimated undiscounted future net cash flows, we recognize an impairment charge in the amount by which the carrying amount of the asset exceeds the fair value of the asset. We review the carrying amount of long-lived assets on a regular basis for the existence of facts, both internal and external, that may suggest impairment. During the years ended December 31, 2018 and 2017, there were no events or changes in circumstances that indicated the carrying amount of our finite-lived assets may not be recoverable from their undiscounted cash flows. Consequently, we did not perform an impairment test. We did not record any impairments to intangibles for the years ended December 31, 2018 and 2017. We also reviewed the depreciation and amortization policies for the long-lived asset groups and ensured the remaining useful lives are appropriate. We review the carrying amount of property and equipment assets on a regular basis for the existence of facts, both internal and external, that may suggest impairment. Charges related to the impairment of property and equipment were insignificant for the years ended December 31, 2018 and 2017. We will continue to evaluate the carrying amount of our long-lived assets, and if we determine in the future that there is a potential further impairment, we may be required to record additional charges to earnings, which could affect our financial results. Stock-based compensation We use the fair value method of accounting for our stock options, performance-based stock options (the “PSOs”), and restricted stock units (“RSUs”) granted to employees to measure the cost of employee services received in exchange for the stock-based awards. The fair value of stock options and performance-based stock options is estimated on the grant or offering date using the Black-Scholes option valuation model. The fair value of RSUs is measured on the grant date based on the closing fair market value of our common stock. The Black-Scholes option valuation model requires inputs such as the risk-free interest rate, expected term and expected volatility. These inputs are subjective and generally require significant judgment. Arlo common stock did not have a long history of being publicly traded at grant date, the estimated term of Arlo's options granted was determined under the simplified method, using an average of the contractual term and vesting period of the stock options. The risk-free interest rate of options granted was based on the implied yield currently available on U.S. Treasury securities, with a remaining term commensurate with the estimated expected term. The estimated volatility assumption was calculated based on a compensation peer group analysis of stock price volatility on the grant date. The stock-based compensation cost is recognized ratably over the period during which an employee is required to provide service in exchange for the awards, usually the vesting period, which is generally four years for stock options and four years for RSUs. For performance-based stock options, stock-based compensation expense is recognized over the expected performance achievement period of individual performance milestones when the achievement of each individual performance milestone becomes probable. As we accumulate additional employee stock-based awards data over time and as we incorporate market data related to our common stock, we may calculate significantly different volatilities and expected lives, which could materially impact the valuation of our stock-based awards and the stock-based compensation expense that we will recognize in future periods. On the Distribution Date, outstanding equity awards granted to Arlo employees under NETGEAR’s stock-based compensation plans were adjusted into NETGEAR awards and Arlo awards based on the conversion ratio as set forth in the employee matters agreement between Arlo and NETGEAR. We did not recognize any incremental expense in connection with the conversion of NETGEAR’s Stock based awards into Arlo awards. Refer to Note 13, Employee Benefit Plans, in Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K, for a further discussion on stock-based compensation. Income Taxes The operations of our business have been included in the consolidated U.S. federal income tax return and certain foreign income tax returns of NETGEAR. The income tax provisions and related deferred tax assets and liabilities that have been reflected in our historical consolidated financial statements have been estimated as if we were a separate taxpayer. We are subject to taxation in all geographies in which we operate, and as a standalone entity, will file tax returns in each jurisdiction in which we operate. We record a provision for income taxes for the anticipated tax consequences of the reported results of operations using the asset and liability method. Under this method, we recognize deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial reporting and tax basis of assets and liabilities, as well as for operating loss and tax credit carryforwards. As a result of the spin-off of Arlo from NETGEAR on December 31, 2018, all net operating losses, with the exception of acquired net operating losses, and tax credit carryforwards determined under the separate return approach that were utilized by NETGEAR or will be retained by NETGEAR were eliminated on December 31, 2018, with an offsetting reduction to our valuation allowance. Deferred tax assets and liabilities are measured using the tax rates that are expected to apply to taxable income for the years in which those tax assets and liabilities are expected to be realized or settled. We record a valuation allowance to reduce our deferred tax assets to the net amount that we believe is more likely than not to be realized. Our assessment considers the recognition of deferred tax assets on a jurisdictional basis. Accordingly, in assessing our future taxable income on a jurisdictional basis, we consider the effect of its transfer pricing policies on that income. We have placed a valuation allowance against U.S. federal and state deferred tax assets since we do not anticipate to realize the benefits of deferred tax assets. We recognize tax benefits from uncertain tax positions only if we believe that it is more likely than not that the tax position will be sustained on examination by the taxing authorities based on the technical merits of the position. As we expand internationally, we will face increased complexity in determining the appropriate tax jurisdictions for revenue and expense items which may differ from that of NETGEAR. Our policy is to adjust these reserves when facts and circumstances change, such as the closing of a tax audit or refinement of an estimate. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will affect the provision for income taxes in the period in which such determination is made and could have a material impact on our financial condition and operating results. The provision for income taxes includes the effects of any accruals that we believe are appropriate, as well as the related net interest and penalties. On December 22, 2017, the Tax Act was signed into law, making significant changes to the Code. Changes include, but are not limited to, a corporate tax rate decrease from 35% to 21% effective for tax years beginning after December 31, 2017, the transition of U.S. international taxation from a worldwide tax system to a territorial system, and a one-time transition tax on the mandatory deemed repatriation of cumulative foreign earnings. The enacted Tax Act significantly changed how the United States taxes corporations. Recent Accounting Pronouncements For a complete description of recent accounting pronouncements, including the expected dates of adoption and estimated effects on financial condition and results of operations, refer to Note 2, Summary of Significant Accounting Policies, in Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K. Emerging Growth Company Status As an emerging growth company (“EGC”), under the Jumpstart Our Business Startups Act (“JOBS Act”), we are allowed to delay adoption of new or revised accounting pronouncements applicable to public companies until such pronouncements are made applicable to private companies, unless we otherwise irrevocably elect not to avail ourselves of this exemption. While we have not made such an irrevocable election, we have not delayed the adoption of any applicable accounting standards.
-0.024963
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<s>[INST] You should read the following discussion of our financial condition and results of operations together with the audited consolidated financial statements and notes to the financial statements included elsewhere in this Annual Report on Form 10K. This discussion contains forwardlooking statements that involve risks and uncertainties. The forwardlooking statements are not historical facts, but rather are based on current expectations, estimates, assumptions and projections about our industry, business and future financial results. Our actual results could differ materially from the results contemplated by these forwardlooking statements due to a number of factors, including those discussed under “Risk Factors” in Part I, Item 1A above. Business and Executive Overview Arlo combines an intelligent cloud infrastructure and mobile app with a variety of smart connected devices that transform the way people experience the connected lifestyle. Our cloudbased platform creates a seamless, endtoend connected lifestyle solution that provides customers with visibility, insight, and a powerful means to help them protect and connect with the people and things that matter most to them. Arlo enables users to monitor their environments and engage in realtime with their families and businesses from any location with a WiFi or a cellular network internet connection. Since the launch of our first product in December 2014, we have shipped over 11.7 million smart connected devices, and, as of December 31, 2018, our smart platform had approximately 2.85 million cumulative registered users across more than 100 countries around the world. On February 6, 2018, NETGEAR announced that its board of directors had unanimously approved the pursuit of a separation of its Arlo business from NETGEAR (the “Separation”) to be effected through an initial public offering (the “IPO”) of newly issued shares of the common stock of Arlo Technologies, Inc., a wholly owned subsidiary of NETGEAR. On August 2, 2018, NETGEAR and Arlo announced the pricing of the IPO of 10,215,000 shares of Arlo’s common stock at a price to the public of $16.00 per share. On August 3, 2018, Arlo’s shares began trading on the New York Stock Exchange under the ticker symbol “ARLO.” On August 7, 2018, we completed the IPO of 11,747,250 shares of common stock (including 1,532,250 shares of common stock pursuant to the underwriters’ option to purchase additional shares, which was exercised in full on August 3, 2018), at $16.00 per share, before underwriting discounts and commissions and estimated offering costs and NETGEAR owned approximately 84.2% of the shares of Arlo’s outstanding common stock. On November 29, 2018, NETGEAR announced that its board of directors had approved a special stock dividend (the “Distribution”) to NETGEAR stockholders of the 62,500,000 shares of Arlo common stock owned by NETGEAR, representing approximately 84.2% of the outstanding shares of Arlo common stock. The Distribution was made on December 31, 2018 (the “Distribution Date”) to all NETGEAR stockholders of record as of the close of business on December 17, 2018 (the “Record Date”). In the Distribution, each NETGEAR stockholder of record on the Record Date received 1.980295 shares of Arlo common stock for every share of NETGEAR common stock held on the Record Date, subject to cash in lieu of fractional shares. The Distribution was intended to qualify as generally tax free to NETGEAR stockholders for U.S. federal income tax purposes. We conduct business across three geographic regionsthe Americas; Europe, MiddleEast and Africa (“EMEA”); and Asia Pacific (“APAC”) and we primarily generate revenue by selling devices through retail, wholesale distribution and wireless carrier channels and paid subscription services through inapp purchases. International revenue was 22.6%, 24.6% and 23.0% of our revenue for the years ended December 31, 2018, [/INST] Negative. </s>
2,019
11,705
1,736,946
Arlo Technologies, Inc.
2020-02-28
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 together with the audited consolidated financial statements and notes to the financial statements included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. The forward-looking statements are not historical facts, but rather are based on current expectations, estimates, assumptions and projections about our industry, business and future financial results. Our actual results could differ materially from the results contemplated by these forward-looking statements due to a number of factors, including those discussed under “Risk Factors” in Part I, Item 1A above. Business and Executive Overview Arlo combines an intelligent cloud infrastructure and mobile app with a variety of smart connected devices that transform the way people experience the connected lifestyle. Our cloud-based platform provides users with visibility, insight and a powerful means to help protect and connect in real-time with the people and things that matter most, from any location with a Wi-Fi or a cellular connection. Since the launch of our first product in December 2014, we have shipped over 15.8 million smart connected devices, and, as of December 31, 2019, our smart platform had approximately 4.02 million cumulative registered accounts across more than 100 countries around the world. We conduct business across three geographic regions-the Americas; Europe, Middle-East and Africa (“EMEA”); and Asia Pacific (“APAC”) and we primarily generate revenue by selling devices through retail, wholesale distribution and wireless carrier channels and paid subscription services through in-app purchases. International revenue was 48.6%, 22.6% and 24.6% of our revenue for the years ended December 31, 2019, 2018 and 2017, respectively. For the years ended December 31, 2019, 2018 and 2017, we generated revenue of $370.0 million, $464.9 million and $370.7 million, respectively. Loss from operations was $85.2 million for the year ended December 31, 2019 compared with Loss from operations of $74.8 million for the year ended December 31, 2018 and Income from operations of $5.7 million for the year ended December 31, 2017. Income (loss) from operations for the year ended December 31, 2019, 2018 and 2017 included separation expense of $1.9 million, $27.3 million, and $1.4 million, respectively. Our goal is to continue to develop innovative, world-class connected lifestyle solutions to expand and further monetize our current and future user and subscriber bases. We believe that the growth of our business is dependent on many factors, including our ability to innovate and launch successful new products on a timely basis and grow our installed base, to increase subscription-based recurring revenue, to invest in brand awareness and channel partnerships and to continue our global expansion. We expect to maintain our investment in research and development going forward as we continue to introduce new and innovative products and services to enhance the Arlo platform. Key Business Metrics In addition to the measures presented in our consolidated financial statements, we use the following key metrics to evaluate our business, measure our performance, develop financial forecasts and make strategic decisions. In addition, management’s incentive compensation is partially determined using certain of these key business metrics. We believe these key business metrics provide useful information by offering the ability to make more meaningful period-to-period comparisons of our on-going operating results and a better understanding of how management plans and measures our underlying business. Our key business metrics may be calculated in a manner different from the same key business metrics used by other companies. We regularly review our processes for calculating these metrics, and from time to time we may discover inaccuracies in our metrics or make adjustments to better reflect our business or to improve their accuracy, including adjustments that may result in the recalculation of our historical metrics. We believe that any such inaccuracies or adjustments are immaterial unless otherwise stated. _________________________ (1) Starting with this Annual Report Form 10-K, Service Revenue is included as a line item in the consolidated statement of operations in Item 8 of Part II of this Annual Report on Form 10-K. Cumulative Registered Accounts. We believe that our ability to increase our user base is an indicator of our market penetration and growth of our business as we continue to expand and innovate our Arlo platform. We define our registered accounts at the end of a particular period as the number of unique registered accounts on the Arlo platform as of the end of such particular period. The number of registered accounts does not necessarily reflect the number of end-users on the Arlo platform, as one registered account may be used by multiple people. We have changed our definition from registered users to registered accounts due to the Verisure transaction, Verisure will own the registered accounts but we will continue to provide services to these European customers under the Verisure Agreements. Paid Accounts. Paid accounts worldwide measured as any account where a subscription to a paid service is being collected (either by the Company or by the Company’s customers or channel partners), plus paid service plans of a duration of more than 3 months bundled with products (such bundles being counted as a paid account after 90 days have elapsed from the date of registration). During the second quarter of 2019, we factored in an adjustment to the first quarter of 2019 paid account number and have subsequently revised the first quarter of 2019 paid accounts total to 162,000. We have redefined paid subscribers as paid accounts to include customers that were transferred to Verisure as part of the disposal of our commercial operations in Europe because we will continue to provide services to these European customers and receive payments under the Verisure Agreements. Devices Shipped. Devices shipped represents the number of Arlo cameras, lights, and doorbells that are shipped to our customers during a period. Devices shipped does not include shipments of Arlo accessories and Arlo base stations, nor does it take into account returns of Arlo cameras, lights, and doorbells. The growth rate of our revenue is not necessarily correlated with our growth rate of devices shipped, as our revenue is affected by a number of other variables, including but not limited to returns from customers, end-user customer rebates and other channel sales incentives deemed to be a reduction of revenue per the authoritative guidance for revenue recognition, sales of accessories, and premium services, the types of Arlo products sold during the relevant period and the introduction of new product offerings that have different U.S. manufacturer’s suggested retail prices. Comparability of Historical Results The operating results of Arlo have historically been disclosed as a reportable segment within the consolidated financial statements of NETGEAR, enabling the identification of directly attributable transactional information, functional departments, and headcount. Through July 1, 2018, Revenue and Cost of revenue, with the exception of channel sales incentives, were derived from transactional information specific to Arlo products and services. Directly attributable operating expenses were derived from activities relating to Arlo functional departments and headcount. Arlo employees also historically participated in NETGEAR’s stock-based incentive plans, in the form of restricted stock units (“RSUs”), stock options, and purchase rights issued pursuant to NETGEAR’s employee stock purchase plan. Stock-based compensation expense has been either directly reported by or allocated to Arlo based on the awards and terms previously granted to NETGEAR’s employees. The consolidated statements of operations of the Company as presented reflect the directly attributable transactional information specific to Arlo and certain additional allocated costs through July 1, 2018. The allocated costs for corporate functions included, but were not limited to, allocations of general corporate expenses from NETGEAR including expenses related to corporate services, such as executive management, information technology, legal, finance and accounting, human resources, tax, treasury, research and development, sales and marketing, shared facilities and other shared services. These costs were allocated based on revenue, headcount, or other measures the Company has determined as reasonable. Following July 1, 2018, the consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. The amount of these allocations from NETGEAR reflected within operating expenses in the consolidated statements of operations was $30.6 million from January 1, 2018 to the date of the completion of the IPO, which included $9.4 million for research and development, $10.0 million for sales and marketing, and $11.2 million for general and administrative expense. For the year ended December 31, 2017, allocations amounted to $40.0 million, which included $11.8 million for research and development, $13.1 million for sales and marketing and $15.1 million for general and administrative expense. The management of Arlo believes the assumptions underlying the consolidated financial statements, including the assumptions regarding the allocated expenses, reasonably reflect the utilization of services provided, or the benefit received by Arlo during the periods presented. Nevertheless, the consolidated financial statements may not be indicative of Arlo’s future performance and do not necessarily reflect Arlo’s results of operations, financial position, and cash flows had Arlo been a standalone company during the periods presented. Our Relationship with NETGEAR On August 2, 2018, in connection with the IPO, the Company entered into a master separation agreement, a transition services agreement, an intellectual property rights cross-license agreement, a tax matters agreement, an employee matters agreement, and a registration rights agreement, in each case with NETGEAR, which effect the Separation, provide a framework for the Company’s relationship with NETGEAR after the Separation and provide for the allocation between NETGEAR and the Company of NETGEAR’s assets, employees, liabilities and obligations (including its investments, property and employee benefits assets and liabilities) attributable to periods prior to, at and after the Separation. NETGEAR has provided certain of the services on a transitional basis following the Distribution pursuant to the Transition Services Agreement ("NETGEAR TSA"). Under the NETGEAR TSA, NETGEAR charges a fee that is consistent with our historical allocation for such services. During the year ended December 31, 2018, we incurred $6.3 million in NETGEAR TSA related costs, which included $0.4 million for research and development, $1.6 million for sales and marketing, and $4.3 million for general and administrative expense. During the year ended December 31, 2019, we incurred $0.7 million in NETGEAR TSA related costs, which included $0.1 million for cost of revenue, $0.3 million for research and development, $0.1 million for sales and marketing, and $0.2 million for general and administrative expense. We do not expect to incur any NETGEAR TSA related costs during fiscal year 2020. In addition, to operate as a standalone company, we incurred costs to replace certain services that were previously provided by NETGEAR, which were higher than those reflected in our historical combined financial statements. The most significant component of these costs was IT-related costs, including capital expenditures, to implement certain new systems, including infrastructure and an enterprise resource planning system. As of December 31, 2018, we have fully completed the implementation of these new systems. We are subject to the reporting requirements of the Exchange Act, and we are required to establish procedures and practices as a standalone public company in order to comply with our obligations under the Exchange Act and related rules and regulations, as well as rules of the New York Stock Exchange. As a result, we will continue to incur additional costs, including internal audit, investor relations, stock administration, and regulatory compliance costs. These additional costs may differ from the costs that were historically allocated to us by NETGEAR. Components of Our Operating Results Revenue Our gross revenue consists primarily of sales of devices and prepaid and paid subscription service revenue. We generally recognize revenue from product sales at the time the product is shipped and transfer of control from us to the customer occurs. Our prepaid services primarily pertain to devices which are sold with our Arlo prepaid services offering, providing users with the ability to store and access data for up to five cameras for a rolling seven-day period, one-year free subscription for basic services. Prepaid services also include one year of Arlo Smart bundled with our for our Arlo Ultra products launched in early 2019, and three-month free subscription for Arlo Smart services for our Arlo Pro 3 products launched in late September 2019 and Arlo Video Doorbell launched in late November 2019. Upon device shipment, we attribute a portion of the sales price to the prepaid service, deferring this revenue at the outset and subsequently recognizing it ratably over the estimated useful life of the device or free trial period, as applicable. Our paid subscription services relate to sales of subscription plans to our registered accounts. Our revenue consists of gross revenue, less end-user customer rebates and other channel sales incentives deemed to be a reduction of revenue per the authoritative guidance for revenue recognition, allowances for estimated sales returns, price protection, and net changes in deferred revenue. A significant portion of our marketing expenditure is with customers and is deemed to be a reduction of revenue under authoritative guidance for revenue recognition. Under the Supply Agreement, Verisure became the exclusive distributor of our products in Europe for all channels, and will non-exclusively distribute our products through its direct channels globally. Revenue associated with the NRE arrangement under the Supply Contract is not significant for the year ended December 31, 2019. We expect that our revenue and profitability in Europe will improve over the life of the Supply Agreement. We expect that our revenue and gross margin for the first half of 2020 will be negatively impacted by delayed delivery of components from suppliers located in regions affected by COVID-19 and other potential impacts of COVID-19 on our operations. Cost of Revenue Cost of revenue consists of both product costs and costs of service. Product costs primarily consist of: the cost of finished products from our third-party manufacturers; overhead costs, including purchasing, product planning, inventory control, warehousing and distribution logistics, third-party software licensing fees, inbound freight, warranty costs associated with returned goods, write-downs for excess and obsolete inventory, royalties to third parties; and amortization expense of certain acquired intangibles. Cost of service consists of costs attributable to the provision and maintenance of our cloud-based platform, including personnel, storage, security, and computing. Our cost of revenue as a percentage of revenue can vary based upon a number of factors, including those that may affect our revenue set forth above and factors that may affect our cost of revenue, including, without limitation: product mix, sales channel mix, registered user acceptance of paid subscription service offerings, fluctuation in foreign exchange rates and changes in our cost of goods sold due to fluctuations in prices paid for components, net of vendor rebates, cloud platform costs, warranty and overhead costs, inbound freight and duty product conversion costs, charges for excess or obsolete inventory, and amortization of acquired intangibles. We outsource our manufacturing, warehousing, and distribution logistics. We also outsource certain components of the required infrastructure to support our cloud-based back-end IT infrastructure. We believe this outsourcing strategy allows us to better manage our product and services costs and gross margin. Research and Development Research and development expense consists primarily of personnel-related expense, safety, security, regulatory services and testing, other research and development consulting fees, and corporate IT and facilities overhead. We recognize research and development expense as it is incurred. We have invested in and expanded our research and development organization to enhance our ability to introduce innovative products and services. We believe that innovation and technological leadership are critical to our future success, and we are committed to continuing a significant level of research and development to develop new technologies, products, and services, including our hardware devices, cloud-based software, AI-based algorithms, and machine learning capabilities. We expect research and development expense to stay relatively flat in absolute dollars as we manage our expenses while continuing to develop new product and service offerings to support the connected lifestyle market. We expect research and development expense to fluctuate depending on the timing and number of development activities in any given period, and such expense could vary significantly as a percentage of revenue, depending on actual revenue achieved in any given period. Sales and Marketing Sales and marketing expense consists primarily of personnel expense for sales and marketing staff; technical support expense; advertising; trade shows; corporate communications and other marketing expense; product marketing expense; IT and facilities overhead; outbound freight costs; and amortization of certain intangibles. We expect our sales and marketing expense to fluctuate based on the seasonality of our business for the foreseeable future. General and Administrative General and administrative expense consists primarily of personnel-related expense for certain executives, finance and accounting, investor relations, human resources, legal, information technology, professional fees, corporate IT and facilities overhead, strategic initiative expense, and other general corporate expense. We expect our general and administrative expense to moderately decrease in absolute dollars. However, we also expect our general and administrative expense to fluctuate as a percentage of our revenue in future periods based on fluctuations in our revenue and the timing of such expense. Separation Expense Separation expense consists primarily of costs associated with our separation from NETGEAR, including third-party advisory, consulting, legal and professional services for separation matters including IPO-related litigation, IT-related expenses directly related to our separation from NETGEAR, and other items that are incremental and one-time in nature. To operate as a standalone company, we have incurred separation costs of $27.3 million and $1.9 million during the years ended December 31, 2018 and 2019, respectively, to replicate certain services previously provided by NETGEAR. The significant reduction during the year ended December 31, 2019 was as a result of the substantial completion of our Separation from NETGEAR on December 31, 2018. Gain on sale of business Gain on sale of business represents the gain on sale of the Company's commercial operations in Europe in the fourth quarter of 2019. Interest Income Interest income represents interest earned on our cash, cash equivalents and short-term investments. Other Income (Expense), Net Other income (expense), net primarily represents gains and losses on transactions denominated in foreign currencies, foreign currency contract gain (loss), net, and other miscellaneous income and expense. We have also included any reimbursement for the Verisure TSA in Other income. Income Taxes We record our provision for income taxes in our consolidated financial statements using the asset and liability method. Under this method, we recognize income tax liabilities or receivable for the current year. We also recognize deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial reporting and tax basis of assets and liabilities, as well as for operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using the tax rates that are expected to apply to taxable income for the years in which those tax assets and liabilities are expected to be realized or settled. We record a valuation allowance to reduce our deferred tax assets to the net amount that we believe is more likely than not to be realized. Our assessment considers the recognition of deferred tax assets on a jurisdictional basis. Accordingly, in assessing our future taxable income on a jurisdictional basis, we consider the effect of its transfer pricing policies on that income. We have placed a valuation allowance against U.S. federal and state deferred tax assets and certain foreign tax attribute carryforwards since we do not anticipate to realize the benefits of deferred tax assets. We recognize tax benefits from uncertain tax positions only if we believe that it is more likely than not that the tax position will be sustained on examination by the taxing authorities based on the technical merits of the position. As we expand internationally, we will face increased complexity in determining the appropriate tax jurisdictions for revenue and expense items. Our policy is to adjust these reserves when facts and circumstances change, such as the closing of a tax audit or refinement of an estimate. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will affect the provision for income taxes in the period in which such determination is made and could have a material impact on our financial condition and operating results. The provision for income taxes includes the effects of any accruals that we believe are appropriate, as well as the related net interest and penalties. The Tax Cuts and Jobs Act of 2017 ("Tax Act") introduced the global intangible low-taxed income (“GILTI”) provisions effective in 2018, which generally impose a tax on the net income earned by foreign subsidiaries of U.S company in excess of a deemed return on their tangible assets. We recognize the tax on GILTI as a period cost when the tax is incurred. Results of Operations We operate as one operating and reportable segment. The following table sets forth, for the periods presented, the consolidated statements of operations data, which we derived from the accompanying consolidated financial statements: Revenue We conduct business across three geographic regions: Americas, EMEA, and APAC. We generally base revenue by geography on the ship-to location of the customer for device sales and device location for service sales. Revenue decreased 20.4% across all geographic regions for the year ended December 31, 2019 compared to the prior year. The decrease was primarily driven by a slowdown in our customer demand for connected cameras, increased competition, higher marketing expenditures deemed to be a reduction of revenues, increased in provisions for price protection that are deemed to be a reduction of revenue, offset by higher service revenue. We launched Arlo Ultra, with 4K video resolution capability, in the first fiscal quarter of 2019, Arlo Pro 3, with 2K video resolution capability, in the third fiscal quarter of 2019 and Arlo Video Doorbell with 180 degree viewing angle, in the fourth quarter of 2019. Service revenue increased by $9.0 million, or 23.7%, for the year ended December 31, 2019 compared to the prior year, as our paid subscribers increased compared to the prior year. Revenue increased 25.4% across all geographic regions for the year ended December 31, 2018 compared to the prior year. The increase was primarily driven by continued rollout of our Arlo Pro 2 camera, which launched in the fourth quarter of fiscal 2017. Additionally, service revenue increased by $8.7 million, or 30.0%, for the year ended December 31, 2018 compared to the prior year. We experienced a slowdown in end user demand for our cameras in the fourth quarter of 2018. Cost of Revenue and Gross Margin The following table presents cost of revenue and gross margin for the periods indicated: Cost of revenue decreased for the year ended December 31, 2019, due primarily to a decline in product revenue compared to the prior year. Service cost of revenue increased for the year ended December 31, 2019, in line with the service revenue growth and due to our continued investment in our cloud service offerings to improve our customer experience and to enhance our security profile. Gross margin decreased significantly for the year ended December 31, 2019 compared to the prior year, due to a combination of both product and service margin declines. The product margin decline is primarily due to increased marketing expenditures deemed to be a reduction of revenues, increased provisions for price protection that are deemed to be reductions of revenue, increased warranty costs, product overhead and freight-related costs, offset by less charges for excess or obsolete inventory. Service margin decreased for the year ended December 31, 2019 compared to the prior year, primarily due to higher service cost growth which included the cost of the free 3-month and 12-month trials of Arlo Smart included in our new product offerings in fiscal 2019. Cost of revenue increased for the year ended December 31, 2018, due primarily to revenue growth compared to the prior year. Gross margin decreased for the year ended December 31, 2018 compared to the prior year due primarily to higher channel marketing promotion activities deemed to be a reduction of revenue and due to an increase in inventory reserves for excess and obsolete products as well as excess materials from our original design manufacturers (“ODMs”). The decrease was partially offset by higher revenue and product margin, mainly from the continued rollout of our Arlo Pro 2 camera. During the fourth quarter of 2018, we experienced a decline in our gross margin mainly from increased marketing expenditures that are deemed to be a reduction in revenue. Operating Expenses For the year ended December 31, 2019, our operating expenses, which reflect a full year as a standalone public company, were expected to increase compared to historical periods. The full year of 2017 and first and second quarters of 2018, are based on carve-out financials and reflect the transactions which are directly attributable to Arlo and certain allocated costs, whereas third quarter and fourth quarter of 2018 and 2019 are based on our actual results for the periods as a standalone public company. Research and Development The following table presents research and development expense for the periods indicated: Research and development expense increased for the year ended December 31, 2019 compared to the prior year due to increases of $2.5 million in personnel-related expenses and $8.3 million in corporate IT and facilities overhead. The increased expenditures on personnel-related expense and engineering projects were due to continuous investment in strategic focus areas, principally the expansion of our Arlo product and service offerings and the growth of our cloud platform capabilities. The increase in corporate IT and facilities overhead is due to the fact that starting in late 2018 Arlo moved to separate facilities globally and for the whole of 2019 Arlo maintained its own facilities and IT infrastructures and systems globally as a standalone public company. Research and development expense increased for the year ended December 31, 2018 compared to the prior year due to increases of $11.6 million in personnel-related expenses, $9.2 million in corporate IT and facilities overhead, $2.5 million in engineering projects and outside professional services, and $0.4 million in NETGEAR TSA related expense. The increased expenditures on personnel-related expense, engineering projects and outside professional services were due to continuous investment in strategic focus areas, principally the expansion of our Arlo product and service offerings and the growth of our cloud platform capabilities. Sales and Marketing The following table presents sales and marketing expense for the periods indicated: Sales and marketing expense increased for the year ended December 31, 2019 compared to the prior year, primarily due to an increase in outside professional services of $2.0 million, corporate IT and facilities overhead of $2.7 million, and personnel-related expenses of $1.2 million. The increases were partially offset by a decrease NETGEAR TSA related expenses of $1.5 million. The increased in corporate IT and facilities overhead is due to the fact that starting in late 2018 Arlo moved to separate facilities globally and for the whole of 2019 Arlo maintained its own facilities and IT infrastructures and systems globally as a standalone public company. Sales and marketing expense increased for the year ended December 31, 2018 compared to the prior year, primarily due to an increase in personnel-related expenses of $7.7 million, digital advertising, media and other costs of $7.1 million, IT and facilities overhead of $2.3 million, NETGEAR TSA related expense of $1.6 million, and sales freight out expenses of $0.7 million. The increase was partially offset by a decrease in marketing expenditures of $1.1 million further to the launch of our Arlo Pro 2 camera in fiscal 2017. General and Administrative The following table presents general and administrative expense for the periods indicated: General and administrative expense increased for the year ended December 31, 2019 compared to the prior year, primarily due to higher corporate IT and facilities overhead of $9.7 million, higher personnel-related expenditures of $6.0 million, higher legal and professional services of $5.3 million, and transaction costs of $1.9 million related to the disposal of our commercial operations in Europe, partially offset by $4.2 million decrease in NETGEAR TSA related expenses. The increase in general and administrative expense was driven by the increase in related corporate IT and facilities overhead due to the fact that starting in late 2018 Arlo moved to separate facilities globally and for the whole of 2019 Arlo maintained its own facilities and IT infrastructures and systems globally, increased customary public company costs, including outside legal and audit fees, insurance and other costs as our company became a standalone public company since August 2018. General and administrative expense increased for the year ended December 31, 2018 compared to the prior year, primarily due to higher personnel-related expenditures of $7.0 million, NETGEAR TSA related expense of $4.3 million, and higher legal and professional services of $1.8 million. Refer to Overview for further detail about the NETGEAR TSA. Separation Expense The following table presents separation expense for the periods indicated: **Percentage change not meaningful. Separation expense consists primarily of charges for third-party advisory, consulting, legal and professional services, IT-related expenses, and other items that are incremental and one-time in nature related to our separation from NETGEAR. There was a significant reduction in our separation expense in the fiscal year ended December 31, 2019 as we completed our Separation from NETGEAR on December 31, 2018. Gain on sale of business **Percentage change not meaningful. Our disposal of our commercial operations in Europe generated a gain on sale of business for the year ended December 31, 2019 of $54.9 million in the fourth quarter of 2019. There was no gain or loss for the year ended December 31, 2018. Refer to Note 4, Disposal of business, in Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K for a complete discussion of this disposal. Interest Income and Other Income (Expense), Net The following table presents other income (expense), net for the periods indicated: **Percentage change not meaningful. During the year ended December 31, 2019, we earned interest income of $2.7 million from our cash equivalents and short-term investments. Other income (expense), net increased for the year ended December 31, 2019 compared to the prior year, due primarily to Verisure TSA related income of $798 thousand and higher foreign currency transaction gains, mainly as a result of the U.S. dollar strengthening against transaction currencies. During the year ended December 31, 2018, we earned interest income of $1.2 million from our cash proceeds from the IPO and from our cash equivalents and short-term investments. Other income (expense), net decreased for the year ended December 31, 2018 compared to the prior year, due primarily to higher foreign currency transaction losses, mainly as a result of the U.S. dollar strengthening against transaction currencies. We entered into a foreign currency hedging program during the third quarter of fiscal 2018, which effectively reduced volatility associated with hedged currency exchange rate movements. For a detailed discussion of our hedging program and related foreign currency contracts, refer to Note 7, Derivative Financial Instruments, in Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K. Provision for Income Taxes Provision for income taxes and effective tax rate consisted of the following: The increase in provision for income taxes for the year ended December 31, 2019 compared to 2018 was primarily due to higher foreign earnings in 2019 and gain on sale of certain assets related to the Company's commercial operations in Europe during the fourth quarter of 2019. Losses incurred predominantly in the U.S continue to be subject to a full valuation allowance. The decrease in provision for income taxes for the year ended December 31, 2018 compared to 2017 was primarily caused by the deemed repatriation of foreign earnings in 2017 following the 2017 U.S. Tax Act. The negative 1.0% effective tax rate was a result of losses in the U.S for which the Company was not recognizing a tax benefit due to its full U.S federal and state valuation allowance. Liquidity and Capital Resources Following the completion of the IPO, our capital structure and sources of liquidity changed significantly from our historical capital structure as we became a standalone public company. We are no longer participating in cash management and funding arrangements managed by NETGEAR. Arlo maintained a separate cash management and financing function for our operations. We have a history of losses and may continue to incur operating and net losses for the foreseeable future. As of December 31, 2019, our accumulated deficit was $131.5 million. Our principal sources of liquidity are cash, cash equivalents and short-term investments. Short-term investments are marketable government securities with an original maturity or a remaining maturity at the time of purchase of greater than three months and no more than 12 months. The marketable securities are held in our company’s name with a high quality financial institution, which acts as our custodian and investment manager. As of December 31, 2019, we had cash, cash equivalents and short-term investments totaling $256.7 million. In November 2019, we entered into a business financing agreement with Western Alliance Bank providing for a credit facility to up to $40.0 million and as of December 31, 2019, we have not borrowed against this credit facility. Refer to Note 10. Debt in the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K for further details on such business financing agreement. In December 2019, we received a total of $75.2 million from Verisure for the disposal of our commercial operations in Europe, including a $20.0 million prepayment for product purchases and a $2.5 million installment payment for the NRE Services under the Supply Agreement. As of December 31, 2019, 25.2% of our cash and cash equivalents were held outside of the U.S. Starting in 2018, as a result of the Tax Cuts and the Jumpstart Our Business Startups Act of 2017 (the “Tax Act”), due to the one-time transition tax on un-repatriated earnings, the tax impact is generally immaterial should we repatriate our cash from foreign earnings. The cash and cash equivalents balance outside of the U.S is subject to fluctuation based on the settlement of intercompany balances. Based on our current plans, business financing agreement with Western Alliance Bank, and market conditions, we believe that such sources of liquidity will be sufficient to satisfy our anticipated cash requirements for at least the next 12 months. However, in the future, including sooner as may be anticipated, we may require or desire additional funds to support our operating expenses and capital requirements or for other purposes, such as acquisitions, and may seek to raise such additional funds through public or private equity or debt financings or collaborative agreements or from other sources. To preserve the tax-free treatment of our separation from NETGEAR, we have agreed in the tax matters agreement with NETGEAR to certain restrictions on our business, which generally will be effective during the two-year period following the Distribution that could limit our ability to pursue certain transactions including equity issuances. We have no commitments to obtain such additional financing and cannot assure you that additional financing will be available at all or, if available, that such financing would be obtainable on terms favorable to us and would not be dilutive. Our future liquidity and cash requirements will depend on numerous factors, including the introduction of new products, the growth in our service revenue, as well as the ability to increase our gross margin dollars and continue to maintain controls over our operating expenditures. Cash Flow The following table presents our cash flows for the periods presented. Operating activities Net cash provided by operating activities increased by $26.9 million for the year ended December 31, 2019 compared to the prior year, due primarily to improved working capital management, offset by a $55.0 million year over year decrease in the adjusted net loss from operations. Our cash inflow from changes in assets and liabilities increased by $81.9 million year over year as a result of increased accounts receivable collections, prepayments from Verisure product purchases and NRE services under the Supply Agreement and lower inventory balance. Net cash used in operating activities decreased by $21.3 million for the year ended December 31, 2018 compared to the prior year, due primarily to the favorable net working capital changes offset by the net loss incurred. Changes in operating activities also reflected the movements of the balances for Statements of Cash Flows purposes since the balances contributed by NETGEAR on or before the initial public offering reflects the contributed balances to us as per the master separation agreement between Arlo and NETGEAR and related documents governing the Contribution. Our days sales outstanding (“DSO”) decreased to 97 days as of December 31, 2019 as compared to 125 days as of December 31, 2018. Inventory decreased to $68.6 million as of December 31, 2019 from $124.8 million as of December 31, 2018, primarily due to better inventory management. As a result, ending inventory turns were 5.9x in the three months ended December 31, 2019 down from 3.6x turns in the three months ended December 31, 2018. Our accounts payable increased to $111.7 million as of December 31, 2019 from $82.5 million as of December 31, 2018, primarily as a result of extended payment terms with our suppliers. Investing activities Net cash provided by investing activities increased by $147.5 million for the year ended December 31, 2019 compared to the prior year, primarily due to the more maturity of short-term investments in the amount of $55.0 million, less purchases of short-term investments of $24.9 million, less purchases of property equipment of $15.0 million, and proceeds from sale of our commercial operations in Europe in the amount of $52.7 million. Net cash used in investing activities increased by $67.0 million for the year ended December 31, 2018 compared to the prior year, primarily due to the purchase of short-term investments of $54.6 million and the increased capital expenditures as we implement certain new systems, including infrastructure and an enterprise resource planning system. In the year ended December 31, 2017, we made a $0.7 million payment in connection with our Placemeter acquisition. Financing activities Net cash used in financing activities was $38 thousand in the year ended December 31, 2019 represented by proceeds from ESPP contributions of $1.8 million, partially offset by $1.9 million in tax withholdings from restricted stock unit releases. Net cash provided by financing activities was $244.3 million in the year ended December 31, 2018, primarily due to net proceeds from IPO of $173.4 million and net investment from parent of $70.9 million. Prior to the completion of the IPO, because cash and cash equivalents were held by NETGEAR at the corporate level and were not attributable to Arlo, cash flows related to financing activities primarily reflect changes in Net parent investment. Backlog Our backlog consists of products for which customer purchase orders have been received and that are scheduled or in the process of being scheduled for shipment. As of December 31, 2019, we had a backlog of $5.4 million, compared to $18.9 million as of December 31, 2018 and $15.6 million as of December 31, 2017. As we typically fulfill orders received within a relatively short period (e.g., within one week for our top three customers) after receipt, our revenue in any fiscal year depends primarily upon orders booked and the availability of supply of our products in that year. In addition, most of our backlog is subject to rescheduling or cancellation with minimal penalties. As a result, our backlog as of any particular date may not be an indicator of revenue for any succeeding period. Similarly, there is a lack of meaningful correlation between year-over-year changes in backlog as compared with year-over-year changes in revenue. Accordingly, we do not believe that backlog information is material to an understanding of our overall business, and backlog as of any particular date should not be considered a reliable indicator of our ability to achieve any particular level of revenue or financial performance. Contractual Obligations The following table summarizes our non-cancelable operating lease commitments and purchase obligations as of December 31, 2019: Operating leases We entered into several office lease agreements under non-cancelable operating leases with various expiration dates through June 2029. The terms of certain of our facility leases provide for rental payments on a graduated scale. We recognize rent expense on a straight-line basis over the lease period and have accrued for rent expense incurred but not paid. The amounts presented are consistent with contractual terms and are not expected to differ significantly, unless a substantial change in our headcount requires us to exit an office facility early or expand our occupied space. For the year ended December 31, 2019, rent expense was $7 million. For the year ended December 31, 2017 and six months ended July 1, 2018, rent expense reflected allocations from NETGEAR and may not be indicative of our results. Rent expense was $1.4 million after the Separation through December 31, 2018. Letters of Credit In connection with the lease agreement for the headquarters located in San Jose, California, we executed a letter of credit with the landlord as the beneficiary. As of December 31, 2019, we had approximately $3.6 million of unused letters of credit outstanding, of which $3.1 million pertains to the lease arrangement. Purchase obligations We enter into various inventory-related purchase agreements with suppliers. Generally, under these agreements, 50% of the orders are cancelable by giving notice of 46 to 60 days prior to the expected shipment date and 25% of orders are cancelable by giving notice 31 to 45 days prior to the expected shipment date. Orders are not cancelable within 30 days prior to the expected shipment date. As of December 31, 2019, we had $29.6 million in non-cancelable purchase commitments with suppliers. We expect to sell all products for which we have committed purchases from suppliers. Uncertain tax position As of December 31, 2019, the total gross unrecognized tax benefits and related interest and penalties was $0.7 million. The timing of any payments that could result from these unrecognized tax benefits will depend upon a number of factors. The unrecognized tax benefits have been excluded from the contractual obligations table because reasonable estimates cannot be made of whether, or when, any cash payments for such items might occur. We do not expect to reduce our liabilities for uncertain tax positions in any jurisdiction, where the impact would affect the statement of operations, in the next 12 months. We do not estimate any long-term liability related to a one-time transaction tax that resulted from the passage of the Tax Act. 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 SEC Regulation S-K. Critical Accounting Policies and Estimates Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and pursuant to the regulations of the SEC. The preparation of the consolidated financial statements requires management to make assumptions, judgments and estimates that can have a significant impact on the reported amounts of assets, liabilities, revenue and expenses. We base our estimates on historical experience and on various other assumptions believed to be applicable and reasonable under the circumstances. Actual results could differ significantly from these estimates. These estimates may change as new events occur, as additional information is obtained and as our operating environment changes. On a regular basis, we evaluate our assumptions, judgments and estimates and make changes accordingly. We also discuss our critical accounting estimates with the Audit Committee of the Board of Directors. Note 2, Summary of Significant Accounting Policies, in Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K describes the significant accounting policies used in the preparation of the consolidated financial statements. We have listed below our critical accounting policies that we believe to have the greatest potential impact on our consolidated financial statements. Revenue Recognition Revenue from contracts with customers is recognized when control of the promised goods or services is transferred to the customers in an amount that reflects the consideration we expect to be entitled to in exchange for those goods or services. The majority of revenue comes from sales of hardware products to customers (retailers, distributors, and service providers). Revenue is recognized at a point in time when control of the goods is transferred to the customer, generally occurring upon shipment or delivery dependent upon the terms of the underlying contract. The amount recognized reflects the consideration we expect to be entitled to in exchange for the transferred goods. We sell paid subscription services to our end user customers where we provide customers access to our cloud services. Revenue for subscription sales is generally recognized on a ratable basis over the contract term, beginning on the date that the service is made available to the customers at the time of registration. The subscription contracts are generally 30 days or 12 months in length, billed in advance. All such service or support sales are typically recognized using an output measure of progress by looking at the time elapsed as the contracts generally provide the customer equal benefit throughout the contract period. In addition to selling paid subscriptions, we also sell services bundled with hardware products and accounts for these sales in line with the multiple performance obligations guidance. Revenue from all sales types is recognized at transaction price, the amount we expect to be entitled to in exchange for transferring goods or providing services. Transaction price is calculated as selling price net of variable consideration which may include estimates for future returns, sales incentives, and price protection related to current period product revenue. Our standard obligation to our direct customers generally provides for a full refund in the event that such product is not merchantable or is found to be damaged or defective. In determining estimates for future returns, management analyzes historical sales and returns data, channel inventory levels, current economic trends, and changes in customer demand for our products. Sales incentives and price protection are determined based on a combination of the actual amounts committed and estimated future expenditure based upon historical customary business practice. Typically variable consideration does not need to be constrained as estimates are based on predictive historical data or future commitments that we plan and control. However, we continue to assess variable consideration estimates such that it is probable that a significant reversal of revenue will not occur. Contracts with Multiple Performance Obligations Some of our contracts with customers contain multiple promised goods or services. Such contracts include hardware products with bundled services, various subscription services, and support. For these contracts, we account for the promises separately as individual performance obligations if they are distinct. Performance obligations are determined to be considered distinct if they are both capable of being distinct and distinct within the context of the contract. In determining whether performance obligations meet the criteria for being distinct, we consider a number of factors, such as the degree of interrelation and interdependence between obligations, and whether or not the good or service significantly modifies or transforms another good or service in the contract. The embedded software in most of the hardware products is not considered distinct and therefore the combined hardware and incidental software are treated as one performance obligation and recognized at the point in time when control of product transfers to the customer. Services that are included with certain hardware products are considered distinct and therefore the hardware and service are treated as separate performance obligations. After identifying the separate performance obligations, the transaction price is allocated to the separate performance obligations on a relative standalone selling price basis. Standalone selling prices are generally determined based on the prices charged to customers or using an adjusted market assessment. Standalone selling price of the hardware is directly observable from add-on camera and base station sales. Standalone selling price of the premium services are directly observable from direct sales to end users, while the service is estimated using an adjusted market approach. Revenue is then recognized for each distinct performance obligation as control is transferred to the customer. Revenue attributable to hardware is recognized at the time control of the product transfers to the customer. The transaction price allocated to the service is recognized over the specified service period or over the estimated useful life of the hardware, beginning when the customer is expected to activate their account. Useful life of the hardware is determined by industry norms, technical and financial relevance, frequency of new model releases, and user history. Long-term Supply Arrangement - Verisure We have entered into a Supply Agreement as part of the disposal of our commercial operations in Europe where Verisure prepays future product purchases with a minimum product purchase commitment also required. The Supply Agreement includes product purchases, paid subscription services, basic services, and an option for Verisure to acquire development services by submitting a statement of work (“SOW”). Products sold come with a standard twelve month warranty. Verisure assumes responsibilities for all warranty claims, returns on products and certain technical support to the end users. We provide technical support for paid subscription services where Verisure can not resolve the issue. Verisure is responsible for any marketing and promotion of our products and services sold in Europe. Products are priced at a cost plus markup based on markups specified in the agreement and that price varies based on the cost of the product. The paid subscription services and basic services pricing is based on the number of users monthly and is priced at a cost plus markup specified in the Supply Agreement that varies based on the user and service type. The transaction price for products and paid subscription services is entirely variable because the consideration is dependent on the actual costs. We allocate variable consideration specified for products entirely to products, and variable consideration specified for the paid subscription services entirely to the paid subscription services. For development services, no contract exists until an SOW is submitted and approved by both parties. For products, since quantity and product types are not specified in the agreement, contracts are not deemed to exist until we receive and accept the customer purchase order (PO). Each product with a valid PO is a single performance obligation. We recognize variable consideration for products upon delivery and for services when the monthly service is rendered for paid subscription services and basic services. The non-refundable prepayment does not relate to future goods or services, as such no further assessment of material rights is required. Further, as the transfer of products is at the discretion of the customer (i.e. when Verisure issues a PO), a significant financing component does not exist as it relates to the prepayment. We also expect that prepayment will be fully utilized by Verisure within one year, hence, no additional accounting consideration is necessary for breakage. We also concluded that we are acting as the principal in the Supply Agreement and determined that revenue should be presented gross. Non-recurring Engineering ("NRE") Arrangement - Verisure The Supply Agreement also provides for certain development services under an SOW to Verisure ("NRE arrangement") as part of the disposal of our commercial operations in Europe. In the NRE arrangement, Verisure pays non-refundable installments upon the commencement of agreed-upon milestones. There is a single performance obligation as the distinct goods and services promised under the SOW are highly interdependent or interrelated inputs that produce a single combined output given the nature of such arrangement. The output (or work-in-progress of such output) typically has no alternative use to us given the customized nature of the arrangement and we have enforceable rights given that the non-refundable milestone payments are prepayments in nature; control for NRE development services therefore transfers over time. We determined that the most appropriate measure of progress for revenue recognition is the input method based on cost because we can reasonably estimate the total costs for the NRE, and the costs incurred reasonably reflects our efforts to satisfy the performance obligation. The NRE costs include labor, material, overhead as well as the use of outside services. The total estimated NRE costs are based on a combination of historical costs together with quotes from vendors for supplying parts or services towards the completion. Adjustments to cost and profit estimates are made periodically due to changes in scope of work, hours to complete and estimated profitability, including those arising from final contract settlements. These changes may result in revisions to revenue and costs and are recognized in the period in which the revisions are determined. Any losses expected to be incurred on contracts in progress are charged to operations in the period such losses are determined. If total NRE costs calculated upon completion in the current period are more than the estimated total costs at completion used to calculate revenue in a prior period, then the profits in the current period will be lower than if the estimated costs used in the prior period calculation were equal to the actual total costs upon completion. Allowances for Warranty Obligations and Returns due to Stock Rotation Our standard warranty obligation to our direct customers generally provides for a right of return of any product for a full refund in the event that such product is not merchantable or is found to be damaged or defective. At the time we recognize revenue, we record an estimate of future warranty returns to reduce revenue in the amount of the expected credit or refund to be provided to our direct customers. At the time we record the reduction to revenue related to warranty returns, we include within cost of revenue a write-down to reduce the carrying value of such products to net realizable value. Our standard warranty obligation to end-users provides for replacement of a defective product for one or more years. Factors that affect the warranty obligation include product failure rates, material usage and service delivery costs incurred in correcting product failures. We record the estimated cost associated with fulfilling the warranty obligation to end-users in cost of revenue. Because our products are manufactured by third-party manufacturers, in certain cases we have recourse to the third-party manufacturer for replacement or credit for the defective products. We give consideration to amounts recoverable from our third-party manufacturers in determining our warranty liability. Our estimated allowances for product warranties can vary from actual results, and we may have to record additional revenue reductions or charges to cost of revenue, which could materially impact our financial position and results of operations. In addition to warranty-related returns, certain distributors and retailers generally have the right to return products for stock rotation purposes. Upon shipment of the product, we reduce revenue by an estimate of potential future stock rotation returns related to the current period product revenue. We analyze historical returns, channel inventory levels, current economic trends and changes in customer demand for our products when evaluating the adequacy of the allowance for stock rotation returns. Our estimated allowances for returns due to stock rotation can vary from actual results, and we may have to record additional revenue reductions, which could materially impact our financial position and results of operations. Sales Incentives We accrue for sales incentives as a marketing expense if we receive an identifiable benefit in exchange and can reasonably estimate the fair value of the identifiable benefit received; otherwise, it is recorded as a reduction to revenue. As a consequence, we record a substantial portion of our channel marketing costs as a reduction of revenue. We record estimated reductions to revenue for sales incentives when the related revenue is recognized or ahead of customer or end customer commitment if customary business practice creates an implied expectation that such activities will occur in the future. Valuation of Inventory We value our inventory at the lower of cost or net realizable value, cost being determined using the first-in, first-out method. We continually assess the value of our inventory and will periodically write down its value to account for estimated excess and obsolete inventory based upon assumptions about future demand and market conditions. On a quarterly basis, we review inventory quantities on hand and on order under non-cancelable purchase commitments and compare those quantities to our estimated forecast of product demand for the next nine months to determine what inventory, if any, is not saleable. We base our analysis on the product demand forecast but take into account market conditions, product development plans, product life expectancy and other factors. Based on this analysis, we write down the carrying value of the affected inventory to account for estimated excess and obsolete amounts. At the point of loss recognition, a new, lower cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis. As demonstrated during prior years, demand for our products can fluctuate significantly. If actual demand is lower than our forecasted demand and we fail to reduce our manufacturing accordingly, we could be required to write down the value of additional inventory, which would have a negative effect on our gross profit. Goodwill Goodwill pertains to the acquisitions of Avaak, Inc. (“Avaak”) and Placemeter, Inc. (“Placemeter”). Goodwill represents the purchase price exceeds the estimated fair value of net assets of businesses acquired in a business combination. We perform an annual impairment assessment of goodwill at the reporting unit level on the first day of the fourth fiscal quarter. The analysis may include both qualitative and quantitative factors to assess the likelihood of an impairment. Should certain events or indicators of impairment occur between annual impairment tests, we will perform the impairment test as those events or indicators occur. Examples of such events or circumstances include: a significant decline in our expected future cash flows, a sustained, significant decline in our stock price and market capitalization, a significant adverse change in the business climate and slower growth rates. We test goodwill for impairment at the reporting unit level by first performing a qualitative assessment to determine whether it is more likely than not (that is, a likelihood of more than 50%) that the fair value of the reporting unit is less than its carrying amount. The qualitative assessment considers: macroeconomic conditions, industry and market considerations, cost factors, overall company financial performance, events affecting the reporting units and changes in our stock price. If the reporting unit does not pass the qualitative assessment, we estimate its fair value and compare the fair value with the carrying amount of the reporting unit, including goodwill. If the fair value is greater than the carrying amount of the reporting unit, we do not record an impairment. We also test goodwill for impairment by performing a quantitative assessment, which is used to identify both the existence of impairment and the amount of impairment loss. The quantitative assessment compares the fair value of a reporting unit with its carrying amount, including goodwill. If the fair value is less than the carrying amount, an impairment loss shall be recognized in an amount equal to that excess, limited to the total amount of goodwill allocated to that reporting unit. We would record any impairment charge within earnings in the consolidated statements of operations. A quantitative assessment of goodwill was performed on the first day of the fourth quarter of fiscal 2019. We identified that we had one reporting unit for the purpose of goodwill impairment testing and the reporting unit is at the same level as the operating segment and reportable segment. We utilized our market capitalization as a proxy for fair value of the business and compared it to the carrying amount as of October 1, 2019. Based on the results of the quantitative assessment, the respective fair value was substantially in excess of the carrying amount by $68.0 million, or 38%. We updated our quantitative test as of December 31, 2019 at which time the fair value of the business was substantially in excess of the carrying amount by $115.7 million, or 57%. No goodwill impairment was recognized for the years ended December 31, 2019 and 2018. However, included in our accounting for the disposal of our commercial operations in Europe was a derecognition of $4.6 million of goodwill associated with the disposal of our commercial operations in Europe. We do not believe it is likely that there will be a material change in the estimates or assumptions we use to test for impairment loss on goodwill. However, if the actual result is not consistent with our estimates or assumptions, we may be exposed to an impairment charge that could be material. Stock-based compensation Our employees have historically participated in NETGEAR’s stock-based compensation plans. Stock-based compensation expense has been allocated to us based on the awards and terms previously granted to our employees as well as an allocation of NETGEAR’s corporate and shared functional employee expenses. We measure stock-based compensation at the grant date based on the fair value of the award. The fair value of stock options and the shares offered under the employee stock purchase plan is estimated using the Black-Scholes option pricing model. Estimated compensation cost relating to restricted stock units ("RSUs") is based on the closing fair market value of NETGEAR’s common stock on the date of grant. Equity awards granted under our own stock-based compensation plans on or after the completion of the IPO are comprised of performance-based stock options (the “PSOs”), stock options, and RSUs. We use the fair value method of accounting for its equity awards granted to employees and measures the cost of employee services received in exchange for the stock-based awards. We recognize these compensation expenses generally on a straight-line basis over the requisite service period of the award. The fair value of stock options and PSOs is estimated on the grant or offering date using the Black-Scholes option pricing model and the forfeitures recorded as they occur. The fair value of RSUs is measured on the grant date based on the closing fair market value of our common stock. The stock-based compensation cost is recognized ratably over the period during which an employee is required to provide service in exchange for the awards, usually the vesting period, which is generally four years for stock options and three to four years for RSUs. For PSOs, stock-based compensation expense of individual performance milestone is recognized over the expected performance achievement period when the achievement becomes probable. Our 2018 Employee Stock Purchase Plan (“ESPP”) is intended to provide employees with the opportunity to purchase our common stock through accumulated payroll deductions at the end of specified purchase period. Eligible employees may contribute up to 15% of compensation, subject to certain income limits, to purchase shares of our common stock. The terms of the plan include a look-back feature that enables employees to purchase stock semi-annually at a price equal to 85% of the lesser of the fair market value at the beginning of the offering period or the purchase date. The duration of each purchasing period is generally six months. We determine the fair value using the Black-Scholes Model using various inputs, including our estimate of expected volatility, term, dividend yield and risk-free interest rate. We recognize compensation costs for the ESPP on a straight-line basis over the requisite service period of the award. Income Taxes We record our provision for income taxes in our consolidated financial statements using the asset and liability method. Under this method, we recognize income tax liabilities or receivable for the current year. We also recognize deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial reporting and tax basis of assets and liabilities, as well as for operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using the tax rates that are expected to apply to taxable income for the years in which those tax assets and liabilities are expected to be realized or settled. We record a valuation allowance to reduce our deferred tax assets to the net amount that we believe is more likely than not to be realized. Our assessment considers the recognition of deferred tax assets on a jurisdictional basis. Accordingly, in assessing our future taxable income on a jurisdictional basis, we consider the effect of its transfer pricing policies on that income. We have placed a valuation allowance against U.S. federal and state deferred tax assets and certain foreign tax attribute carryforwards since we do not anticipate to realize the benefits of deferred tax assets. We recognize tax benefits from uncertain tax positions only if we believe that it is more likely than not that the tax position will be sustained on examination by the taxing authorities based on the technical merits of the position. As we expand internationally, we will face increased complexity in determining the appropriate tax jurisdictions for revenue and expense items. Our policy is to adjust these reserves when facts and circumstances change, such as the closing of a tax audit or refinement of an estimate. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will affect the provision for income taxes in the period in which such determination is made and could have a material impact on our financial condition and operating results. The provision for income taxes includes the effects of any accruals that we believe are appropriate, as well as the related net interest and penalties. The Tax Act introduced the global intangible low-taxed income (“GILTI”) provisions effective in 2018, which generally impose a tax on the net income earned by foreign subsidiaries of U.S company in excess of a deemed return on their tangible assets. We recognize the tax on GILTI as a period cost when the tax is incurred. Recent Accounting Pronouncements For a complete description of recent accounting pronouncements, including the expected dates of adoption and estimated effects on financial condition and results of operations, refer to Note 2, Summary of Significant Accounting Policies, in Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K. Emerging Growth Company Status As an emerging growth company (“EGC”), under the Jumpstart Our Business Startups Act (“JOBS Act”), we are allowed to delay adoption of new or revised accounting pronouncements applicable to public companies until such pronouncements are made applicable to private companies, unless we otherwise irrevocably elect not to avail ourselves of this exemption. While we have not made such an irrevocable election, we have not delayed the adoption of any applicable accounting standards.
-0.025645
-0.025447
0
<s>[INST] You should read the following discussion of our financial condition and results of operations together with the audited consolidated financial statements and notes to the financial statements included elsewhere in this Annual Report on Form 10K. This discussion contains forwardlooking statements that involve risks and uncertainties. The forwardlooking statements are not historical facts, but rather are based on current expectations, estimates, assumptions and projections about our industry, business and future financial results. Our actual results could differ materially from the results contemplated by these forwardlooking statements due to a number of factors, including those discussed under “Risk Factors” in Part I, Item 1A above. Business and Executive Overview Arlo combines an intelligent cloud infrastructure and mobile app with a variety of smart connected devices that transform the way people experience the connected lifestyle. Our cloudbased platform provides users with visibility, insight and a powerful means to help protect and connect in realtime with the people and things that matter most, from any location with a WiFi or a cellular connection. Since the launch of our first product in December 2014, we have shipped over 15.8 million smart connected devices, and, as of December 31, 2019, our smart platform had approximately 4.02 million cumulative registered accounts across more than 100 countries around the world. We conduct business across three geographic regionsthe Americas; Europe, MiddleEast and Africa (“EMEA”); and Asia Pacific (“APAC”) and we primarily generate revenue by selling devices through retail, wholesale distribution and wireless carrier channels and paid subscription services through inapp purchases. International revenue was 48.6%, 22.6% and 24.6% of our revenue for the years ended December 31, 2019, 2018 and 2017, respectively. For the years ended December 31, 2019, 2018 and 2017, we generated revenue of $370.0 million, $464.9 million and $370.7 million, respectively. Loss from operations was $85.2 million for the year ended December 31, 2019 compared with Loss from operations of $74.8 million for the year ended December 31, 2018 and Income from operations of $5.7 million for the year ended December 31, 2017. Income (loss) from operations for the year ended December 31, 2019, 2018 and 2017 included separation expense of $1.9 million, $27.3 million, and $1.4 million, respectively. Our goal is to continue to develop innovative, worldclass connected lifestyle solutions to expand and further monetize our current and future user and subscriber bases. We believe that the growth of our business is dependent on many factors, including our ability to innovate and launch successful new products on a timely basis and grow our installed base, to increase subscriptionbased recurring revenue, to invest in brand awareness and channel partnerships and to continue our global expansion. We expect to maintain our investment in research and development going forward as we continue to introduce new and innovative products and services to enhance the Arlo platform. Key Business Metrics In addition to the measures presented in our consolidated financial statements, we use the following key metrics to evaluate our business, measure our performance, develop financial forecasts and make strategic decisions. In addition, management’s incentive compensation is partially determined using certain of these key business metrics. We believe these key business metrics provide useful information by offering the ability to make more meaningful periodtoperiod comparisons of our ongoing operating results and a better understanding of how management plans and measures our underlying business. Our key business metrics may be calculated in a manner different from the same key business metrics used by other companies. We regularly review our processes for calculating these metrics, and from time to time we may discover inaccuracies in our metrics or make adjustments to better reflect our business or to improve their accuracy, including adjustments that may result in the recalculation of our historical metrics. We believe that any such inaccuracies or adjustments are immaterial unless otherwise stated. _________________________ (1) Starting with this Annual Report Form 10K, Service Revenue is included as a line item in the consolidated statement of operations in Item 8 of Part II of this Ann [/INST] Negative. </s>
2,020
11,127
1,724,670
Perspecta Inc.
2018-06-29
2018-03-31
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis is intended to help investors understand our business, financial condition, results of operations, liquidity and capital resources. You should read this discussion in conjunction with the Combined Financial Statements and related Notes included elsewhere in this document. The statements in this discussion regarding industry outlook, expectations regarding our future performance, liquidity and capital resources and other non-historical statements are forward-looking statements. These forward-looking statements are subject to numerous risks and uncertainties, including, but not limited to, the risks and uncertainties described in “Risk Factors” and “Cautionary Statement Regarding Forward-Looking Statements.” Actual results may differ materially from those contained in any forward-looking statements. The Combined Financial Statements, discussed below, reflect our financial condition, results of operations, and cash flows. The financial information discussed below and included in this document, however, may not necessarily reflect what our financial condition, results of operations, or cash flows would have been had we been operated as a separate, independent entity during the periods presented, or what our financial condition, results of operations, and cash flows may be in the future. Overview We are a leading provider of end-to-end enterprise IT services to government customers across U.S. federal, state and local markets. Using our market-leading enterprise offerings and solutions, we help our government customers implement modern collaborative workplaces, hybrid cloud platforms and integrated digital systems of engagement with their enterprise management systems. By delivering these modern enterprise solutions, often while ensuring interoperability with mission critical legacy systems, we believe we have helped our government customers better realize the benefits of technology, which will ultimately enable them to fulfill their mission objectives and achieve business outcomes. In addition to providing substantial benefits through increased efficiencies and capabilities, we believe demand for our services is also driven by the technological advances that already reinvented commercial industries, which are now exerting a similar evolutionary effect on government customers. In response to these pressures, we believe modern government customers are increasingly turning to outside partners, such as Perspecta, to help guide them through this digital transformation. We believe our breadth of contracts and customers in the U.S. government, and our longstanding history of having partnered with our public sector customers for more than 50 years, provides us with a competitive advantage. For example, we have existing contracts with a range of public sector entities ranging from the VA, to the United States Postal Service, NASA, the FDA and the large state and local government customers such as the county of San Diego, California. Based on this breadth of experience and our expertise, we believe we are well positioned to help its U.S. government customers continue our ongoing digital transformation journey, all the while addressing real business needs. Basis of Presentation The Combined Financial Statements included in this Annual Report on Form 10-K have been derived from the Consolidated Financial Statements and accounting records of Parent, as if USPS operated on a standalone basis during the periods presented, and were prepared in accordance with GAAP. USPS historically reported its results based on a fiscal year ending on October 31 and upon the formation of DXC, USPS began reporting its results based on a fiscal year ended March 31. The combined financial statements of USPS for the annual periods ending October 31, 2015 and 2016, for the five-month period ended March 31, 2017 do not give effect to purchase price allocation adjustments associated with the HPES Merger. These adjustments are reflected in the successor period results for USPS for the annual period ending March 31, 2018, therefore, successor period results for USPS are not comparable to predecessor period results. The Combined Statements of Operations reflect allocations of general corporate expenses from Parent including, but not limited to, executive management, finance, legal, IT, employee benefits administration, treasury, risk management, procurement and other shared services. These allocations were made on a direct usage basis when identifiable, with the remainder allocated on the basis of revenue, expenses, headcount or other relevant measures. We consider these allocations to be a reasonable reflection of the utilization of services by, or the benefits provided to, USPS. The allocations may not, however, reflect the expense USPS would have incurred as a standalone company for the periods presented. Actual costs that may have been incurred if we had been a standalone company would depend on a number of factors, including the chosen organizational structure, what functions were outsourced or performed by employees and strategic decisions made in areas such as IT and infrastructure. The Combined Balance Sheets include Parent assets and liabilities that are specifically identifiable or otherwise attributable to USPS, including subsidiaries and affiliates in which Parent had a controlling financial interest or of which was the primary beneficiary. Parent’s cash has not been assigned to USPS for any of the periods presented because those cash balances are not directly attributable to USPS. We reflect transfers of cash to and from Parent's cash management system as a component of Parent investment on the Combined Balance Sheets. Parent’s receivables sales facility and long-term debt, other than capital lease obligations, have not been attributed to us for any of the periods presented because Parent's borrowings are not our legal obligation. Parent maintained various benefit and stock-based compensation plans at a corporate level and other benefit plans at a subsidiary level. Our employees participate in those programs and a portion of the cost of those plans are allocated and included in the Combined Financial Statements. However, the Combined Balance Sheets do not include any net benefit plan obligations as the pension plans were accounted as multiemployer benefit plans. In the opinion of management, the Combined Financial Statements of USPS contain all adjustments, including normal recurring adjustments, necessary to present fairly USPS’s financial position as of March 31, 2018 and 2017, and its results of operations and cash flows for the fiscal year ending March 31, 2018, the five months ended March 31, 2017, and the fiscal years ending October 31, 2016 and 2015. Principles of Combination The Combined Financial Statements include USPS’s net assets and results of operations as described above. All intercompany transactions and accounts within the combined businesses of USPS have been eliminated. Intercompany transactions between USPS and Parent other than leases with HPE’s wholly-owned leasing subsidiary (“HPE Financial Services”) are considered to be effectively settled in the Combined Financial Statements at the time the transaction is recorded. The total net effect of the settlement of these intercompany transactions is reflected in the Combined Statements of Cash Flows within financing activities and in the combined balance sheets within Parent’s investment. The Combined Financial Statements include the operations of USPS except for certain USPS consulting activities that were historically conducted pursuant to contracts with USPS's former parent, HPE, rather than USPS or its subsidiaries. Because those contracts were not novated to USPS until after October 31, 2016, no information regarding our consulting activities performed pursuant to those contracts has been presented in the results of operations for the fiscal years ending October 31, 2016 and 2015 and only a portion of the revenues associated with these consulting activities is presented in the results of operations for the five-month period ended March 31, 2017. Periods subsequent to March 31, 2017 reflect all these consulting activities performed pursuant to those contracts in our results of operations. For comparability purposes, the revenue and income before taxes related to these contracts not reflected in the results of operations for the periods referenced above are set forth below: Factors and Trends Affecting our Results of Operations Revenue Generation Revenue is generated by providing services on a variety of contract types which vary in duration from as little as six months to more than 10 years. Factors affecting revenue include our ability to successfully: • bid on and win new contract awards; • satisfy existing customers, obtain add-on business, and win contract re-competes; • compete on services offered, delivery models offered, technical ability and innovation, quality, flexibility, experience, and results created; and • identify and integrate acquisitions and leverage them to generate new revenues. Earnings are impacted by the above revenue factors and, in addition, our ability to: • integrate acquisitions and eliminate redundant costs; • control costs, particularly labor costs, subcontractor expenses, and overhead costs including healthcare, pension and general and administrative costs; • anticipate talent needs to avoid staff shortages or excesses; and • accurately estimate various factors incorporated in contract bids and proposals. Competitive Markets We believe that we are well positioned to take advantage of the markets in which we operate because of our expertise and specialization. Our ability to effectively manage project engagements, including logistics, client requirements, engineering resources and service levels, will affect our financial performance. Increased competition from other government contractors and market entrants seeking to take advantage of certain industry trends may result in the emergence of companies that are better able to compete against us. Regulations Increased audit, review, investigation and general scrutiny by U.S. government agencies of government contractors’ performance under U.S. government contracts and compliance with the terms of those contracts and applicable laws could affect our operating results. Negative publicity and increased scrutiny of government contractors in general, including us, relating to U.S. government expenditures for contractor services; incidents involving the mishandling of sensitive or classified information; and the increasingly complex requirements of the DoD and the intelligence community, including those related to cybersecurity, management of federal health care cost growth, and focus on reforming existing government regulation of various sectors of the economy, such as financial regulation and healthcare, could impact our ability to perform in the marketplace. Seasonality The U.S. federal government’s fiscal year ends on September 30. It is not uncommon for U.S. federal government agencies to award extra tasks or complete other contract actions in the weeks leading up to the end of its fiscal year in order to avoid the loss of unexpended fiscal year funds. We have generally experienced increased bid and proposal costs in the months leading up to the U.S. federal government’s fiscal year end as we pursue new contract opportunities being awarded shortly before the U.S. federal government fiscal year end. We also experience some seasonality effects from the timing of the fiscal year end close for state and local governments, which in many instances are different than the U.S. federal government fiscal year end. In general, we tend to experience an increase in revenue in the first half of the calendar year from our state and local government customers as that is when funds are generally allocated to specific projects. Finally, we also tend to generate less revenue and profit from our labor services during the three months ending December 31, as a result of higher leave-taking during the holiday season. Cash Flows Cash flows are affected by the above earnings factors and, in addition, by the following factors: • the ability to efficiently manage capital resources and expenditures; • timely management of receivables and payables; • investment opportunities available, particularly related to business acquisitions and implementations, dispositions and large outsourcing contracts; and • tax obligations. Key Performance Indicators We manage and assess the performance of our business through various means, with the primary financial measures including new contract wins, revenue and Adjusted EBITDA (as defined below under "Non-GAAP Financial Measures"). New contract wins - In addition to being a primary driver of future revenue, new contract wins also provide management an assessment of our ability to compete. The total level of wins tends to fluctuate from year to year depending on the timing of new or re-competed contracts, as well as numerous external factors. Revenue - Revenue is a product of contracts won in prior periods, and work secured in the current year. Year-over-year revenues tend to vary less than new contract wins, and reflect performance on both new and existing contracts. Adjusted EBITDA - Adjusted EBITDA is a non-GAAP measure that we use to evaluate financial performance and is one of the measures we use in assessing management performance. We believe that this non-GAAP financial measure provides useful information to investors regarding our results of operations as it provides another measure of our profitability, our ability to service the planned debt, and is considered an important measure by financial analysts covering our industry. Economic and Industry Factors Our results of operations are impacted by general economic conditions including macroeconomic conditions. We are monitoring current macroeconomic and credit market conditions and levels of business confidence and their potential effect on our customers and on us. A severe and/or prolonged economic downturn could adversely affect our customers’ financial condition and the levels of business activities in the industries and geographies in which we operate. Such a downturn may reduce demand for our services or depress pricing of those services and have a material adverse effect on our new contract bookings and results of operations. Particularly in light of recent economic uncertainty, we continue to monitor costs closely in order to respond to changing conditions and to manage any impact to our results of operations. Our results of operations are also affected by the evolving priorities of the U.S. federal government, as well as by the pace of technological change and the type and level of technology spending by our customers. The ability to identify and capitalize on these markets and technological changes early in their cycles is a key driver of our performance. We see potential for positive developments in the federal government budget for its 2018 fiscal year. We are also experiencing an increased number of requests to extend the period of performance for our largest and most complex IT contracts, are observing increased procurement activity across the U.S. federal government and expect to see adjudications increase. We expect another threatened government shut down by Congress and the passage of a series of continuing resolutions to keep the U.S. federal government funded, with the possibility that Congress will ultimately pass a full year continuing resolution. In the event Congress passes a full year continuing resolution, we would expect this to support our initiative to extend the period of performance for its largest and most complex IT contracts. Revenues are driven by our ability to secure new contracts and to deliver solutions and services that add value to our customers. Our ability to add value for customers, and therefore generate revenues, depends in part on our ability to deliver market-leading service offerings and to deploy skilled teams of professionals quickly across all government industries and domains. Our market is highly competitive and has characteristics unique to the federal contracting environment. Almost all of our U.S. federal government contracts and subcontracts may be modified, curtailed, or terminated either at the convenience of the government or for default based on factors set forth in the FAR. Upon termination for convenience of a fixed-price type contract, our U.S. federal government contracts normally entitle us to receive the purchase price for delivered items, reimbursement for contractual commitments and allowable costs for work-in-process, and a reasonable allowance for profit, although there can also be financial impact resulting from the negotiated contract settlement. Upon termination for convenience of a U.S. federal government cost reimbursable or time and material contract, we are normally entitled to reimbursement of allowable costs plus a fee. Allowable costs generally include the cost to terminate agreements with suppliers and subcontractors. The amount of the fee recovered, if any, generally is related to the portion of the work completed prior to termination and is determined by negotiation. See “Risk Factors.” If contracts are lost through the competitive bid process, our operating results may differ materially and adversely from those anticipated. Finally, shifting U.S. federal government priorities can also impact the future of projects. Management monitors U.S. federal government priorities and industry factors through numerous industry and government publications and forecasts, legislative activity, budgeting and appropriation processes, and by participating in industry professional associations in order to anticipate these shifting priorities. Results of Operations Fiscal 2018 Highlights Financial highlights for the fiscal year ending March 31, 2018 include the following: • Revenues were $2,819 million. • Net income was $208 million, including the cumulative impact of certain items of $173 million, reflecting restructuring costs of $14 million, transaction, separation and integration-related costs of $90 million and amortization of acquired intangible assets of $69 million. • We generated $530 million of cash from operations. Year Ended March 31, 2018 Revenues Our revenues for the year ended March 31, 2018 were $2,819 million and increased by $87 million as compared to revenues for the year ended October 31, 2016. The results of the year were primarily impacted by an increase of $79 million in revenues from new business and $63 million associated with increases in ongoing business in addition to the exclusion of certain USPS consulting activities that were historically conducted pursuant to contracts with USPS’s former parent, HPE, rather than USPS or its subsidiaries. Because those contracts were not novated to USPS until after October 31, 2016, no information regarding USPS consulting activities performed pursuant to those contracts has been presented in USPS’s results of operations for the year ended October 31, 2016. These increases were offset by contracts that concluded or were renewed at a lower rate in 2018 as compared to the year ended October 31, 2016 and by $133 million in revenues recognized in the year ended October 31, 2016 associated with a major contract renegotiation. Costs of services Costs of services for the year ended March 31, 2018 were $2,155 million and increased by $69 million as compared to cost of services for the year ended October 31, 2016. The increase is due to increases in new and ongoing business in addition to the exclusion of certain USPS consulting activities that were historically conducted pursuant to contracts with USPS’s former parent, HPE, rather than USPS or its subsidiaries. Because those contracts were not novated to USPS until after October 31, 2016, no information regarding USPS consulting activities performed pursuant to those contracts has been presented in USPS’s results of operations for the year ended October 31, 2016. These increases were offset by USPS’s implementation of certain strategic measures to improve efficiencies across multiple clients and programs and the 2016 major contract renegotiation. Selling, general and administrative Selling, general and administrative expenses for the year ended March 31, 2018 was $182 million and decreased by $25 million as compared to the year ended October 31, 2016. The decrease was largely driven by efficiencies gained as a result of USPS’s implementation of certain strategic measures to improve efficiencies in an effort to reduce expenses. Depreciation and amortization Depreciation and amortization for the year ended March 31, 2018 was $167 million and represented 6% of revenues, a decrease, on a percentage of revenue basis, from the year ended October 31, 2016, which was largely driven by reductions in property and equipment balances in the period associated with acquisition accounting. Separation costs Separation costs for the year ended March 31, 2018 were $90 million and represented 3% of revenues. Separation costs of $42 million and $48 million were associated with expenses incurred in connection with the HPES Merger and the Spin-Off and Mergers, respectively. Interest expense Interest expense for the year ended March 31, 2018 was $12 million and relates to interest associated with capital lease obligations. Interest expense for the year decreased by $24 million as compared to the year ended October 31, 2016, primarily due to reductions in capital lease balances in the period. Income tax benefit Our effective tax rate ("ETR") on income for the year ended March 31, 2018 was (5)%. In fiscal 2018, the ETR was primarily impacted by the U.S. tax reform. 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 7 - "Income Taxes" to the Combined Financial Statements. Five Months Ended March 31, 2017 Revenues Revenues for the five-month period ended March 31, 2017 were $1,073 million. Costs of services Costs of services for the five-month period ended March 31, 2017 was $820 million and represented 76% of revenues, which was the same, on a percentage of revenue basis, as the year ended October 31, 2016. Selling, general and administrative Selling, general and administrative expenses for the five-month period ended March 31, 2017 were $77 million and represented 7% of revenues, a 1% decrease, on a percentage of revenue basis, from the year ended October 31, 2016. Depreciation and amortization Depreciation and amortization for the five-month period ended March 31, 2017 was $73 million and represented 7% of revenues, a 1% decrease, on a percentage of revenue basis, from the year ended October 31, 2016, which was largely driven by reductions in property and equipment balances in the period. Separation costs Separation costs for the five-month period ended March 31, 2017 were $34 million and represented 3% of revenues. Separation costs were associated with expenses incurred in connection with the HPES Merger. Separation costs for the year ended October 31, 2016 were $34 million and mainly related to the separation of HPE from HPI in early 2016. Interest expense Interest expense for the five-months ended March 31, 2017 was $10 million or 1% of revenues, which was the same, on a percentage of revenue basis, as the year ended October 31, 2016. Interest expense relates to interest associated with capital lease obligations. Interest income No interest income was earned in the five-months ended March 31, 2017. Interest income for the fiscal year ended October 31, 2016 was $5 million and related to lease rental income. Years Ended October 31, 2016 and 2015 Revenues Our revenues for the year ended October 31, 2016 increased by $147 million or 6% as compared to the prior fiscal year. The $147 million increase in revenues for the year ended October 31, 2016 was primarily due to an increase of $41 million in revenues from new business and $133 million associated with a major contract renegotiation that resulted in the recognition of revenues that had been previously deferred. These increases were partially offset by contracts that concluded or were renewed at a lower rate. Costs of services Costs of services for the year ended October 31, 2016 decreased by $15 million or 1% as compared to the prior fiscal year. The decrease was mainly driven by labor and non-labor efficiency actions taken across multiple clients and programs associated with the Company’s restructuring programs (see Note 2 - “Acquisition” to the Combined Financial Statements). Selling, general and administrative Selling, general and administrative expenses for the year ended October 31, 2016 decreased by $35 million or 14% as compared to the prior fiscal year. The decrease was mainly driven by the implementation during the year of certain strategic measures to improve efficiencies in an effort to reduce expenses. Depreciation and amortization Depreciation and amortization expenses for the year ended October 31, 2016 increased by $11 million or 5% as compared to the prior fiscal year. The increase was mainly driven by acquisitions of property and equipment through capital leases during the year. Restructuring costs Restructuring costs for the year ended October 31, 2016 remained consistent with the prior year, with a decrease of $2 million or 9% as compared to the prior fiscal year. Restructuring costs incurred in fiscal year 2016 are associated with employee severance and infrastructure charges recognized with the restructuring plan in fiscal year 2015 (see Note 4 - “Restructuring” to the Combined Financial Statements). Separation Costs Separation costs for the year ended October 31, 2016 increased by $6 million or 21% as compared to the prior fiscal year. Separation costs incurred in the fiscal years ended October 31, 2016 and 2015 were mainly associated with the separation of HPE from HPI in early 2016. Interest expense Interest expense for the year ended October 31, 2016 increased by $3 million or 9% as compared to the prior fiscal year. Our interest expense results from capital lease obligations, which remained at similar levels year over year. Interest income Interest income for the year ended October 31, 2016 increased by $1 million as compared to the prior fiscal year. Interest income recognized during the year is related to lease rental income earned during the year. Income (loss) before taxes Income before taxes for the year ended October 31, 2016 increased by $180 million to $129 million in fiscal year 2016 as compared to the prior fiscal year. The increase was mainly driven by the increase in revenues of $147 million and the decrease in costs and expenses of $33 million, which was largely due to the successful implementation by USPS of certain strategic initiatives during the year, which increased efficiencies. Income taxes Income taxes for the year ended October 31, 2016 increased by $71 million to a $49 million tax provision in fiscal year 2016 as compared to a $22 million tax benefit in the same period in the prior year. The increase was driven by the increase in revenues and decrease in costs that resulted in higher income before taxes in 2016 as compared to 2015. Non-GAAP Financial Measures We present non-GAAP financial measures of performance that are derived from the combined statements of operations for the twelve-month period ended March 31, 2018, the combined statements of operations for the five-month period ended March 31, 2017 and the combined statements of operations for the twelve-month periods ended October 31, 2016 and 2015. These non-GAAP financial measures include earnings before interest, taxes and depreciation and amortization (“EBITDA”) and Adjusted EBITDA. 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. These non-GAAP financial measures exclude certain items from GAAP results, which our management believes are not indicative of core operating performance. Our management believes these non-GAAP measures provide investors supplemental information about our financial performance exclusive of the impacts of corporate wide strategic decisions. We believe 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. We believe the non-GAAP measures provided are also considered important measures by financial analysts. There are limitations to the use of the non-GAAP financial measures we present. 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. 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 us and other companies. Reconciliation of Non-GAAP Financial Measures Our adjustments to our non-GAAP performance measures include: • Restructuring costs-reflects restructuring costs, net of reversals, related to workforce optimization and infrastructure charges. • Transaction, separation and integration-related costs-reflects costs related to integration planning, financing, and advisory fees associated with the separation of HPI into two separate companies in 2015 and the HPES Merger, forming DXC. • Share-based compensation-represents the share-based compensation attributable to USPS based on the awards and terms previously granted under the incentive compensation plan to USPS’s employees and an allocation of Parent’s corporate and shared functional employee expenses. A reconciliation of net income (loss) to EBITDA and Adjusted EBITDA is as follows: (1) Includes corporate allocations as set forth below: Liquidity and Capital Resources Liquidity Prior to the Spin-Off and the Mergers Our total liquidity is comprised of operating cash and cash equivalents. We have generated and expect to continue to generate positive operating cash flow to fund our requirements for working capital, capital expenditures and other discretionary investments. Our exposure to operational liquidity risk is primarily from long-term contracts, which require significant investment of cash flows from operating activities 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. Liquidity Following the Spin-Off and the Mergers Following the Spin-Off and Mergers, existing cash and cash equivalents and cash generated by operations will continue to be our primary sources of liquidity, as well as available borrowings under our Revolving Credit Facility and sales of receivables under our MARPA Facility (defined under "Accounts Receivable Facility" below). See “Description of Material Indebtedness” and “Accounts Receivable Facility” for more information. Our primary cash needs will continue to be for working capital, capital expenditures and other discretionary investments, as well as to service our outstanding indebtedness, including borrowings under our Credit Facilities (defined under "Description of Material Indebtedness" below); however, our capital structure and liquidity profile have changed because we are no longer a part of DXC. Our ability to fund our future operating needs depends, in part, on our ability to continue to generate positive cash flows from operations and, if necessary, raise cash in the capital markets. Following the Spin-Off and the Mergers, it is our belief, based upon our history of generating strong cash flows, that we will be able to meet our short-term liquidity and cash needs, including debt servicing, through the combination of cash flows from operating activities, available cash balances, available borrowings under our Revolving Credit Facility (defined under "Description of Material Indebtedness" below) and sales of receivables under our MARPA Facility. If these sources of liquidity need to be augmented, additional cash requirements would likely be financed through the issuance of debt or equity securities, although there can be no assurance that we will able to obtain such financing on acceptable terms (or at all) in the future. Upon completion of the Spin-Off on May 31, 2018, we closed on financing of approximately $2.5 billion under our Term Loan A Facilities and Term Loan B Facility, and drew $50 million in borrowings under our new $600 million Revolving Credit Facility, net of $42 million of issuance costs for all Credit Facilities in the aggregate. Proceeds in the aggregate amount of $1.1 billion were used by Perspecta to pay a distribution of approximately $984 million in cash to DXC and to pay transaction costs. Proceeds in the aggregate amount of $1.5 billion were used to fund the cash portion of the merger consideration to stockholders of Vencore HC, to repay, refinance and/or redeem substantially all of Vencore HC’s and KGS HC’s existing indebtedness, to pay for additional transaction costs, and for general corporate purposes. Description of Material Indebtedness Term Loan Facilities and Revolving Credit Facility On May 31, 2018, Perspecta, as borrower, entered into a credit agreement (“Credit Agreement”) with MUFG Bank, Ltd., a member of MUFG, a global financial group (“MUFG”), as administrative agent, MUFG Union Bank, N.A., as collateral agent, the guarantors party thereto, and a syndicate of banks arranged by MUFG, Merrill Lynch, Pierce, Fenner & Smith Incorporated, JPMorgan Chase Bank, N.A., Mizuho Bank, Ltd. and RBC Capital Markets. The credit facilities under the Credit Agreement include (i) a five-year senior secured revolving credit facility (the “Revolving Credit Facility”) with initial borrowing capacity of $600 million, of which $550 million is available and undrawn after giving effect to the Spin-Off and the Merger to provide support for Perspecta’s business, including ongoing liquidity, (ii) a three-year senior secured tranche A1 term loan facility in an aggregate principal amount of $350 million (the “Tranche A1 Facility”), (iii) a five-year senior secured tranche A2 term loan facility in an aggregate principal amount of $1.65 billion (the “Tranche A2 Facility” and, together with the Tranche A1 Facility, the “Term Loan A Facilities”; the Term Loan A Facilities together with the Revolving Credit Facility, the “Pro Rata Facilities”) and (iv) a seven-year senior secured term loan B facility in an aggregate principal amount of $500 million (the “Term Loan B Facility”; and, together with the Pro Rata Facilities, the “Credit Facilities”). On May 31, 2018, all of the Tranche A1 Facility and a portion of the Tranche A2 Facility were funded in an aggregate amount of $1.1 billion, the proceeds of which were used by Perspecta to pay the Perspecta Payment (defined below) to DXC and to pay transaction costs. Additionally, $50 million of the Revolving Credit Facility, the remainder of the Tranche A2 Facility and all of the Term Loan B Facility were funded in an additional aggregate amount of $1.45 billion, the proceeds of which were used to fund the cash portion of the merger consideration to stockholders of Vencore HC, to repay, refinance and/or redeem substantially all of Vencore HC’s and KGS HC’s existing indebtedness, to pay for additional transaction costs, and for general corporate purposes. The Pro Rata Facilities and the Term Loan B Facility have the following material terms: Interest. Borrowings under (1) the Revolving Credit Facility and the Tranche A2 Facility bear interest at an interest rate per annum equal to, at Perspecta’s option, (A) LIBOR plus the applicable margin of 1.250%-2.250% or (B) the base rate plus the applicable margin of 0.250%-1.250%, (2) the Tranche A1 Facility bears interest at an interest rate per annum equal to, at Perspecta’s option, (A) LIBOR plus the applicable margin of 1.125%-2.125% or (B) the base rate plus the applicable margin of 0.125%-1.125% and (3) the Term Loan B Facility bears interest at an interest rate per annum equal to, at Perspecta’s option, (A) LIBOR plus the applicable margin of 2.25% or (B) the base rate plus the applicable margin of 1.25%. In each of the foregoing cases, LIBOR shall at no time be deemed to be less than 0.00%. The applicable margins for borrowings under the Pro Rata Facilities will vary and will be determined based on Perspecta’s consolidated total net leverage ratio. Perspecta will also owe unused facility fees on the Revolving Credit Facility and paid upfront fees under the Pro Rata Facilities and (in the form of original issue discount) under the Term Loan B Facility on May 31, 2018. Amortization and Prepayment. Borrowings under the Revolving Credit Facility can be prepaid at any time and can be repeatedly redrawn until its maturity. The Tranche A1 Facility has no scheduled amortization prior to maturity. The Tranche A2 Facility requires quarterly scheduled amortization at a rate equivalent to 5% of the original principal amount per annum until the remaining balance is due at maturity. The Term Loan B Facility requires quarterly scheduled amortization at a rate equivalent to 1% of the original principal amount per annum until the remaining balance is due at maturity. The Company can prepay the Tranche A1 Facility, the Tranche A2 Facility or the Term Loan B Facility, in whole or in part, at any time at its election at 100% of par without premium; provided that if Perspecta prepays the Term Loan B Facility in connection with a repricing event within six months following the initial funding, the prepayment must be made at 101% of par. Security and Guarantees. The Pro Rata Facilities and the Term Loan B Facility are guaranteed by each of Perspecta’s direct and indirect, existing and future, material domestic subsidiaries (excluding certain entities, including special purpose subsidiaries) (such subsidiaries, together with Perspecta, the “Grantors”), and are secured by a perfected first priority security interest in substantially all of Perspecta’s assets and the assets of those guarantors, subject to certain customary exceptions. Covenants. The Pro Rata Facilities and the Term Loan B Facility contain negative covenants customary for financings of this type, including covenants that place limitations on the incurrence of additional indebtedness; the creation of liens; the payment of dividends; sales of assets; fundamental changes, including mergers and acquisitions; loans and investments; negative pledges; transactions with affiliates; restrictions affecting subsidiaries; modification to charter documents in a manner materially adverse to the lenders; changes in fiscal year and limitations on conduct of business. The Pro Rata Facilities and the Term Loan B Facility also contain affirmative covenants and representations and warranties customary for financings of this type. In addition, the Pro Rata Facilities contain financial maintenance covenants requiring, as at the end of any fiscal quarter of Perspecta ending on or after September 30, 2018, (a) a ratio of consolidated total net debt to consolidated EBITDA not in excess of 4:50:1:00, stepping down to 3.75: 1.00 no later than fiscal quarter ending December 31, 2019 and thereafter stepping up to 4.00:1.00 during the twelve-month period following the consummation of a permitted acquisition that involves consideration with a fair market value in excess of $100 million; and (b) a ratio of consolidated EBITDA to interest expense of not less than 3.00:1.00. Events of Default. The lenders under the Pro Rata Facilities and the Term Loan B Facility may declare any indebtedness outstanding thereunder due and payable, and cancel any remaining commitments under the Revolving Credit Facility, if an event of default occurs and is continuing, including a failure to pay principal when due or interest or commitment fees within five days of the date when due; a material inaccuracy of a representation or warranty at the time made; a bankruptcy event; a failure to comply with the covenants (other than the financial covenants), subject to a customary grace period; cross-events of default to material indebtedness; certain material ERISA events; material judgments; actual or asserted invalidity of any guarantee or non-perfection of any material portion of the collateral under the security documents; a change in control; and, solely as to the lenders under the Pro Rata Facilities, a breach of the financial covenants. In addition, on May 31, 2018, Perspecta and each of the other Grantors entered into a Collateral Agreement (the “Collateral Agreement”) with MUFG, in its capacity as administrative agent, and MUFG Union Bank, N.A., in its capacity as Collateral Agent. Pursuant to the terms of the Collateral Agreement, each of the Grantors granted a perfected first priority security interest in substantially all of its assets to secure its obligations under the Credit Agreement and related documents to which it is a party, subject to certain customary exceptions. Accounts Receivable Facility On May 31, 2018, Perspecta entered into a Guaranty (the “Guaranty”) made in favor of MUFG Bank, Ltd. (f/k/a The Bank of Tokyo-Mitsubishi UFJ, Ltd., New York Branch), as administrative agent (the “Agent”), that guarantees the obligations of ES LLC, a Delaware limited liability company (the “Seller”) and wholly-owned subsidiary of Perspecta, under a Master Accounts Receivable Purchase Agreement, dated as of July 14, 2017 (as amended by that certain First Amendment to Master Accounts Receivable Purchase Agreement, dated as of January 23, 2018, and that certain Second Amendment to Master Accounts Receivable Purchase Agreement (the “Second Amendment”), dated as of May 31, 2018, the “Purchase Agreement”), among the Seller, the Agent, and MUFG, The Bank of Nova Scotia and Mizuho Bank, Ltd., as purchasers (collectively, the “Purchasers”). The Guaranty does not cover any credit losses with respect to the receivables sold under the Purchase Agreement. The Purchase Agreement establishes a federal government obligor receivables purchase facility (the “MARPA Facility”) that provides for up to $450 million in funding based on the availability of eligible receivables and the satisfaction of certain conditions. The MARPA Facility is a committed facility that has a current term of one (1) year from the effective date of the Second Amendment, unless terminated earlier by the Seller, the Agent or the Purchasers. The Purchase Agreement also provides for optional extensions of the MARPA Facility’s term, if agreed to by the Purchasers, in each case for an additional six month duration. Each such extension may be requested as early as two hundred ten (210) days prior to, and not less than sixty (60) days prior to, the then scheduled termination date. Under the MARPA Facility, the Seller will sell eligible federal government obligor receivables, including both receivables that have already been billed under an invoice and also certain unbilled receivables arising from contracts where the Seller has performed work and revenue has been recognized in accordance with generally accepted accounting principles, subject to satisfaction of other required conditions. The MARPA Facility results in the continuous non-recourse true sale of eligible receivables by the Seller to the Purchasers. The Seller expects to use the proceeds from receivables sales under the MARPA Facility for general corporate purposes. EDS Notes On October 12, 1999, ES LLC (then known as Electronic Data Systems Corporation) issued, in a registered offering, $300 million aggregate principal amount of notes (the "EDS Notes") pursuant to that certain first supplemental indenture, dated as of October 12, 1999 (the “First Supplemental Indenture”), between ES LLC (then known as Electronic Data Systems Corporation) and The Bank of New York Mellon Trust Company N.A. (successor to Chase Bank of Texas, National Association (f/k/a Texas Commerce Bank National Association), as trustee (the “Trustee”), supplementing that certain indenture, dated as of August 12, 1996 (the “Base Indenture” and, as amended, modified or otherwise supplemented from time to time, the “EDS Indenture”), between ES LLC (then known as Electronic Data Systems Corporation) and the Trustee. The EDS Notes were deregistered on September 9, 2008. On January 8, 2018, DXC commenced (i) an exchange offer to exchange all validly tendered and accepted EDS Notes for new notes issued by DXC (the “Exchange Offer”); and (ii) a consent solicitation to certain Amendments (as defined below) to the EDS Indenture (the “Consent Solicitation”). On January 22, 2018, DXC, ES LLC, and the Trustee entered into that certain ninth supplemental indenture to the EDS Indenture, dated as of January 22, 2018 (the “Ninth Supplemental Indenture”), which among other things, eliminates substantially all of the restrictive covenants in the EDS Indenture, eliminates certain events of default, amends the EDS Indenture to provide for the termination and replacement of guarantees and makes certain conforming changes to the EDS Indenture to reflect the foregoing changes (the “Amendments”). The Amendments became operative on February 7, 2018, the settlement date of the Exchange Offer and Consent Solicitation (the “Settlement Date”). On the Settlement Date, the holders of approximately $234 million aggregate principal amount of EDS Notes exchanged their EDS Notes for a like amount of the DXC Notes. As a result, DXC holds $234 million aggregate principal amount of EDS notes. EDS notes in the aggregate principal amount of $66 million held by public noteholders remain outstanding following the Distribution. Interest on the EDS Notes, which accrues at the annual rate of 7.45%, is payable on April 15 and October 15 of each year, and the EDS Notes mature on October 15, 2029. ES LLC may redeem the EDS Notes, in whole or in part, at any time or from time to time, in each case, at its option, at a redemption price equal to (1) the greater of 100% of the principal amount of the EDS Notes and (2) as determined by the Quotation Agent (as defined in the EDS Indenture), the sum of the present values of the principal amount of the notes to be redeemed and the remaining scheduled payments of principal and interest thereon, discounted to the redemption date on a semi-annual basis (assuming a 360-day year consisting of twelve 30-day months) at the Treasury Rate (as defined in the First Supplemental Indenture) plus 20 basis points, plus, in either of (1) or (2) above, accrued and unpaid interest to the date of redemption. The EDS Indenture contains customary events of default, including (1) failure to pay interest with respect to the EDS Notes; (2) failure to pay the principal (or premium, if any) when due with respect to the EDS Notes; (3) failure to pay any sinking fund payment with respect to the EDS Notes (4) failure to observe or perform any other covenant contained in the EDS Notes or the EDS Indenture; and (5) specified events involving bankruptcy, insolvency or reorganization. Cash and Cash Equivalents and Cash Flows We reflect transfers of cash to and from Parent’s cash management system as a component of Parent company investment on the Combined Balance Sheets. The following table summarizes our cash flow activity: Operating Cash Flow Net cash provided by operating activities for the year ended March 31, 2018 was $530 million as compared to $495 million for the year ended October 31, 2016. The increase of $35 million was driven by an increase in net income of $128 million, partially offset by decreases in adjustments to net income of $89 million and decreases in net cash from movements in working capital of $4 million. Net cash provided by operating activities for the year ended October 31, 2016 was $495 million as compared to $100 million for the year ended October 31, 2015. The increase of $395 million was driven by an increase in net income of $109 million and adjustments to net income of $19 million, as well as net cash increases from movements in working capital of $267 million. Investing Cash Flow Net cash used in investing activities for the year ended March 31, 2018 was $34 million as compared to $21 million during the year ended October 31, 2016. This increase of $13 million in cash used in investing activities was driven by higher purchases of property and equipment and higher payments for outsourcing contract costs. Net cash used in investing activities for the year ended October 31, 2016 was $21 million as compared to $18 million during the year ended October 31, 2015. This increase of $3 million in cash used in investing activities was primarily driven by higher purchases of property and equipment. Financing Cash Flow Net cash used in financing activities for the year ended March 31, 2018 was $496 million as compared to $474 million during the year ended October 31, 2016. The increase was due to higher cash transfers to Parent, which are mainly associated with higher cash provided by operating activities. Net cash used in financing activities for the year ended October 31, 2016 was $474 million as compared to $82 million during the year ended October 31, 2015. The increase was primarily due to higher cash transfers to Parent, which are mainly associated with higher cash provided by operating activities. Off-Balance Sheet Arrangements We are party to a receivables sales arrangement with off-balance sheet risk. See Note 3 - "Sales of Receivables" to the Combined Financial Statements for information about our receivables sales arrangement. Contractual Obligations Our contractual obligations as of March 31, 2018 were as follows: The amounts reported above do not reflect the obligations of Perspecta following the completion of the Spin-Off and Mergers on May 31, 2018, including the Credit Facilities, MARPA Facility or EDS Notes. See “Liquidity and Capital Resources - Liquidity Following the Spin-Off and the Mergers,” “Description of Material Indebtedness" and “Risk Factors - Risks Relating to Our Business - We have substantial indebtedness following the Spin-Off and Mergers, and have the ability to incur significant additional indebtedness, which could adversely affect our business, financial condition and results of operations.” above for more information. Critical Accounting Policies and Estimates The preparation of combined 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. In some cases, changes in the accounting estimates are reasonably likely to occur from period to period. 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, acquisition accounting and income taxes. Revenue Recognition General We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or services are rendered, the sales price or fee is fixed or determinable, and collectability is reasonably assured. We limit the amount of revenue recognized for delivered elements to the amount that is not contingent on the future delivery of products or services, future performance obligations or subject to customer-specified refund or return rights. In instances when revenue is derived from sales of third-party vendor products or services, we record revenue on a gross basis when we are a principal to the transaction and on a net basis when we are acting as an agent between the customer and the vendor. We consider several factors to determine whether we are acting as a principal or an agent, most notably whether we are the primary obligor to the customer, have established our own pricing and have inventory and credit risks. Multiple Element Arrangements When a sales arrangement contains multiple elements or deliverables, such as hardware and software products, and/or services, we allocate revenue to each element based on a selling price hierarchy. The selling price for a deliverable is based on its vendor specific objective evidence (“VSOE”) of selling price, if available, third-party evidence (“TPE”) if VSOE of selling price is not available, or estimated selling price (“ESP”) if neither VSOE of selling price nor TPE is available. We establish VSOE of selling price using the price charged for a deliverable when sold separately and, in rare instances, using the price established by management having the relevant authority. We establish TPE of selling price by evaluating largely similar and interchangeable competitor products or services in standalone sales to similarly situated customers. We establish ESP based on management judgment considering internal factors such as margin objectives, pricing practices and controls, customer segment pricing strategies and the product life-cycle. Consideration is also given to market conditions such as competitor pricing strategies and technology industry life cycles. In most arrangements with multiple elements, we allocate the transaction price to the individual units of accounting at inception of the arrangement based on their relative selling price. We evaluate each deliverable in an arrangement to determine whether it represents a separate unit of accounting. A deliverable constitutes a separate unit of accounting when it has standalone value to the customer. For elements with no standalone value, we recognize revenue consistent with the pattern of the undelivered elements. If the arrangement includes a customer-negotiated refund or return right or other contingency relative to the delivered items, and the delivery and performance of the undelivered items is considered probable and substantially within our control, the delivered element constitutes a separate unit of accounting. In arrangements with combined units of accounting, changes in the allocation of the transaction price among elements may impact the timing of revenue recognition for the contract but will not change the total revenue recognized for the contract. Services Revenue We recognize revenue from certain fixed-price contracts, such as consulting arrangements, as work progresses over the contract period on a proportional performance basis, as determined by the percentage of labor costs incurred to date compared to the total estimated labor costs of a contract. We recognize revenue on fixed-price contracts for design and build projects (to design, develop and construct software infrastructure and systems) using the percentage-of-completion method. We use the cost-to-cost method to measure progress toward completion as determined by the percentage of cost incurred to date compared to the total estimated costs of the project. Estimates of total project costs for fixed-price contracts are regularly revised during the life of a contract. Provisions for estimated losses on fixed-priced contracts are recognized in the period when such losses become known. If reasonable and reliable cost estimates for a project cannot be made, we use the completed contract method and recognize revenue and costs upon service completion. For time and material contracts, we recognize revenue as services are rendered and recognize costs as they are incurred. We generally recognize outsourcing services revenue in the period when the service is provided and the amount earned is not contingent on the occurrence of any future event. We recognize revenue using an objective measure of output for unit-priced contracts. Revenue for fixed-price outsourcing contracts with periodic billings is recognized on a straight-line basis if the service is provided evenly during the contract term. Provisions for estimated losses on outsourcing arrangements are recognized in the period when such losses become probable and estimable. Product Revenue For hardware and software products, we recognize revenue generated from direct sales to end customers when the relevant revenue recognition criteria are satisfied. Product revenue was not material in any of the periods presented, except for fiscal 2016 when product revenue was approximately 13% of revenue, with a related margin of approximately 16%, primarily as a result of a large product sale on a contract that did not occur in any other period. Acquisition Accounting When we acquire a controlling financial interest through a business combination, we use the acquisition method of accounting to allocate the purchase consideration to the assets acquired and liabilities assumed, which are recorded at fair value. Any excess of purchase consideration over the fair value of the assets acquired and liabilities assumed is recognized as goodwill. Acquisition-related costs are recognized separately from the business combination and are expensed as incurred. The results of operations of acquired businesses are included in the combined financial statements from the acquisition date. The goodwill impairment test initially involves the assessment of qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. We test goodwill for impairment on an annual basis, as of the first day of the second fiscal quarter, and between annual tests if circumstances change, or if an event occurs, that would more likely than not reduce the fair value of a reporting unit below its carrying amount. A significant amount of judgment is involved in determining whether an event indicating impairment has occurred between annual testing dates. Such indicators include the loss of significant business, significant reductions in U.S. government appropriations or other significant adverse changes in industry or market conditions. Income Taxes On December 22, 2017, the President of the United States signed into law comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (the “Tax Act”). The Tax Act makes significant changes to the Internal Revenue Code of 1986 with varying effective dates. The Tax Act reduces the maximum corporate income tax rate to 21% effective as of January 1, 2018, broadens the tax base, creates a new limitation on the deductibility of interest expense, limits the deductibility of certain executive compensation, and allows for immediate capital expensing of certain qualified property. As a fiscal year taxpayer, the Company will not be subject to many of the tax law provisions until fiscal year 2019; however, GAAP principles require companies to revalue their deferred tax assets and liabilities with resulting tax effects accounted for in the reporting period of enactment including retroactive effects. Section 15 of the Code stipulates that USPS’s fiscal year ending March 31, 2018, will have an estimated blended corporate U.S. federal income tax rate of 31.5%, which is based on the applicable tax rates before and after the effective date of the Tax Act and the number of days in the Company’s federal tax year ending on October 31, 2017. Also, the SEC staff issued Staff Accounting Bulletin 118 (“SAB 118”), which provides guidance on accounting for the tax effects of the Tax Act. SAB 118 provides a measurement period that should not extend beyond one year from the Tax Act enactment date for companies to complete the accounting under Accounting Standards Codification 740 (“ASC 740”). In accordance with SAB 118, a company must reflect the income tax effects of those aspects of the Tax Act for which the accounting under ASC 740 is complete. To the extent that a company’s accounting for certain income tax effects of the Tax Act is incomplete but it is able to determine a reasonable estimate, it must record a provisional estimate in the financial statements. If a company cannot determine a provisional estimate to be included in the financial statements, it should continue to apply ASC 740 on the basis of the provisions of the tax laws that were in effect immediately before the enactment of the Tax Act. We have quantified the impact of the Tax Act on the Combined Financial Statements. Our operations have historically been included in the tax returns filed by the respective Parent entities of which our businesses have been a part. Income tax expense and other income tax related information contained in the Combined Financial Statements included elsewhere in this Annual Report on Form 10-K are presented on a separate return basis as if USPS filed its own tax returns. The separate return method applies the accounting guidance for income taxes to the standalone financial statements as if we were a separate taxpayer and a standalone enterprise for the periods presented. Current income tax liabilities are assumed to be settled with Parent on the last day of the reporting period and are relieved through the Parent investment account and the net transfers from Parent in the Combined Statements of Cash Flows. We recognize deferred tax assets and liabilities for the expected tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts using enacted tax rates in effect for the year the differences are expected to reverse. We record a valuation allowance to reduce the deferred tax assets to the amount that is more likely than not to be realized. We record accruals for uncertain tax positions in accordance with ASC 740 on the basis of a two-step process in which (1) we determine whether it is more likely than not that the tax positions will be sustained on the basis of the technical merits of the position and (2) for those tax positions that meet the more likely than not recognition threshold, we recognize the largest amount of tax benefit that is more than 50 percent likely to be realized upon ultimate settlement with the related tax authority. We make adjustments to these accruals when facts and circumstances change, such as the closing of a tax audit or the refinement of an estimate. The provision for income taxes includes the effects of adjustments for uncertain tax positions, as well as any related interest and penalties.
0.066578
0.066725
0
<s>[INST] The statements in this discussion regarding industry outlook, expectations regarding our future performance, liquidity and capital resources and other nonhistorical statements are forwardlooking statements. These forwardlooking statements are subject to numerous risks and uncertainties, including, but not limited to, the risks and uncertainties described in “Risk Factors” and “Cautionary Statement Regarding ForwardLooking Statements.” Actual results may differ materially from those contained in any forwardlooking statements. The Combined Financial Statements, discussed below, reflect our financial condition, results of operations, and cash flows. The financial information discussed below and included in this document, however, may not necessarily reflect what our financial condition, results of operations, or cash flows would have been had we been operated as a separate, independent entity during the periods presented, or what our financial condition, results of operations, and cash flows may be in the future. Overview We are a leading provider of endtoend enterprise IT services to government customers across U.S. federal, state and local markets. Using our marketleading enterprise offerings and solutions, we help our government customers implement modern collaborative workplaces, hybrid cloud platforms and integrated digital systems of engagement with their enterprise management systems. By delivering these modern enterprise solutions, often while ensuring interoperability with mission critical legacy systems, we believe we have helped our government customers better realize the benefits of technology, which will ultimately enable them to fulfill their mission objectives and achieve business outcomes. In addition to providing substantial benefits through increased efficiencies and capabilities, we believe demand for our services is also driven by the technological advances that already reinvented commercial industries, which are now exerting a similar evolutionary effect on government customers. In response to these pressures, we believe modern government customers are increasingly turning to outside partners, such as Perspecta, to help guide them through this digital transformation. We believe our breadth of contracts and customers in the U.S. government, and our longstanding history of having partnered with our public sector customers for more than 50 years, provides us with a competitive advantage. For example, we have existing contracts with a range of public sector entities ranging from the VA, to the United States Postal Service, NASA, the FDA and the large state and local government customers such as the county of San Diego, California. Based on this breadth of experience and our expertise, we believe we are well positioned to help its U.S. government customers continue our ongoing digital transformation journey, all the while addressing real business needs. Basis of Presentation The Combined Financial Statements included in this Annual Report on Form 10K have been derived from the Consolidated Financial Statements and accounting records of Parent, as if USPS operated on a standalone basis during the periods presented, and were prepared in accordance with GAAP. USPS historically reported its results based on a fiscal year ending on October 31 and upon the formation of DXC, USPS began reporting its results based on a fiscal year ended March 31. The combined financial statements of USPS for the annual periods ending October 31, 2015 and 2016, for the fivemonth period ended March 31, 2017 do not give effect to purchase price allocation adjustments associated with the HPES Merger. These adjustments are reflected in the successor period results for USPS for the annual period ending March 31, 2018, therefore, successor period results for USPS are not comparable to predecessor period results. The Combined Statements of Operations reflect allocations of general corporate expenses from Parent including, but not limited to, executive management, finance, legal, IT, employee benefits administration, treasury, risk management, procurement and other shared services. These allocations were made on a direct usage basis when identifiable, with the remainder allocated on the basis of revenue, expenses, headcount or other relevant measures. We consider these allocations to be a reasonable reflection of the utilization of services by, or the benefits provided to, USPS. The allocations may not, however, reflect the expense USPS would have incurred as a standalone company for the periods presented. Actual costs that may have been incurred if we had been a standalone company would depend on a number of factors, including the chosen organizational structure, what functions were outsourced or performed by employees and strategic decisions made in areas such as IT and infrastructure. The Com [/INST] Positive. </s>
2,018
9,723
1,724,670
Perspecta Inc.
2019-06-06
2019-03-31
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis is intended to help investors understand our business, financial condition, results of operations, liquidity and capital resources. You should read this discussion in conjunction with the financial statements and related notes included elsewhere in this document. The statements in this discussion regarding industry outlook, expectations regarding our future performance, liquidity and capital resources and other non-historical statements are forward-looking statements. These forward-looking statements are subject to numerous risks and uncertainties, including, but not limited to, the risks and uncertainties described in “Risk Factors” and “Cautionary Statement Regarding Forward-Looking Statements.” Actual results may differ materially from those contained in any forward-looking statements. The financial information, discussed below, reflects our financial condition, results of operations, and cash flows. The financial information discussed below and included in this document, however, may not necessarily reflect what our financial condition, results of operations, or cash flows would have been had we been operated as a separate, independent entity during the periods presented, or what our financial condition, results of operations, and cash flows may be in the future. Overview We are a leading provider of end-to-end enterprise IT services to government customers across U.S. federal, state and local markets. Using our market-leading enterprise offerings and solutions, we help our government customers implement modern collaborative workplaces, hybrid cloud platforms and integrated digital systems of engagement with their enterprise management systems. By delivering these modern enterprise solutions, often while ensuring interoperability with mission critical legacy systems, we believe we have helped our government customers better realize the benefits of technology, which will ultimately enable them to fulfill their mission objectives and achieve their desired business outcomes. In addition to providing substantial benefits through increased efficiencies and capabilities, we believe demand for our services is also driven by the technological advances that already reinvented commercial industries, which are now exerting a similar evolutionary effect on government customers. In response to these pressures, we believe government customers are increasingly turning to outside partners, such as Perspecta, to help guide them through this digital transformation. We believe our breadth of contracts and customers in the U.S. government, and our longstanding history of having partnered with our public sector customers for more than 50 years via our legacy companies, provides us with a competitive advantage. For example, we have existing contracts with a range of public sector entities ranging from the VA, to the U.S. Postal Service, National Aeronautics and Space Administration, the U.S. Food and Drug Administration and large state and local government customers such as the county of San Diego, California. Based on this breadth of experience and our expertise, we believe we are well positioned to help our U.S. government customers continue their ongoing digital transformation journey. Perspecta was formed on May 31, 2018, when DXC completed the Spin-Off and Mergers. Following the completion of the Spin-Off and Mergers, Perspecta, a Nevada corporation, became a publicly traded company. Perspecta’s common stock began trading under the ticker symbol “PRSP” on the New York Stock Exchange on June 1, 2018. The financial results of Perspecta prior to May 31, 2018, are based upon the historical results of USPS and do not give effect to the Mergers. See Note 1 - “Overview and Summary of Significant Accounting Policies” to the financial statements for additional details. The purpose of this Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is to present information that management believes is relevant to an assessment and understanding of Perspecta’s results of operations and cash flows for the year ended March 31, 2019. This MD&A is provided as a supplement to, and should be read in conjunction with, our financial statements and accompanying notes, as well as the other information included in this Annual Report on Form 10-K and our other public filings. Segments and Services Our reportable segments are (1) Defense and Intelligence, which provides services to the DoD, intelligence community, branches of the U.S. Armed Forces, and other DoD agencies, and (2) Civilian and Health Care, which provides services to the DHS, DOJ, HHS, as well as other federal civilian and state and local government agencies. Segment information is included in Note 19 - “Segment Information” to the financial statements. For a discussion of risks associated with our operations, see Part I, Item 1A “Risk Factors.” Factors and Trends Affecting our Results of Operations Revenue Generation Revenue is generated by providing services on a variety of contract types which vary in duration from as little as six months to more than ten years. Factors affecting revenue include, among others, our ability to successfully: • bid on and win new contract awards; • satisfy existing customers, obtain add-on business, and win contract re-competes; • compete on services offered, delivery models offered, technical ability and innovation, quality, flexibility, experience, and results created; and • identify and integrate acquisitions and leverage them to generate new revenue. Earnings are impacted by the above revenue factors and, among others, our ability to: • integrate acquisitions and eliminate redundant costs; • control costs, particularly labor costs, subcontractor expenses, and overhead costs including health care, pension and general and administrative costs; • anticipate talent needs to avoid staff shortages or excesses; and • accurately estimate various factors incorporated in contract bids and proposals. Competitive Markets We believe that we are well positioned to take advantage of the markets in which we operate because of our expertise in providing information technology services to public sector customers. Our ability to effectively manage project engagements, including logistics, client requirements, engineering resources and service levels, will affect our financial performance. Increased competition from other government contractors and market entrants seeking to take advantage of certain industry trends may result in the emergence of companies that are better able to compete against us. Regulations Increased audit, review, investigation and general scrutiny by U.S. government agencies of government contractors’ performance under U.S. government contracts and compliance with the terms of those contracts and applicable laws could affect our operating results. Negative publicity and increased scrutiny of government contractors in general, including us, relating to U.S. government expenditures for contractor services; incidents involving the mishandling of sensitive or classified information; and the increasingly complex requirements of the DoD and the intelligence community, including those related to cybersecurity, management of federal health care cost growth, and focus on reforming existing government regulation of various sectors of the economy, such as financial regulation and health care, could impact our ability to perform in the marketplace. Seasonality The U.S. federal government’s fiscal year ends on September 30. It is not uncommon for U.S. federal government agencies to award extra tasks or complete other contract actions in the weeks leading up to the end of its fiscal year in order to avoid the loss of unexpended fiscal year funds. We have generally experienced increased bid and proposal costs in the months leading up to the U.S. federal government’s fiscal year end as we pursue new contract opportunities being awarded shortly before the U.S. federal government fiscal year end. We also experience some seasonality effects from the timing of the fiscal year end close for state and local governments, which in many instances are different than the U.S. federal government fiscal year end. In general, we tend to experience an increase in revenue in the first half of the calendar year from our state and local government customers as that is when funds are generally allocated to specific projects. Finally, we also tend to generate less revenue and profit from our labor services during the three months ending December 31, as a result of increased employee vacations during the holiday season. Cash Flows Cash flows are affected by the above earnings factors and, in addition, by the following factors: • the ability to efficiently manage capital resources and expenditures; • timely management of receivables and payables; • investment opportunities available, particularly related to business acquisitions and implementations, dispositions and large outsourcing contracts; and • tax obligations. Economic and Industry Factors Our results of operations are impacted by general economic conditions including macroeconomic conditions. We are monitoring current macroeconomic and credit market conditions and levels of business confidence and their potential effect on our customers and on us. A severe and/or prolonged economic downturn could adversely affect our customers’ financial condition and the levels of business activities in the industries and geographies in which we operate. Such a downturn may reduce demand for our services or depress pricing of those services and have a material adverse effect on our new contract bookings and results of operations. Particularly in light of recent economic uncertainty, we continue to monitor costs closely in order to respond to changing conditions and to manage any impact to our results of operations. Our results of operations are also affected by the evolving priorities of the U.S. federal government, as well as by the pace of technological change and the type and level of technology spending by our customers. The ability to identify and capitalize on these markets and technological changes early in their cycles is a key driver of our performance. Revenue is driven by our ability to secure new contracts and to deliver solutions and services that add value to our customers. Our ability to add value for customers, and therefore generate revenue, depends in part on our ability to deliver market-leading service offerings and to deploy skilled teams of professionals quickly across all government industries and domains. Our market is highly competitive and has characteristics unique to the federal contracting environment. Almost all of our U.S. federal government contracts and subcontracts may be modified, curtailed, or terminated either at the convenience of the government or for default based on factors set forth in the FAR. Upon termination for convenience of a fixed-price type contract, our U.S. federal government contracts normally entitle us to receive the purchase price for delivered items, reimbursement for contractual commitments and allowable costs for work- in-process, and a reasonable allowance for profit, although there can also be financial impact resulting from the negotiated contract settlement. Upon termination for convenience of a U.S. federal government cost reimbursable or time and material contract, we are normally entitled to reimbursement of allowable costs plus a fee. Allowable costs generally include the cost to terminate agreements with suppliers and subcontractors. The amount of the fee recovered, if any, generally is related to the portion of the work completed prior to termination and is determined by negotiation. See Part I, Item 1A “Risk Factors.” If contracts are lost through the competitive bid process, our operating results may differ materially and adversely from those anticipated. Finally, shifting U.S. federal government priorities can also impact the future of projects. Management monitors U.S. federal government priorities and industry factors through numerous industry and government publications and forecasts, legislative activity, budgeting and appropriation processes, and by participating in industry professional associations in order to anticipate these shifting priorities. Backlog Since our adoption of Accounting Standards Update 2014-09, Revenue from Contracts with Customers (Topic 606), on April 1, 2018, revenue from remaining unsatisfied performance obligations is now calculated as the dollar value of our remaining performance obligations on executed contracts. As of March 31, 2019, approximately $3.6 billion of revenue is expected to be recognized from remaining performance obligations. The Company expects to recognize approximately 67% of these remaining performance obligations as revenue within one year and approximately 79% within two years, with the remainder recognized thereafter. Total contract value (“TCV”) backlog is our estimate of the remaining revenue from existing signed contracts, assuming the exercise of all options relating to such contracts and including executed task orders issued under ID/IQ contracts. TCV backlog can include award fees, incentive fees, or other variable consideration estimated at the most likely amount to which the Company is expected to be entitled to the extent that it is probable that a significant reversal of cumulative revenue recognized will not occur. TCV backlog includes both funded and unfunded future revenue under government contracts. We define funded backlog as estimated future revenue under government contracts and task orders for which funding has been appropriated by Congress and authorized for expenditure by the applicable agency. Funded backlog does not include the full potential value of the Company’s contracts because Congress often appropriates funds to be used by an agency for a particular program of a contract on a yearly or quarterly basis even though the contract may call for performance over a number of years. As a result, contracts typically are only partially funded at any point during their term, and all or some of the work to be performed under the contracts may remain unfunded unless and until Congress makes subsequent appropriation and the procuring agency allocates funding to the contract. A variety of circumstances or events may cause changes in the amount of our TCV backlog and funded backlog, including the execution of new contracts, the extension of existing contracts, the non-renewal or completion of current contracts, the early termination of contracts, and adjustment to estimates for previously included contracts. Changes in the amount of our funded backlog also are affected by the funding cycles of the government. The estimated value of our TCV backlog as of March 31, 2019 was as follows: Results of Operations Fiscal Year 2019 Highlights Financial highlights for the fiscal year ended March 31, 2019 include the following: • Revenue was $4.0 billion. • Net income was $72 million, including the cumulative impact of certain items of $281 million, reflecting restructuring costs of $10 million, transaction, separation and integration-related costs of $106 million and amortization of acquired intangible assets of $165 million. • We generated $462 million of cash from operations. Revenue Our total revenue for the year ended March 31, 2019 was $4.0 billion, an increase of $1.2 billion as compared to revenue for the year ended March 31, 2018. The revenue growth is primarily driven by $1.3 billion attributed to the revenue acquired in the Mergers, new contracts and increased scope on existing contracts, partially offset by decreases in contract scope and contract completions. Our total revenue for the year ended March 31, 2018 was $2.8 billion, an increase of $87 million as compared to revenue for the year ended October 31, 2016. The results for the year were primarily impacted by an increase of $79 million in revenue from new business and $63 million associated with increases in ongoing business in addition to the exclusion of certain USPS consulting activities that were historically conducted pursuant to contracts held by HPE, rather than USPS or its subsidiaries. Because those contracts were not novated to USPS until after October 31, 2016, no information regarding USPS consulting activities performed pursuant to those contracts has been presented in USPS’s results of operations for the year ended October 31, 2016. These increases were offset by contracts that concluded or were renewed at a lower rate in 2018 as compared to the year ended October 31, 2016 and by $133 million in revenue recognized in the year ended October 31, 2016 associated with a major contract renegotiation. Revenue for the years ended March 31, 2019 and March 31, 2018, five months ended March 31, 2017 and the year ended October 31, 2016 were as follows: Defense and Intelligence Segment Our Defense and Intelligence segment revenue during the year ended March 31, 2019 was $2.6 billion, or 64% of our total revenue for the period, and represented an increase of $1.2 billion or 83% as compared to the prior year. The revenue growth is primarily driven by $1.2 billion attributed to the revenue acquired in the Mergers, growth in new contracts and increases in scope on existing contracts across multiple programs, partially offset by a net decrease related to the divestiture of a contract due to organizational conflict of interest, decreases in scope on certain contracts and contract completions. Our Defense and Intelligence segment revenue during the year ended March 31, 2018 was $1.4 billion, or 50% of our total revenue for the period, and represented an increase of $263 million or 23% as compared to the year ended October 31, 2016. The increase was primarily due to an increase in revenue from new business and increases in ongoing business, in addition to the exclusion of certain USPS consulting activities in the prior period, as mentioned above. For the year ended March 31, 2019, Defense and Intelligence segment contract awards were $4.7 billion. Civilian and Health Care Segment Our Civilian and Health Care segment revenue during the year ended March 31, 2019 was $1.4 billion, or 36% of our total revenue for the period, and represented an increase of $40 million or 3% as compared to the prior year. The revenue growth is primarily driven by $62 million attributed to the revenue acquired in the Mergers, new contracts and increased scope on existing contracts, partially offset by decreases in contract scope and contract completions. Our Civilian and Health Care segment revenue during the year ended March 31, 2018 was $1.4 billion, or 50% of our total revenue for the period, and represented a decrease of $176 million or 11% as compared to the year ended October 31, 2016. The decrease was primarily due to contracts that concluded or were renewed at a lower rate in 2018 as to the year ended October 31, 2016, and revenue recognized in the year ended October 31, 2016 associated with a major contract renegotiation. For the year ended March 31, 2019, Civilian and Health Care segment contract awards were $2.1 billion. Costs and Expenses for Years Ended March 31, 2019 and March 31, 2018 Costs of services Costs of services for the year ended March 31, 2019 were $3.0 billion and increased by $888 million as compared to cost of services for the year ended March 31, 2018. Costs of services as a percentage of revenue was 76% for the year ended March 31, 2019, as compared to 76% for the same period of the prior year due to continued focus on cost discipline and program management on our fixed-price portfolio. We expect that over the long-term, contract mix will continue to move in the direction of fixed price. Costs of services for the year ended March 31, 2018 were $2.2 billion and increased by $69 million as compared to cost of services for the year ended October 31, 2016. The increase is due to increases in new and ongoing business in addition to the exclusion of certain USPS consulting activities that were historically conducted pursuant to contracts held by HPE, rather than USPS or its subsidiaries. Because those contracts were not novated to USPS until after October 31, 2016, no information regarding USPS consulting activities performed pursuant to those contracts has been presented in USPS’s results of operations for the year ended October 31, 2016. These increases were offset by USPS’s implementation of certain strategic measures to improve efficiencies across multiple clients and programs and the 2016 major contract renegotiation. Selling, general and administrative Selling, general and administrative expenses for the year ended March 31, 2019 was $300 million and increased by $118 million as compared to the year ended March 31, 2018. Selling, general and administrative expenses as a percentage of revenue was 7% for the year ended March 31, 2019, as compared to 6% for the comparable periods of the prior year. Selling, general and administrative expenses for the year ended March 31, 2018 was $182 million and decreased by $25 million as compared to the year ended October 31, 2016. The decrease was largely driven by efficiencies gained as a result of USPS’s implementation of certain strategic measures to improve efficiencies in an effort to reduce expenses. Depreciation and amortization Depreciation and amortization for the year ended March 31, 2019 was $330 million and represented 8% of revenue, an increase, on a percentage of revenue basis, from the year ended March 31, 2018, which was largely driven by the Merger resulting in an increase of $96 million of amortization related to acquired intangible assets. Depreciation and amortization for the year ended March 31, 2018 was $167 million and represented 6% of revenue, a decrease, on a percentage of revenue basis, from the year ended October 31, 2016, which was largely driven by reductions in property and equipment balances in the period associated with acquisition accounting. Separation and integration-related costs Separation and integration-related costs for the year ended March 31, 2019 were $106 million and represented 3% of revenue. Separation and integration-related costs were associated with expenses incurred in connection with the Spin-Off and Mergers. Separation and integration-related costs for the year ended March 31, 2018 were $90 million and represented 3% of revenue. Separation and integration-related costs of $42 million and $48 million were associated with expenses incurred in connection with the strategic combination of CSC with the HPE Enterprise Services business (“HPES”) to form DXC (“HPES Merger”) and the Spin-Off and Mergers, respectively. Interest expense, net Interest expense, net for the year ended March 31, 2019 was $121 million, an increase of $109 million as compared to the year ended March 31, 2018, primarily due to the Credit Facilities (as defined in Note 12 - “Debt” to the financial statements), resulting in total indebtedness of approximately $2.4 billion as of March 31, 2019. Interest expense, net for the year ended March 31, 2018 was $12 million and relates to interest associated with capital lease obligations. Interest expense for the year decreased by $19 million as compared to the year ended October 31, 2016, primarily due to reductions in capital lease balances in the period. Other expense, net Other expense, net comprises certain components of the net periodic pension cost for defined benefit pension plans, equity earnings of unconsolidated affiliates and other miscellaneous gains and losses. The $8 million increase in other expense, net for the year ended March 31, 2019 as compared to the prior year was primarily due to a pension remeasurement charge of $35 million in the fourth quarter, partially offset by the $24 million gain on the May 2018 sale of a contract to eliminate a potential organizational conflict of interest that resulted from the Mergers. Income tax expense (benefit) Our effective tax rate (“ETR”) on income for the year ended March 31, 2019 was 36%. In fiscal year 2019, the ETR was primarily impacted by discrete items including the revaluation of our state deferred taxes, the posting of a valuation allowance on our Virginia state tax deferred items, and non-deductible transaction costs. Our ETR on income for the year ended March 31, 2018 was (5)%. In fiscal year 2018, the ETR was primarily impacted by the U.S. tax reform legislation enacted in December 2017. 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 15 - “Income Taxes” to the financial statements. Costs and Expenses for Five Months Ended March 31, 2017 and Year Ended October 31, 2016 Costs of services Costs of services for the five months ended March 31, 2017 was $820 million and represented 76% of revenue, which was the same, on a percentage of revenue basis, as the year ended October 31, 2016. Selling, general and administrative Selling, general and administrative expenses for the five months ended March 31, 2017 were $77 million and represented 7% of revenue, a 1% decrease, on a percentage of revenue basis, from the year ended October 31, 2016. Depreciation and amortization Depreciation and amortization for the five months ended March 31, 2017 was $73 million and represented 7% of revenue, a 1% decrease, on a percentage of revenue basis, from the year ended October 31, 2016, which was largely driven by reductions in property and equipment balances in the period. Separation costs Separation costs for the five months ended March 31, 2017 were $34 million and represented 3% of revenue. Separation costs were associated with expenses incurred in connection with the HPES Merger. Separation costs for the year ended October 31, 2016 were $34 million and mainly related to the separation of HPE from HPI in early 2016. Interest expense, net Interest expense, net for the five months ended March 31, 2017 was $10 million or 1% of revenue, which was the same, on a percentage of revenue basis, as the year ended October 31, 2016. Interest expense relates to interest associated with capital lease obligations. Liquidity and Capital Resources Following the Spin-Off and Mergers, existing cash and cash equivalents and cash generated by operations continue to be our primary sources of liquidity, as well as available borrowings under our Revolving Credit Facility (as defined in Note 12 - “Debt” to the financial statements) and sales of receivables under a U.S. federal government obligor receivables purchase facility established pursuant to a Master Accounts Receivable Purchase Agreement, dated July 14, 2017, by and among PES LLC, our wholly-owned subsidiary, and certain financial institutions (the MARPA Facility). Our primary cash needs will continue to be for working capital, capital expenditures and other discretionary investments, as well as to service our outstanding indebtedness, including borrowings under our Credit Facilities; however, our capital structure and liquidity profile have changed because we are no longer a part of DXC. Our ability to fund our future operating needs depends, in part, on our ability to continue to generate positive cash flows from operations and, if necessary, raise cash in the capital markets. Based upon our history of generating strong cash flows, it is our belief that we will be able to meet our short-term liquidity and cash needs, including debt servicing, through the combination of cash flows from operating activities, available cash balances, available borrowings under our Revolving Credit Facility and sales of receivables under our MARPA Facility. If these sources of liquidity need to be augmented, additional cash requirements would likely be financed through the issuance of debt or equity securities, although there can be no assurance that we will able to obtain such financing on acceptable terms (or at all) in the future. Upon completion of the Spin-Off on May 31, 2018, we (i) closed on financing of an aggregate of $2.0 billion under our Term Loan A Facilities and $500 million under our the Term Loan B Facility, net of $34 million of debt issuance costs, and (ii) drew $50 million in borrowings under our Revolving Credit Facility, net of $9 million of debt issuance costs. Proceeds were used by Perspecta to pay a distribution of approximately $984 million in cash to DXC and to pay transaction costs associated with the Spin-Off and Mergers. Proceeds also funded the $400 million cash consideration paid to Veritas Capital for the Mergers and approximately $1.0 billion repayment of existing Vencore debt. In July 2017, the Financial Conduct Authority (the authority that regulates the London Interbank Offered Rate, or “LIBOR”) announced it intends to stop compelling banks to submit rates for the calculation of LIBOR after 2021. The Alternative Reference Rates Committee (“ARRC”) has proposed that the Secured Overnight Financing Rate (“SOFR”) is the rate that represents best practice as the alternative to USD-LIBOR for use in derivatives and other financial contracts that are currently indexed to USD-LIBOR. ARRC has proposed a paced market transition plan to SOFR from USD-LIBOR and organizations are currently working on industry wide and company specific transition plans as it relates to derivatives and cash markets exposed to USD-LIBOR. The Company has material contracts that are indexed to USD-LIBOR and is monitoring this activity and evaluating the related risks. 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 when transition and transformation costs are incurred. The recovery of these investments is over the life of the contract and is dependent upon our performance as well as customer acceptance. See Note 20 - “Commitments and Contingencies” to the financial statements for discussion of general purpose of guarantees and commitments. The anticipated sources of funds to fulfill such commitments are listed below: Cash and Cash Equivalents and Cash Flows Prior to the Spin-Off and Mergers we reflected transfers of cash to and from Parent’s cash management system as a component of Parent company investment on the balance sheet. The following table summarizes our cash flow activity: Operating Cash Flow Net cash provided by operating activities for the year ended March 31, 2019 was $462 million, as compared to $530 million for the year ended March 31, 2018. The decrease of $68 million included decreases in net cash of $134 million from movements in working capital assets and liabilities, partially offset by a $66 million increase in net income adjusted for non-cash items. Net cash provided by operating activities for the year ended March 31, 2018 was $530 million, as compared to $495 million for the year ended October 31, 2016. The increase of $35 million was driven by an increase in net income of $128 million, partially offset by decreases in adjustments to net income of $89 million and decreases in net cash from movements in working capital of $4 million. Investing Cash Flow Net cash used in investing activities for the year ended March 31, 2019 was $1.3 billion, as compared to $34 million during the year ended March 31, 2018. The increase of $1.3 billion was predominantly due to acquisitions of $312 million and payments of acquired debt of $994 million in the year ended March 31, 2019, as compared to no cash paid for acquisitions or acquired debt in the comparable period of the prior fiscal year. Net cash used in investing activities for the year ended March 31, 2018 was $34 million, as compared to $21 million during the year ended October 31, 2016. This increase of $13 million in cash used in investing activities was driven by higher purchases of property and equipment and higher payments for outsourcing contract costs. Financing Cash Flow Net cash provided by financing activities for the year ended March 31, 2019 was $955 million, as compared to net cash used in financing activities of $496 million during the year ended March 31, 2018. The increase in cash provided by financing activities of $1.5 billion was primarily due to issuance of long-term debt of $2.5 billion in connection with the Spin-Off and Mergers, partially offset by net transfers to Parent prior to the Spin-Off. Net cash used in financing activities for the year ended March 31, 2018 was $496 million, as compared to $474 million during the year ended October 31, 2016. The increase was due to higher cash transfers to Parent, which are mainly associated with higher cash provided by operating activities. Capital Resources The following table summarizes our total debt: The $2.4 billion increase in total debt as of March 31, 2019, as compared to total debt as of March 31, 2018, was attributed to the Credit Facilities obtained to fund the Spin-Off and Mergers. As discussed above, on May 31, 2018, we closed on financing of approximately $2.6 billion, of which $50 million related to amounts drawn on the Revolving Credit Facility. During the year ended March 31, 2019, we repaid $220 million of debt, including $170 million in term loans, of which $104 million were voluntary repayments, and the $50 million Revolving Credit Facility balance. At March 31, 2019, our $600 million Revolving Credit Facility remains unused. We were in compliance with all financial covenants associated with our borrowings as of March 31, 2019. For more information on our debt, see Note 12 - “Debt” to the financial statements. The following table summarizes our capitalization ratios: (1) Net debt is total debt less cash and cash equivalents. 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 increase in our total capitalization as of March 31, 2019, as compared to total debt as of March 31, 2018, was primarily due to a $2.3 billion increase in net debt, partially offset by a $567 million decrease in equity, which were primarily a result of the effects of the Spin-Off and Mergers. Interest Rate Swaps We use interest rate swaps to reduce our exposure to increases in interest rates on our variable rate debt. The interest rate swaps effectively convert our floating interest rate debt into fixed interest rate debt. Each swap agreement is designated as a cash flow hedge. We pay a stream of fixed interest payments for the term of the swap, and in turn, receive variable interest payments based on one-month LIBOR. At March 31, 2019, one-month LIBOR was 2.50%. The net receipt or payment from the interest rate swap agreements is included on the statements of operations as interest expense. Beginning in 2021, there is expected to be a transition from LIBOR as an interest rate benchmark. We are currently evaluating the implications of the LIBOR transition for our swap arrangements. The following table summarizes our interest rate swaps at March 31, 2019: Share Repurchases On June 1, 2018, Perspecta’s Board of Directors authorized up to $400 million for future repurchases of outstanding shares of our common stock. Repurchases may be made at the Company’s discretion from time to time on the open market depending on market conditions. The repurchase program has no time limit, does not obligate the Company to make any repurchases and may be suspended for periods or discontinued at any time. During the fiscal year ended March 31, 2019, 2.7 million shares were purchased at an aggregate purchase price of $60 million, of which $1 million was settled subsequent to the end of the year. Dividends During the fiscal year ended March 31, 2019, the Board of Directors declared cash dividends to our stockholders of approximately $33 million in the aggregate, of which $25 million had been paid as of March 31, 2019 and $8 million of which was paid on April 16, 2019. On May 21, 2019, the Board of Directors declared a dividend of $0.06 per common share payable on July 16, 2019 to common stockholders of record at the close of business on June 5, 2019. Off-Balance Sheet Arrangements We are party to a receivables sales arrangement with off-balance sheet risk. See Note 5 - “Receivables” to the financial statements for information about our receivables sales arrangement. Contractual Obligations Our contractual obligations as of March 31, 2019 were as follows: (1) Amounts represent scheduled principal cash payments of long-term debt. (2) Amounts represent scheduled principal cash payments of capital lease obligations. (3) Includes long-term purchase and separate services agreements with DXC for the purchase of certain hardware, software, and support services as well as the provision of certain outsourced IT services and excludes agreements that are cancellable without penalty. If we cancel the purchase agreements prior to their natural expiration, we will be required to pay to DXC any required shortfall. If we cancel the services agreements for any reason other than for cause, we will have to pay DXC significant termination fees, which will vary, depending on the date and manner of termination. Purchase obligations assumed from DXC will reflect a significant increase as a result of newly executed contracts. (4) Amounts represent scheduled interest payments on long-term debt and capital lease obligations. (5) See Note 14 - “Pension and Other Benefit Plans” for the estimated liability related to estimated future benefit payments under our pension and other postretirement plans that have been omitted from this table. (6) We have excluded obligations for uncertain tax positions of $52 million, as the timing of such payments, if any, cannot be reasonably estimated. Critical Accounting Policies and Estimates The preparation of the financial statements in accordance with GAAP requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, as well as the disclosure of contingent assets and liabilities. In some cases, changes in the accounting estimates are reasonably likely to occur from period to period. 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, acquisition accounting and income taxes. Revenue Recognition The Company’s revenue from contracts with customers is derived from its primary service offerings, including technology and business solutions, systems engineering and integration, cybersecurity, applied research and big data analytics, and investigative and risk mitigation services to the U.S. government and its agencies. The Company also serves various state and local governments. The Company performs under various types of contracts, which include (1) fixed price contracts, such as firm-fixed-price (“FFP”), (2) cost reimbursable contracts such as cost-plus-fixed-fee, cost-plus-award-fee and cost-plus-incentive-fee, and (3) time-and-materials (“T&M”) contracts, including fixed-price-level-of-effort (“FP-LOE”) contracts. To determine the proper revenue recognition, the Company first evaluates whether it has a duly approved and enforceable contract with a customer, in which the rights of the parties and payment terms are identified, and collectability is probable. The Company also evaluates whether two or more contracts should be combined and accounted for as a single contract, including the task orders issued under an ID/IQ award. In addition, the Company assesses contract modifications to determine whether the changes to existing contracts should be accounted for as part of the original contract or as a separate contract. Contract modifications for the Company may relate to changes in contract specifications and requirements and do not add distinct services, and therefore are accounted for as part of the original contract. If contract modifications add distinct goods or services and increase the contract value by the stand-alone selling price, those modifications are accounted for as separate contracts. For each contract, the Company assesses if multiple promises should be accounted for as separate performance obligations or combined into a single performance obligation. The Company generally separates multiple promises in a contract as separate performance obligations if those promises are distinct, both individually and in the context of the contract. If multiple promises in a contract are highly interrelated or comprise a series of distinct services performed over time, they are combined and accounted for as a single performance obligation. The Company’s contracts with the U.S. federal government often contain options to renew existing contracts for an additional period of time (generally a year at a time) under the same terms and conditions as the original contract. The Company accounts for renewal options as separate contracts when they include distinct goods or services at stand-alone selling prices. Contracts with the U.S. federal government are generally subject to the FAR and priced on an estimated or actual costs of providing the goods or services. The FAR provides guidance on types of costs that are allowable in establishing prices for goods and services provided to the U.S. federal government and its agencies. Each contract is competitively priced and bid separately. Pricing for non-U.S. federal government agencies is based on specific negotiations with each customer. The Company excludes any taxes collected or imposed when determining the transaction price. Certain of the Company’s contracts contain award fees, incentive fees or other provisions that may either increase or decrease the transaction price. These variable amounts generally are awarded upon achievement of certain performance metrics, program milestones or cost targets and can be based upon customer discretion. The Company estimates variable consideration at the expected value amount to which it expects to be entitled based on the assessment of the contractual variable fee criteria, complexity of work and related risks, extent of customer discretion, amount of variable consideration received historically and the potential of significant reversal of revenue. The Company allocates the transaction price of a contract to its performance obligations in the proportion of such obligation’s stand-alone selling price. The stand-alone selling prices of the Company’s performance obligations are generally based on an expected cost-plus margin approach. For certain product sales, the Company uses prices from other stand-alone sales. Substantially none of the Company’s contracts contain a significant financing component that would require an adjustment to the transaction price of the contract. The Company recognizes revenue on our service contracts primarily over time as there is continuous transfer of control to the customer over the duration of the contract as the Company performs the promised services. For U.S. federal government contracts, continuous transfer of control to the customer is evidenced by clauses in the contract that allow the customer to unilaterally terminate the contract for convenience, pay for costs incurred plus a reasonable profit and take control of any work-in-process. The Company’s IT and business process outsourcing arrangements typically have a single performance obligation that are a series of distinct goods or services that are substantially the same and are provided over a period of time using the same measure of progress. Revenue derived from IT and business process outsourcing arrangements is generally comprised of a series of distinct services, and thus, is recognized over time based upon the level of services delivered in the distinct periods in which they are provided using an input method based on time increments. IT outsourcing arrangements may include nonrefundable upfront fees billed for activities to familiarize us with the client’s operations, take control over their administration and operation, and adapt them to the Company’s solutions. These activities typically do not qualify as separate performance obligations, and the related revenue is allocated to the relevant performance obligation and satisfied over time as the performance obligation is satisfied. On FFP contracts, revenue recognized over time generally uses a method that measures the extent of progress toward completion of a performance obligation, principally using a cost-input method (referred to as the cost-to-cost method). Under the cost-to-cost method, revenue is recognized based on the proportion of total cost incurred to estimated total costs at completion (“EAC”). The cost-to-cost method best depicts the Company’s performance and transferring control of services promised to the customer. A performance obligation’s EAC includes all direct costs such as materials, labor, subcontract costs, overhead, and a ratable portion of general and administrative costs. In addition, the Company includes in an EAC future losses of a performance obligation estimated to be incurred on onerous contracts, as and when known, and the most likely amount of transaction price (revenue) that the Company expects to receive for unpriced change orders (modifications). On certain other contracts, principally T&M, FP-LOE, and cost-plus-fixed-fee, revenue is recognized using the right-to-invoice practical expedient as we are contractually able to invoice the customer based on the control transferred to the customer. The Company has contracts to provide services that will be delivered under distinct and individual performance obligations. Revenue for contracts in which control of services provided does not transfer until delivery to the customer is recognized at a point in time. Acquisition Accounting When we acquire a controlling financial interest through a business combination, we use the acquisition method of accounting to allocate the purchase consideration to the assets acquired and liabilities assumed, which are recorded at fair value. Any excess of purchase consideration over the net fair value of the assets acquired and liabilities assumed is recognized as goodwill. Acquisition-related costs are recognized separately from the business combination and are expensed as incurred. The results of operations of acquired businesses are included in the combined financial statements from the acquisition date. The goodwill impairment test initially involves the assessment of qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. We test goodwill for impairment on an annual basis, as of the first day of the second fiscal quarter, and between annual tests if circumstances change, or if an event occurs, that would more likely than not reduce the fair value of a reporting unit below its carrying amount. A significant amount of judgment is involved in determining whether an event indicating impairment has occurred between annual testing dates. Such indicators include the loss of significant business, significant reductions in U.S. government appropriations or other significant adverse changes in industry or market conditions. Income Taxes On December 22, 2017, the President of the United States signed into law comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (the “Tax Act”). As a fiscal year taxpayer with an October 31 tax year-end, the Company was not subject to many of the tax law provisions until fiscal year 2019; however, GAAP principles required the Company to revalue its deferred tax assets and liabilities with resulting tax effects accounted for in the reporting period of enactment including retroactive effects during fiscal year 2018. Perspecta’s fiscal year ended March 31, 2019 contains multiple tax years, one of which began prior to the enactment of the Tax Act and ended upon the Spin-Off on May 31, 2018 and, therefore, the Company was required to blend its federal tax rate to take into account a differing applicable federal tax rate for the portion of the fiscal year preceding the Spin-Off and the portion thereafter. The Company’s net income before taxes for the fiscal year ended March 31, 2019 relating to the period prior to the Spin-Off is subject to federal tax on DXC’s tax return at an applicable federal tax rate of 23.3% under Section 15 of the Code. The Company computed a weighted federal tax rate based upon the number of days that the Company’s fiscal year would be taxed at 23.3% and the number of days that the Company’s federal tax rate was reduced to 21%. For fiscal year 2019, the Company has an estimated blended corporate U.S. federal income tax rate of approximately 21.4%. Under SEC staff issued Staff Accounting Bulletin No 118, the Company made reasonable estimates and recorded provisional amounts during the Company’s fiscal year ended March 31, 2018. The Company has not made any adjustments to the provisional amounts recorded. As of December 22, 2018, we have completed the accounting for all the impacts of the Tax Act. Parent is still in the process of calculating return to provision adjustments for USPS for tax years ending prior to the enactment of the Tax Act. The Company will recognize the return to provision adjustments in the period in which they are finalized and provided by Parent. For years ending prior to the Spin-Off and Mergers, our operations were historically included in the tax returns filed by the respective Parent entities of which our businesses have been a part. The Company’s tax balances as of the beginning of the fiscal year, as well as our tax provisions for the pre-merger period contained in the financial statements included elsewhere in this Annual Report on Form 10-K, are presented on a separate return basis as if USPS filed its own tax returns. The separate return method applies the accounting guidance for income taxes to the standalone financial statements as if we were a separate taxpayer and a standalone enterprise for the periods presented. We recognize deferred tax assets and liabilities for the expected tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts using enacted tax rates in effect for the year the differences are expected to reverse. We record a valuation allowance to reduce the deferred tax assets to the amount that is more likely than not to be realized. We record accruals for uncertain tax positions in accordance with Accounting Standards Codification Topic 740, Income Taxes, on the basis of a two-step process in which (1) we determine whether it is more likely than not that the tax positions will be sustained on the basis of the technical merits of the position and (2) for those tax positions that meet the more likely than not recognition threshold, we recognize the largest amount of tax benefit that is more than 50 percent likely to be realized upon ultimate settlement with the related tax authority. We make adjustments to these accruals when facts and circumstances change, such as the closing of a tax audit. The provision for income taxes includes the effects of adjustments for uncertain tax positions, as well as any related interest and penalties.
0.092119
0.092412
0
<s>[INST] The statements in this discussion regarding industry outlook, expectations regarding our future performance, liquidity and capital resources and other nonhistorical statements are forwardlooking statements. These forwardlooking statements are subject to numerous risks and uncertainties, including, but not limited to, the risks and uncertainties described in “Risk Factors” and “Cautionary Statement Regarding ForwardLooking Statements.” Actual results may differ materially from those contained in any forwardlooking statements. The financial information, discussed below, reflects our financial condition, results of operations, and cash flows. The financial information discussed below and included in this document, however, may not necessarily reflect what our financial condition, results of operations, or cash flows would have been had we been operated as a separate, independent entity during the periods presented, or what our financial condition, results of operations, and cash flows may be in the future. Overview We are a leading provider of endtoend enterprise IT services to government customers across U.S. federal, state and local markets. Using our marketleading enterprise offerings and solutions, we help our government customers implement modern collaborative workplaces, hybrid cloud platforms and integrated digital systems of engagement with their enterprise management systems. By delivering these modern enterprise solutions, often while ensuring interoperability with mission critical legacy systems, we believe we have helped our government customers better realize the benefits of technology, which will ultimately enable them to fulfill their mission objectives and achieve their desired business outcomes. In addition to providing substantial benefits through increased efficiencies and capabilities, we believe demand for our services is also driven by the technological advances that already reinvented commercial industries, which are now exerting a similar evolutionary effect on government customers. In response to these pressures, we believe government customers are increasingly turning to outside partners, such as Perspecta, to help guide them through this digital transformation. We believe our breadth of contracts and customers in the U.S. government, and our longstanding history of having partnered with our public sector customers for more than 50 years via our legacy companies, provides us with a competitive advantage. For example, we have existing contracts with a range of public sector entities ranging from the VA, to the U.S. Postal Service, National Aeronautics and Space Administration, the U.S. Food and Drug Administration and large state and local government customers such as the county of San Diego, California. Based on this breadth of experience and our expertise, we believe we are well positioned to help our U.S. government customers continue their ongoing digital transformation journey. Perspecta was formed on May 31, 2018, when DXC completed the SpinOff and Mergers. Following the completion of the SpinOff and Mergers, Perspecta, a Nevada corporation, became a publicly traded company. Perspecta’s common stock began trading under the ticker symbol “PRSP” on the New York Stock Exchange on June 1, 2018. The financial results of Perspecta prior to May 31, 2018, are based upon the historical results of USPS and do not give effect to the Mergers. See Note 1 “Overview and Summary of Significant Accounting Policies” to the financial statements for additional details. The purpose of this Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is to present information that management believes is relevant to an assessment and understanding of Perspecta’s results of operations and cash flows for the year ended March 31, 2019. This MD&A is provided as a supplement to, and should be read in conjunction with, our financial statements and accompanying notes, as well as the other information included in this Annual Report on Form 10K and our other public filings. Segments and Services Our reportable segments are (1) Defense and Intelligence, which provides services to the DoD, intelligence community, branches of the U.S. Armed Forces, and other DoD agencies, and (2) Civilian and Health Care, which provides services to the DHS, DOJ, HHS, as well as other federal civilian and state and local government agencies. Segment information is included in Note 19 “Segment Information” to the financial statements. For a discussion of risks associated with our operations, see Part I, Item 1A “Risk Factors.” Factors and Trends Affecting [/INST] Positive. </s>
2,019
8,097
1,227,636
Neuronetics, Inc.
2019-03-05
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 audited financial statements and related notes thereto and other financial information included elsewhere in this Annual Report on Form 10-K. In addition to historical financial information, some of the information contained in the following discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. You should review the ‘‘Risk Factors’’ section of this Annual Report on Form 10-K for a discussion of important factors that could cause our 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 commercial stage medical technology company focused on designing, developing and marketing products that improve the quality of life for patients who suffer from psychiatric disorders. Our first commercial product, the NeuroStar Advanced Therapy System, is a non-invasive and non-systemic office-based treatment that uses transcranial magnetic stimulation, or TMS, to create a pulsed, MRI-strength magnetic field that induces electrical currents designed to stimulate specific areas of the brain associated with mood. The system is cleared by the United States Food and Drug Administration, or FDA, to treat adult patients with major depressive disorder, or MDD, that have failed to achieve satisfactory improvement from prior antidepressant medication in the current MDD episode. NeuroStar Advanced Therapy is safe, clinically effective, reproducible and precise and we believe is supported by the largest clinical data set of any competing TMS system. We believe we are the market leader in TMS therapy based on our U.S. installed base of 907 active NeuroStar Advanced Therapy Systems in approximately 707 psychiatrist offices as of December 31, 2018 and the estimated 62,900 patients treated with approximately 2.3 million of our treatment sessions through such date. We generated revenues of $52.8 million and $40.4 million for the years ended December 31, 2018 and 2017, respectively. We designed the NeuroStar Advanced Therapy System as a non-invasive therapeutic alternative to treat patients who suffer from MDD and to address many of the key limitations of existing treatment options. We generate revenues from initial capital sales of our systems, sales of our recurring treatment sessions and from service and repair and extended warranty contracts. We derive the majority of our revenues from recurring treatment sessions. For the year ended December 31, 2018, revenues from sales of our treatment sessions and NeuroStar Advanced Therapy Systems represented 69% and 28% of our U.S. revenues, respectively. For the year ended December 31, 2017, revenues from sales of our treatment sessions and NeuroStar Advanced Therapy Systems represented 71% and 25% of our U.S. revenues, respectively. We currently sell our NeuroStar Advanced Therapy System and recurring treatment sessions in the United States through our sales and customer support team, which was comprised of 133 people as of December 31, 2018. Our sales force primarily targets 15,100 psychiatrists at 3,600 high-decile psychiatric practices that we estimate, based on data from Symphony Health and our own internal estimates, treat approximately 33% of the total MDD patients in the United States who meet our labeled indication and are insured. We expect to continue to expand our direct sales and customer support team to further penetrate the market by demonstrating the benefits of our NeuroStar Advanced Therapy to psychiatrists and their MDD patients. Some of our customers have and may purchase more than one NeuroStar Advanced Therapy System. Based on our commercial data, we believe psychiatrists can recoup their initial capital investment in our system by providing a standard course of treatment to approximately 12 patients. We believe psychiatrists can generate approximately $7,500 to $10,000 of revenue per patient for a standard course of treatment, which may provide meaningful incremental income to their practices. We have a diverse customer base of psychiatrists in group psychiatric practices in the United States. No single customer accounted for more than 10% of our revenues for the years ended December 31, 2018 or 2017. Patients are reimbursed by Medicare and the vast majority of commercial payors in the United States for treatment sessions utilizing our NeuroStar Advanced Therapy System. We market our products in a few select markets outside the United States through independent distributors. International revenues represented 2% and 1% of our total revenues for the years ended December 31, 2018 and 2017, respectively. In October 2017, we entered into an exclusive distribution agreement with Teijin Pharma Limited, or Teijin, for the distribution of our NeuroStar Advanced Therapy Systems and treatment sessions to customers who will treat patients with MDD in Japan. We received regulatory approval for our system in Japan in September 2017, and we plan to continue to work with Teijin to obtain reimbursement for NeuroStar Advanced Therapy in Japan. We expect our international revenues to increase as a percentage of our total revenues as we grow our presence in Japan. Our research and development efforts are focused on the following: hardware and software product developments and enhancements of our NeuroStar Advanced Therapy System and clinical development relating to additional indications, which may include bipolar depression and post-traumatic stress disorder. We outsource the manufacture of components of our NeuroStar Advanced Therapy Systems that are produced to our specifications, and individual components are either shipped directly from our third-party contract manufacturers to our customers or consolidated into pallets at our Malvern, Pennsylvania facility prior to shipment. Final installation of these systems occurs at the customer site. Our total revenues increased by $12.3 million, or 31%, from $40.4 million for the year ended December 31, 2017 to $52.8 million for the year ended December 31, 2018. For the year ended December 31, 2018, our U.S. revenues were $51.5 million, compared to $39.9 million for the year ended December 31, 2017, which represented an increase of 29% period over period. We expect to continue to incur losses for the next several years as we expand our commercial organization to support our planned sales growth and while continuing to invest in our pipeline indications. As of December 31, 2018, we had an accumulated deficit of $221.0 million. On July 2, 2018, we closed our initial public offering, or IPO, in which we issued and sold 6,325,000 shares of our common stock, which included shares sold pursuant to an option granted to the underwriters to purchase additional shares, at a public offering price of $17.00 per share. We received net proceeds $96.5 million after deducting underwriting discounts, commissions and other offering expenses paid by us. Our common stock is listed on the Nasdaq Global Market under the trading symbol “STIM.” Our primary sources of capital to date have been from our IPO, private placements of our convertible preferred securities, borrowings under our credit facilities and revenues from sales of our products. Components of Our Results of Operations Revenues To date, we have generated revenues primarily from the capital portion of our business and related sales and rentals of the NeuroStar Advanced Therapy System and the recurring revenues from our sale of treatment sessions in the United States. NeuroStar Advanced Therapy System Revenues. NeuroStar Advanced Therapy System revenues consist primarily of sales or rentals of a capital component, including upgrades to the equipment attributable to the initial sale of the system. NeuroStar Advanced Therapy Systems can be purchased outright or on a rent-to-own basis by certain customers. We had an installed base of 907 and 752 active NeuroStar Advanced Therapy Systems as of December 31, 2018 and 2017, respectively. Treatment Session Revenues. Treatment session revenues primarily include sales of NeuroStar Treatment Sessions and SenStar treatment links. The NeuroStar Treatment Sessions are access codes that are delivered electronically in the United States. The SenStar treatment links are disposable units containing single-use access codes that are sold and used outside the United States. Access codes are purchased separately by our customers, primarily on an as-needed basis, and are required by the NeuroStar Advanced Therapy System in order to deliver treatment sessions. Other Revenues. Other revenues are derived primarily from service and repair and extended warranty contracts with our existing customers. We refer you to the section titled “-Critical Accounting Policies and Use of Estimates-Revenue Recognition” appearing elsewhere in this Annual Report on Form 10-K for additional information regarding how we account for revenues. Sales in the United States represented 98% and 99% of our total revenues in 2018 and 2017, respectively and have been generated by our direct sales force. Outside the United States, our sales are made through local third-party distributors. International revenues were 2% for the year ended December 31, 2018, compared with 1% for the year ended December 31, 2017. In 2017, we terminated our relationship with our Japanese distributor in anticipation of entering into a new distribution agreement with Teijin, which significantly impacted our international sales for the year ended December 31, 2017. We expect that both our United States and international revenues will increase in the near term as we continue to expand the installed base of NeuroStar Advanced Therapy Systems and increase the related patient utilization in the United States, as well as grow our presence in Japan. We expect our revenues to be positively impacted to the extent our direct sales force is successful in increasing the rate of adoption and utilization of treatment with TMS Therapy as an alternative to other MDD treatments. Cost of Revenues and Gross Margin Cost of revenues primarily consists of the costs of components and products purchased from our third-party contract manufacturers of our NeuroStar Advanced Therapy Systems as well as the cost of treatment packs for individual treatment sessions. We use third-party contract manufacturing partners to produce the components for and assemble the completed NeuroStar Advanced Therapy Systems. Cost of revenues also includes costs related to personnel, royalties, warranty, shipping, and our operations and field service departments. We expect our cost of revenues to increase in absolute dollars as and to the extent our revenues grow. Our gross profit is calculated by subtracting our cost of revenues from our revenues. We calculate our gross margin as our gross profit divided by our revenues. Our gross margin has been and will continue to be affected by a variety of factors, primarily product sales mix, pricing and third-party contract manufacturing costs. Our gross margins on revenues from sales of NeuroStar Advanced Therapy Systems are lower than our gross margins on revenues from sales of treatment sessions and, as a result, the sales mix between NeuroStar Advanced Therapy Systems and treatment sessions can affect the gross margin in any reporting period. Sales and Marketing Expenses Sales and marketing expenses consist of market research and commercial activities related to the sale of our NeuroStar Advanced Therapy Systems and treatment sessions and salaries and related benefits, sales commissions and share-based compensation for employees focused on these efforts. Other significant sales and marketing costs include conferences and trade shows, promotional and marketing activities, including direct and online marketing, practice support programs, television and radio media campaigns, travel and training expenses. We anticipate a significant increase in headcount in our commercial organization and in expenses in executing on our growth initiatives as we continue to expand our business in the United States and internationally. As a result, we expect our sales and marketing expenses to continue to increase in absolute dollars. General and Administrative Expenses General and administrative expenses consist primarily of personnel expenses, including salaries and related benefits, share-based compensation and travel expenses, for employees in executive, finance, information technology, legal and human resource functions. General and administrative expenses also include the cost of insurance, outside legal fees, accounting and other consulting services, audit fees from our independent registered public accounting firm, board of directors’ fees and other administrative costs, such as corporate facility costs, including rent, utilities, depreciation and maintenance not otherwise included in cost of revenues. We anticipate that our general and administrative expenses will increase in absolute dollars because of an expanded infrastructure and an increased headcount. We anticipate higher corporate infrastructure costs including, but not limited to, accounting, legal, human resources, consulting and investor relations fees, listing fees on the Nasdaq Global Market, costs associated with Securities and Exchange Commission, or SEC, reporting and compliance, as well as increased director and officer insurance premiums, as a result of becoming a public company. Research and Development Expenses Research and development expenses consist primarily of personnel expenses, including salaries and related benefits and share-based compensation for employees in clinical development, product development, regulatory and quality assurance functions, as well as expenses associated with outsourced professional scientific development services and costs of investigative sites and consultants that conduct our preclinical and clinical development programs. We typically use our employee, consultant and infrastructure resources across our research and development programs. We plan to incur research and development expenses for the near future as we expect to continue our development of TMS Therapy for the treatment of additional patient populations and new indications, which may include bipolar depression, post-traumatic stress disorder and potential other clinical indications yet to be determined, as well as for various hardware and software development projects. As a result, we expect our research and development expenses to continue to increase in absolute dollars. Interest Expense Interest expense consists of cash interest payable under our credit facility and non-cash interest attributable to the accrual of final payment fees and the amortization of deferred financing costs related to our indebtedness. Other (Income) Expense, Net Other (income) expense, net consists primarily of the revaluation related to our outstanding convertible preferred stock warrants, which were accounted for as a liability as of June 30, 2018 and marked-to-market at each reporting period, as well as gains and losses on the disposal of fixed assets and interest income earned on our money market account balances. Upon the closing of our IPO on July 2, 2018, all of our outstanding convertible preferred stock warrants converted into warrants to acquire an aggregate of 0.1 million shares of our common stock, resulting in the reclassification of the convertible preferred stock warrant liability into additional paid-in capital. Results of Operations Comparison of the Years ended December 31, 2018 and 2017 Revenues Total revenues increased by $12.3 million, or 31%, from $40.4 million for the year ended December 31, 2017 to $52.8 million for the year ended December 31, 2018. Revenues in the United States increased by $11.6 million from 2017 to 2018 due to higher unit sales of both NeuroStar Advanced Therapy Systems and treatment sessions. During the fourth quarter of 2017, we entered into an exclusive distribution agreement with Teijin, which we believe will allow us to increase our revenues in Japan once we obtain reimbursement in that country. Revenues in the United States increased by $11.6 million, or 29%, from $39.9 million for the year ended December 31, 2017 to $51.5 million for the year ended December 31, 2018. NeuroStar Advanced Therapy System revenues in the United States grew by $4.5 million, or 44%, in the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase in U.S. NeuroStar revenue was primarily driven by higher capital revenue growth of 59% due to higher unit sales, partially offset by a 1% decrease in average selling prices, lower upgrade, rent-to-own, and other related revenue. NeuroStar Advanced Therapy System revenues represented 28% and 25% of U.S. revenues for 2018 and 2017, respectively. We believe the growth in NeuroStar Advanced Therapy System revenues between these two periods was the result of the efforts of our expanded commercial organization and increased marketing efforts. As of December 31, 2018, we had an installed base of 907 active systems in the United States, compared to 752 as of December 31, 2017. Treatment sessions revenues in the United States represented 69% and 71% of total revenues in the United States for the years ended December 31, 2018 and 2017, respectively, and increased by 24% from $28.4 million for the year end December 31, 2017 to $35.3 million for the year ended December 31, 2018. The increase in United States treatment session revenues was primarily the result of an approximate 25% increase in the number of treatment sessions sold, partially offset by a 5% decline in average selling price due to pre-determined volume pricing discounts within our existing customer base which are triggered when those customers surpass certain high volume thresholds, plus an increase in other treatment session revenue. Cost of Revenues and Gross Margin Cost of revenues increased by $2.8 million, or 29%, from $9.6 million for the year ended December 31, 2017 to $12.4 million for the year ended December 31, 2018. The increase was primarily due to increased NeuroStar Advanced Therapy System sales. Gross margin was 76.4% for the year ended December 31, 2018 compared to 76.2% for the year ended December 31, 2017. The gross margin was higher due to increased leverage on our service and operation costs, which were partially offset by the higher mix of NeuroStar Advanced Therapy System revenues in 2018 in relation to treatment session revenue and the reduction in average selling prices of our treatment sessions. Sales and Marketing Expenses Sales and marketing expenses increased by $10.4 million, or 37%, from $27.9 million for the year ended December 31, 2017 to $38.3 million for the year ended December 31, 2018. The increase was primarily due to increased personnel costs as a result of our sales and marketing expansion activities, as well as higher marketing expenses and sales commission costs, consistent with our growth in revenues. During 2018, we added 15 new sales territories and undertook several marketing projects to support our expansion plans, including increasing our presence at trade shows, expanding our media campaigns and enhancing our practice support program to include patient starter kits. General and Administrative Expenses General and administrative expenses increased by $5.1 million, or 59%, from $8.6 million for the year ended December 31, 2017 to $13.7 million for the year ended December 31, 2018. The increase was primarily due to an increase in personnel and legal, accounting and other professional services expenses required to support the growth of our business and ready the infrastructure for public company reporting. Research and Development Expenses Research and development expenses increased $0.3 million, or 4%, from $7.9 million for the year ended December 31, 2017 to $8.2 million for the year ended December 31, 2018. The increase was primarily due to expenses relating to the launch of the next generation of our NeuroStar Advanced Therapy System and TrakStar practice management system, which were partially offset by declines in spending relating to our adolescent study. Interest Expense Interest expense increased $0.9 million, or 31%, from $2.8 million for the year ended December 31, 2017 to $3.7 million for the year ended December 31, 2018, primarily as a result of higher cash interest expenses related to the increase in principal borrowings under our current credit facility and higher non-cash interest expenses accrued in connection with final payment fees due to the lender under the agreement. Other (Income) Expense, Net Other expense (income), net decreased by $0.9 million from ($0.3) million for year December 31, 2017 to $0.6 million for the year ended December 31, 2018. The fair value remeasurement of the liability related to our outstanding convertible preferred stock warrants decreased by $1.7 million during the year ended December 31, 2018, which was based on the closing stock price on June 29, 2018, following the pricing of our IPO on June 27, 2018. Upon closing of our IPO on July 2, 2018, all of our outstanding convertible preferred stock warrants converted into common stock warrants, resulting in the reclassification of our convertible preferred stock warrant liability into additional paid-in-capital. This decrease was partially offset by a $0.8 million of increase in interest income earned on the proceeds received from the IPO. Other expense (income), net for 2018 includes a one-time $0.1 million non-utilization fee related to the Company’s election to not draw down the Term C loan, primarily as a result of the funds received from the IPO. Comparison of the Years ended December 31, 2017 and 2016 * Calculation is not meaningful. Revenues Total revenues increased by $6.2 million, or 18%, from $34.2 million for the year ended December 31, 2016 to $40.4 million for the year ended December 31, 2017. Revenues in the United States increased by $8.3 million from 2016 to 2017 due to higher unit sales of both NeuroStar Advanced Therapy Systems and treatment sessions. International revenues declined by $2.1 million primarily due to the transition of our Japanese distributor during the fourth quarter of 2016. During the fourth quarter of 2017, we entered into an exclusive distribution agreement with Teijin, which we believe will allow us to increase our revenues in Japan once we obtain reimbursement in that country. Revenues in the United States increased by $8.3 million, or 26%, from $31.6 million for the year ended December 31, 2016 to $39.9 million for the year ended December 31, 2017. NeuroStar Advanced Therapy System revenues in the United States grew by $4.4 million from 2016 to 2017, or 78%, based on 64% higher unit volume and 14% higher average selling prices. NeuroStar Advanced Therapy System revenues represented 18% and 25% of U.S. revenues for 2016 and 2017, respectively. We believe the growth in NeuroStar Advanced Therapy System revenues between these two periods was the result of the efforts of our expanded sales and customer support team to place additional systems. Treatment sessions revenues in the United States increased by $3.8 million from 2016 to 2017, primarily due to an increase in the installed base of NeuroStar Advanced Therapy Systems. Treatment session revenues represented 78% and 71% of total revenues in the United States for the year ended December 31, 2016 and 2017, respectively. The increase in treatment session revenues in the United States was primarily the result of a 24% increase in the number of treatment sessions performed. This was offset by a 9% decline in average selling price due to certain volume pricing discounts within our existing customer base. Cost of Revenues and Gross Margin Cost of revenues increased by $3.0 million, or 45%, from $6.6 million for the year ended December 31, 2016 to $9.6 million for the year ended December 31, 2017. The increase was primarily due to increased NeuroStar Advanced Therapy System sales becoming a larger portion of the sales mix. Gross margin was 76% for the year ended December 31, 2017 compared to 81% for the year ended December 31, 2016. The decrease in gross margin was primarily due to the higher mix of NeuroStar Advanced Therapy System revenues in 2017 in relation to treatment sessions revenues and the reduction in the average selling price of our treatment sessions. Sales and Marketing Expenses Sales and marketing expenses increased by $6.1 million, or 28%, from $21.8 million for the year ended December 31, 2016 to $27.9 million for the year ended December 31, 2017. The increase was primarily due to increased personnel costs as a result of our sales and marketing expansion activities, as well as higher marketing expenses and sales commission costs, consistent with our growth in revenues. During 2017, we added 15 new sales territories and undertook several marketing projects to support our expansion plans, including increasing our presence at trade shows, expanding our media campaigns and enhancing our practice support program to include patient starter kits. General and Administrative Expenses General and administrative expenses increased by $1.7 million, or 24%, from $6.9 million for the year ended December 31, 2016 to $8.6 million for the year ended December 31, 2017. The increase was primarily due to an increase in personnel and legal, accounting and other professional services expenses required to support the growth of our business and ready the infrastructure for public company reporting. Research and Development Expenses Research and development expenses decreased $0.3 million, or 3%, from $8.2 million for the year ended December 31, 2016 to $7.9 million for the year ended December 31, 2017. The decrease was primarily due to declines in spending relating to our adolescent study, which were partially offset by expenses relating to the launch of the next generation of our NeuroStar Advanced Therapy System and TrakStar practice management system. Interest Expense Interest expense increased $1.0 million, or 53%, from $1.8 million for the year ended December 31, 2016 to $2.8 million for the year ended December 31, 2017, primarily as a result of higher cash interest expenses related to the increase in principal borrowings under our current credit facility and higher non-cash interest expenses accrued in connection with final payment fees due to the lender under the agreement. Other (Income) Expense, Net The fair value remeasurement of the liability related to our outstanding convertible preferred stock warrants decreased by $0.3 million during the year ended December 31, 2017 as a result of the change in the fair value of our Series E and Series F convertible preferred stock during 2017. Liquidity and Capital Resources Overview On July 2, 2018, we closed our IPO, in which we issued and sold 6,325,000 shares of our common stock, which included shares sold pursuant to an option granted to the underwriters to purchase additional shares, at a public offering price of $17.00 per share. We received net proceeds of $96.5 million after deducting underwriting discounts, commissions and other offering expenses paid by us. As of December 31, 2018, we had cash and cash equivalents of $104.6 million and an accumulated deficit of $221.0 million, compared to cash and cash equivalents of $29.1 million and an accumulated deficit of $196.9 million as of December 31, 2017. We incurred negative cash flows from operating activities of $20.6 million and $11.1 million for the years ended December 31, 2018 and 2017, respectively. We have incurred operating losses since our inception, and we anticipate that our operating losses will continue in the near term as we seek to expand our sales and marketing initiatives to support our growth in existing and new markets, invest funds in additional research and development activities and utilize cash for other corporate purposes. Our primary sources of capital to date have been from our IPO, private placements of our convertible preferred securities, borrowings under our credit facilities and sales of our products. As of December 31, 2018, we had $30.0 million of borrowings outstanding under our credit facility, which matures in March 2022. We expect our revenues and expenses to increase in connection with our on-going activities, particularly as we continue to execute on our growth strategy, including expansion of our sales and customer support teams. We also expect to incur additional costs now that we are a public company. Based on our current business plan, we believe that our cash and cash equivalents as of December 31, 2018 and anticipated revenues from sales of our products will be sufficient to meet our anticipated cash requirements for at least the next 24 months after December 31, 2018. However, if these sources are insufficient to satisfy our liquidity requirements, we may seek to sell additional common or preferred equity or debt securities, enter into a new credit facility or another form of third-party funding or seek other debt financing. If we raise additional funds by issuing equity or equity-linked securities, our stockholders would experience dilution and any new equity securities could have rights, preferences and privileges superior to those of holders of our common stock, including the shares of common stock sold in this offering. Debt financing, if available, may involve covenants restricting our operations or our ability to incur additional debt. We cannot be assured that additional equity, equity-linked or debt financing will be available on terms favorable to us or our stockholders, or at all. It is also possible that we may allocate significant amounts of capital towards products or technologies for which market demand is lower than expected and, as a result, abandon such efforts. If we are unable to obtain adequate financing when we require it, or if we obtain financing on terms which are not favorable to us, or if we expend capital on products or technologies that are unsuccessful, our ability to continue to support our business growth and to respond to business challenges could be significantly limited, or we may be required to delay the development, commercialization and marketing of our products. Our current and future funding requirements will depend on many factors, including: • our ability to achieve revenue growth and improve operating margins; • the cost of expanding our operations and offerings, including our sales and marketing efforts; • our ability to improve or maintain coverage and reimbursement arrangements with domestic third-party and government payors; • our rate of progress in establishing coverage and reimbursement arrangements from international commercial third-party and government payors, particularly in Japan; • our rate of progress in, and cost of the sales and marketing activities associated with, establishing adoption of our products and maintaining or improving our sales to our current customers; • the cost of research and development activities, including research and development relating to additional indications, which may include bipolar depression and PTSD; • the effect of competing technological and market developments; • costs related to international expansion; and • the potential cost of and delays in product development as a result of any regulatory oversight applicable to our products. Cash Flows The following table sets forth a summary of our cash flows for the years ended December 31, 2018, 2017 and 2016: Net Cash Used in Operating Activities Net cash used in operating activities for 2018 was $20.6 million, consisting primarily of a net loss of $24.1 million and an increase in net operating assets of $1.6 million, partially offset by non-cash charges of $5.1 million. The increase in net operating assets was primarily due to an increase in accounts receivable and inventory as a result of higher sales volumes. Non-cash charges consisted of depreciation and amortization, non-cash interest expense, share-based compensation, the cost of rental units purchased by customers and the change in the fair value of the liability related to our then-outstanding convertible preferred stock warrants. Net cash used in operating activities for 2017 was $11.1 million, consisting primarily of a net loss of $16.1 million, offset by an increase in net operating liabilities of $3.2 million and non-cash charges of $1.8 million. The increase in net operating liabilities was primarily due to an increase in deferred revenue representing the initial payment and first milestone payment received in accordance with our Japanese distribution agreement as well as expanding commercial and research activities. Non-cash charges consisted of depreciation and amortization, non-cash interest expense, share-based compensation, the cost of rental units purchased by customers and the change in the fair value of the liability related to our then-outstanding convertible preferred stock warrants. Net cash used in operating activities for 2016 was $8.5 million, consisting primarily of a net loss of $11.2 million, offset by an increase in net operating liabilities of $1.4 million and non-cash charges of $1.3 million. The increase in net operating liabilities was primarily due to increases in accounts payable and accrued expenses, offset by an increase in inventory primarily due rent-to-own units from one large customer. Non-cash charges consisted of depreciation and amortization, non-cash interest expense, share-based compensation and the change in the fair value of the liability related to our outstanding convertible preferred stock warrants. Net Cash Used in Investing Activities Net cash used in investing activities for 2018 was $1.0 million, compared to net cash used in investing activities for 2017 of $0.6 million and $0.3 million for 2016, in each case attributable to purchases of property and equipment and capitalized software costs in 2017 and 2018. Net Cash Provided by Financing Activities Net cash provided by financing activities for 2018 was $97.0 million, consisting primarily of $100.0 million of proceeds related to the closing of our IPO on July 2, 2018, partially offset by $3.5 million of payments of costs related to the IPO. Net cash provided by financing activities for 2017 was $23.8 million, consisting of $14.8 million of net proceeds from the issuance of Series G convertible preferred stock and $10.0 million of borrowings under our current credit facility, offset by payment of $1.0 million of deferred debt issuance costs incurred in connection with our March 2017 amended credit facility. Net cash provided by financing activities for 2016 was $4.9 million, consisting primarily of $5.0 million of borrowings under our previous credit facility, offset by payment of the related deferred debt issuance costs incurred in connection with a March 2016 amendment. Indebtedness Current Credit Facility In March 2017, we entered into a new loan and security agreement with Oxford Finance LLC, or Oxford, for a credit facility that replaced our previous $25.0 million credit facility with Oxford and which allowed us to borrow up to $35.0 million in three tranches of term loans: a Term A Loan in the amount of $25.0 million, which was drawn down immediately upon closing in March 2017, a Term B Loan in the amount of $5.0 million, which was drawn down in December 2017, and a Term C Loan in the amount of $5.0 million, which became available to us upon the achievement of $45.0 million of trailing twelve month revenues during the second quarter of 2018. Upon achieving the required revenue milestone, we had 60 days to notify Oxford if we elected to borrow the Term C Loan. As a result of completing our IPO on July 2, 2018 and receiving the proceeds therefrom, we elected not to borrow the additional $5.0 million, and it is no longer available to us. Each term loan accrues interest from the date of borrowing through the date of repayment at a floating per annum rate of interest, which resets monthly and is equal to the greater of (a) 8.15% or (b) the 30-day U.S. LIBOR on the last business day of the month plus 7.38%. At the date of each borrowing, we were required to issue to Oxford warrants to purchase our Series F or later series of convertible preferred stock with a seven-year term and in an amount equal to 3.95% of the first $5.0 million of each tranche borrowed. The credit facility matures and all amounts borrowed thereunder are due on March 1, 2022. As of December 31, 2018, we had borrowed and had outstanding an aggregate of $30.0 million of principal under our credit facility. The Term A Loan featured an interest-only period through March 2019, during which time we were required to make monthly interest payments, after which time we were required to make monthly payments of principal and interest based on a 36-month amortization schedule. However, upon the achievement of $45.0 million of revenues during the fourth quarter of 2018, the interest-only period was extended for an additional 12 months through March 2020, after which time we will be required to make monthly payments of principal and interest based on a 24-month amortization schedule. In connection with the drawdown of the Term A Loan, we issued to Oxford a warrant to purchase shares of its Series F convertible preferred stock. This convertible preferred stock warrant converted into a warrant to purchase 20,303 shares of our common stock at an exercise price of $9.73 per share. The warrant will expire in March 2024. The Term B Loan featured an interest-only period through March 2019, during which time we were required to make monthly interest payments, after which time we were required to make monthly payments of principal and interest based on a 36-month amortization schedule. However, due to the achievement of $45.0 million of revenues during the fourth quarter of 2018, the interest-only period was extended for an additional 12 months through March 2020, after which time we will be required to make monthly payments of principal and interest based on a 24-month amortization schedule. In connection with the drawdown of the Term B Loan, we issued to Oxford a warrant to purchase shares of its Series F convertible preferred stock. This convertible preferred stock warrant converted into a warrant to purchase 20,303 shares of our common stock at an exercise price of $9.73 per share. The warrant will expire in December 2024. In addition to principal and interest payments due under the credit facility, we are required to make final payment fees to Oxford due upon the earlier of prepayment or maturity of each tranche, which increased as a result the extension of the interest-only period and are now equal to 8.5% and 7.5% of the principal amounts of the Term A and Term B Loans, respectively. We accrue the estimated final payment fees using the effective interest rate, with a charge to non-cash interest expense, over the term of borrowing for each tranche. As of December 31, 2018, the effective interest rates for the Term A and Term B Loans were 11.87% and 12.14%, respectively. As of December 31, 2017, the effective interest rates for the Term A and Term B Loans were 10.7% and 11.6%, respectively. If the we prepay our term loans prior to their respective scheduled maturities, we will also be required to make prepayment fees to Oxford equal to 3% if prepaid on or before the first anniversary of funding, 2% if prepaid after the first and on or before the second anniversary of funding, or 1% if prepaid after the second anniversary of funding of the principal amounts borrowed. Our obligations under the credit facility are secured by a first priority security interest in substantially all of our assets, other than our intellectual property. We have agreed not to pledge or otherwise encumber any of our intellectual property. The loan and security agreement related to our credit facility includes a financial maintenance covenant that requires us to achieve at least 75% of our trailing 12-month forecasted revenues, as measured each month in accordance with a forecast that we provided to Oxford upon signing the agreement and future forecasts that we are required to deliver to Oxford each year for the life of the credit facility, as well as customary affirmative and negative covenants. We were in compliance with all of the covenants under our credit facility as of December 31, 2018. The loan and security agreement related to our credit facility contains events of default, including, without limitation, events of default upon: (i) failure to make payment pursuant to the terms of the agreement; (ii) violation of covenants; (iii) material adverse changes to our business; (iv) attachment or levy on our assets or judicial restraint on our business; (v) insolvency; (vi) significant judgments, orders or decrees for payments by us not covered by insurance; (vii) incorrectness of representations and warranties; (viii) incurrence of subordinated debt; (ix) revocation of governmental approvals necessary for us to conduct our business; and (x) failure by us to maintain a valid and perfected lien on the collateral securing the borrowing. Based on a 24-month amortization of the outstanding principal amounts of the Term A and Term B Loans beginning on April 1, 2020 as discussed above, the following table sets forth by year our required future principal payments (in thousands): Previous $25.0 Million Credit Facility Prior to March 2017, we had a $25.0 million credit facility in place with Oxford, which we entered into in February 2014 and which allowed us to borrow up to $25.0 million in three tranches of term loans: a Term A Loan in the amount of $15.0 million, a Term B Loan in the amount of $5.0 million, and a Term C Loan in the amount of $5.0 million, which was never drawn down. Each term loan accrued interest at per annum rates ranging from 8.5% to 8.9%. This facility featured an interest-only period on all tranches through March 2017, and we were also required to issue convertible preferred stock warrants to Oxford at the time of borrowing of each tranche. These convertible preferred stock warrants converted into common stock warrants immediately prior to the closing of our IPO on July 2, 2018, We accrued final payment fees using the effective interest rate, with a charge to non-cash interest expense, over the term of borrowing and until our entry into our current credit facility in March 2017, at which time we paid the lender $1.0 million in satisfaction of all final payment fee liabilities due under the prior credit facility. We evaluated whether our current credit facility entered into in March 2017 represented a debt modification or extinguishment in accordance with ASC 470-50, Debt-Modifications and Extinguishments. Upon determining that the change in cash flows between the previous and current credit facilities was not greater than 10%, we accounted for the transaction as a debt modification. As of March 2017, the unamortized balance of deferred financing costs incurred in connection with the $25.0 million credit facility, and certain additional deferred financing costs incurred in connection with entry into our current credit facility, are being amortized to interest expense through March 2022 utilizing the effective interest method. Cash and Non-Cash Interest Expense For the year ended December 31, 2018, we recognized interest expense of $3.7 million, of which $2.9 million was cash and $0.8 million was non-cash interest expense related to the amortization of deferred financing costs and accrual of final payment fees. For the year ended December 31, 2017, we recognized interest expense of $2.8 million, of which $2.1 million was cash and $0.7 million was non-cash interest expense related to the amortization of deferred financing costs and accrual of final payment fees. Off-Balance Sheet Arrangements We do not maintain any off-balance sheet arrangements, partnerships or other relationships with unconsolidated entities, often referred to as structured finance or special-purpose entities, which are established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Commitments and Contractual Obligations The following table sets forth a summary of our contractual obligations as of December 31, 2018: (1) Interest payable reflects the rate in effect as of December 31, 2018. The interest rate on borrowings under the credit facility is variable and resets monthly. Lender fees reflect final payment fees due. (2) Reflects obligations primarily related to our office and warehouse/storage leases in Malvern, PA. Distribution Agreement with Teijin Pharma Limited In October 2017, we entered into a seven-and-a-half-year distribution agreement with Teijin Pharma Limited, or Teijin, for the exclusive distribution of our NeuroStar Advanced Therapy System to customers who will treat patients with MDD in Japan. Under the distribution agreement, Teijin is generally restricted from selling competing products in Japan. Our distribution agreement provides that we will have primary responsibility for obtaining reimbursement approval for use of NeuroStar Advanced Therapy System for the treatment of MDD in Japan, and Teijin will promote the sales of NeuroStar Advanced Therapy System for treatment of MDD in Japan. We have agreed to provide sales and technical support training to Teijin for our NeuroStar Advanced Therapy Systems. Teijin is required to purchase minimum dollar values of NeuroStar Advanced Therapy Systems and treatment sessions from us following reimbursement approval by the Japanese Ministry of Health, Labour and Welfare, or JMHLW, for TMS treatment for MDD (or, if such approval requires certified training on the NeuroStar Advanced Therapy System by a third party, then upon the first psychiatrist being issued his or her training certification). In 2017, under our distribution agreement with Teijin, we received an upfront payment of $0.75 million and a milestone payment of $2.0 million following JMHLW’s approval of marketing the NeuroStar Advanced Therapy System for the treatment of MDD in Japan. These upfront and milestone payments have been deferred and are being recognized as revenue over the seven- and one-half year term of the agreement. Teijin is required to pay us a milestone payment tied to JMHLW issuing reimbursement for use of our products for the treatment of MDD in Japan. The distribution agreement is scheduled to expire on March 31, 2025, subject to earlier termination if we or Teijin breach the agreement, Teijin fails to maintain distributor-level permits and approvals, Teijin fails to purchase from us specified dollar values of its sales forecasts, reimbursement for treatment of MDD using the NeuroStar Advanced Therapy System is not obtained from JMHLW by specified dates or such reimbursement is below specified minimums, Teijin reasonably believes that it is not commercially reasonable to continue distributing the NeuroStar Advanced Therapy System in Japan or bankruptcy related events occur. The term of the distribution agreement will be automatically extended for two years unless either party gives the other party at least two years’ prior written of notice of non-renewal, except that we cannot decline to renew the agreement if Teijin has purchased 100% of its sales forecasts over the term of the agreement. Executive Employment Agreements We are party to an employment agreement and offer letters with certain members of our executive team that provide for severance and other payments following termination of their employment for various reasons. We refer you to “Item 11. Executive Compensation” in this Annual Report on Form 10-K. Critical Accounting Policies and Use of Estimates The preparation of our financial statements in accordance with accounting principles generally accepted in the United States, or GAAP, and the rules and regulations of the SEC requires us to make estimates and assumptions, based on judgments considered reasonable, which 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 period. We base our estimates and assumptions 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 value of assets and liabilities that are not readily apparent from other sources. Although we believe our estimates and assumptions are reasonable when made, they are based upon information available to us at the time they are made. We evaluate our estimates and assumptions on an ongoing basis and, if necessary, make adjustments. Due to the risks and uncertainties involved in our business and evolving market conditions and given the subjective element of the estimates and assumptions made, actual results may differ from estimated results. We define our critical accounting policies as those accounting policies that are most important to the portrayal of our financial condition and results of operations and require our most difficult and subjective judgments. While our significant accounting policies are more fully described in “Note 3. Summary of Significant Accounting Policies” in our audited financial statements and related notes thereto appearing elsewhere in this Annual Report on Form 10-K, we believe the following discussion addresses our most critical accounting policies. Revenue Recognition Revenue is recognized when title and risk of ownership has been transferred, provided that persuasive evidence of an arrangement exists, the price is fixed and determinable and collectability is reasonably assured. Transfer of title and risk of ownership occurs when the product is shipped or transferred to the customer. We sell to end users in the United States and to third-party distributors outside the United States and do not provide return rights. Sales to distributors outside the United States are made in U.S. dollars. Our NeuroStar Advanced Therapy System sales in the United States typically have a post-sale training obligation. This obligation is fulfilled after product shipment, and we defer recognizing revenue until training occurs. In accordance with the accounting guidance related to multiple element arrangements, we defer the fair value attributable to the post shipment training and recognize such revenue when the obligation is fulfilled. We base the fair value of the training using stand-alone service rates. Our sales to our third-party distributors outside the United States do not have these post-sale obligations. Our consumable single use and accessory products have no post sale obligations and no return rights. Revenue from the sales of these products are recognized upon delivery. Revenue attributable to the NeuroStar Advanced Therapy Systems purchased on a rent-to-own basis are accounted for as operating leases and revenue is recognized on a straight-line basis over the term of the lease. In addition, we provide a one to two year warranty for systems sold in the United States. Terms of product warranty differ amongst our third-party distributors outside the United States but are generally two years. We provide for the estimated cost to repair or replace products under any warranty at the time of sale. We also offer our customers in the United States annual service contracts. Revenue from the sale of annual service contracts is recognized on a straight-line basis over the period of the applicable contract. We also earn revenue from customers from services outside of their warranty term or annual service contracts. Such service revenue is recognized as the services are provided. We had deferred revenue of $1.9 million and $1.6 million at December 31, 2018 and 2017, respectively, primarily related to training, warranty and rent to own units. During the fourth quarter of 2017, we entered into an exclusive Distribution Agreement with Teijin Pharma Limited, which we expect will allow us to increase deliveries to Japan. In connection with the Distribution Agreement, we received an upfront payment as well as the first milestone payment, which are being recognized as revenue over the seven and a half-year term of the agreement. The last milestone payment is due upon achieving reimbursement approval in Japan. At December 31, 2018 and 2017, we had $2.3 million and $2.7 million in deferred revenue, respectively, related to this agreement. Share-based Compensation We recognize the grant-date fair value of share-based awards issued as compensation as expense on a straight-line basis over the requisite service period, which is generally the vesting period of the award. Prior to our IPO, the fair value of restricted stock awards is based on a determination by the board of directors of the estimated fair value of the common stock at the date of grant. The fair value of stock options is estimated at the time of grant using the Black-Scholes option pricing model, which requires the use of inputs and assumptions, the most critical of which prior to our IPO is the estimated fair value of our common stock. We expect the amount of share-based compensation expense recognized for stock options and restricted stock awards and units to increase for future awards in future periods due to the potential increase in both the value of our common stock and the size of our company in terms of headcount. Valuation of Common Stock All options to purchase shares of our common stock are granted with an exercise price per share equal to or greater than the estimated fair value per share of our common stock on the date of grant, based on the information known to us on the date of grant. Prior to our IPO, on each grant date, the fair values of the shares of common stock underlying our stock options were estimated on each grant date by our board of directors, based on information known to us at the date of grant. In order to determine the estimated fair value of our common stock, our board of directors considered, among other things, contemporaneous valuations of our preferred and common stock prepared by an unrelated third-party valuation firm in accordance with the guidance provided by the American Institute of Certified Public Accountants 2013 Practice Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. Given the absence of a public trading market for our capital stock, our board of directors exercised reasonable judgment and considered a number of objective and subjective factors to determine the best estimate of the fair value of our preferred and common stock, including: • contemporaneous third-party valuations of our preferred and common stock; • the prices, rights, preferences and privileges of our preferred stock relative to the common stock; • our business, financial condition and results of operations, including related industry trends affecting our operations; • the likelihood of achieving a liquidity event, such as an initial public offering or the sale of our company, given prevailing market conditions; • the lack of marketability of our preferred and common stock; • the market performance of comparable publicly traded companies; and • United States and global economic and capital market conditions and outlook. Since the closing of our IPO, our board of directors has determined the per share fair value of our common stock based on the closing price of our common stock as reported by the Nasdaq Global Market on the date of grant. JOBS Act Accounting Election We are an “emerging growth company,” as defined in the Jumpstart Our Business Startups Act of 2012, or JOBS Act, and are eligible to take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies. 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 of 1933, or Securities Act, for complying with new or revised accounting standards issued subsequent to the enactment of the JOBS Act until such time as those standards apply to private companies. Section 107 of the JOBS Act provides that we can elect to opt out of the extended transition period at any time, which election is irrevocable. We have elected to avail ourselves of this exemption from complying with new or revised accounting standards and, therefore, will not be subject to the same new or revised accounting standards as other public companies that are not emerging growth companies. Subject to certain conditions, as an emerging growth company, we may rely on certain other exemptions and reduced reporting requirements under the JOBS Act, including without limitation (i) providing an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404(b) of the Sarbanes-Oxley Act and (ii) complying 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, known as the auditor discussion and analysis. We will remain an emerging growth company until the earlier of (a) the last day of the fiscal year in which we have total annual gross revenue of $1.07 billion or more; (b) the last day of the fiscal year following the fifth anniversary of the date of the completion of our IPO; (c) the date on which we have issued more than $1.0 billion in nonconvertible debt during the previous six years; or (d) the date on which we are deemed to be a large accelerated filer under the rules of the SEC. Recent Accounting Pronouncements We refer you to “Note 4. Recent Accounting Pronouncements” in our audited financial statements and related notes thereto included elsewhere in this Annual Report on Form 10-K.
0.067996
0.068058
0
<s>[INST] The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our audited financial statements and related notes thereto and other financial information included elsewhere in this Annual Report on Form 10K. In addition to historical financial information, some of the information contained in the following discussion and analysis contains forwardlooking statements that involve risks, uncertainties and assumptions. You should review the ‘‘Risk Factors’’ section of this Annual Report on Form 10K for a discussion of important factors that could cause our actual results to differ materially from the results described in or implied by the forwardlooking statements contained in the following discussion and analysis. Overview We are a commercial stage medical technology company focused on designing, developing and marketing products that improve the quality of life for patients who suffer from psychiatric disorders. Our first commercial product, the NeuroStar Advanced Therapy System, is a noninvasive and nonsystemic officebased treatment that uses transcranial magnetic stimulation, or TMS, to create a pulsed, MRIstrength magnetic field that induces electrical currents designed to stimulate specific areas of the brain associated with mood. The system is cleared by the United States Food and Drug Administration, or FDA, to treat adult patients with major depressive disorder, or MDD, that have failed to achieve satisfactory improvement from prior antidepressant medication in the current MDD episode. NeuroStar Advanced Therapy is safe, clinically effective, reproducible and precise and we believe is supported by the largest clinical data set of any competing TMS system. We believe we are the market leader in TMS therapy based on our U.S. installed base of 907 active NeuroStar Advanced Therapy Systems in approximately 707 psychiatrist offices as of December 31, 2018 and the estimated 62,900 patients treated with approximately 2.3 million of our treatment sessions through such date. We generated revenues of $52.8 million and $40.4 million for the years ended December 31, 2018 and 2017, respectively. We designed the NeuroStar Advanced Therapy System as a noninvasive therapeutic alternative to treat patients who suffer from MDD and to address many of the key limitations of existing treatment options. We generate revenues from initial capital sales of our systems, sales of our recurring treatment sessions and from service and repair and extended warranty contracts. We derive the majority of our revenues from recurring treatment sessions. For the year ended December 31, 2018, revenues from sales of our treatment sessions and NeuroStar Advanced Therapy Systems represented 69% and 28% of our U.S. revenues, respectively. For the year ended December 31, 2017, revenues from sales of our treatment sessions and NeuroStar Advanced Therapy Systems represented 71% and 25% of our U.S. revenues, respectively. We currently sell our NeuroStar Advanced Therapy System and recurring treatment sessions in the United States through our sales and customer support team, which was comprised of 133 people as of December 31, 2018. Our sales force primarily targets 15,100 psychiatrists at 3,600 highdecile psychiatric practices that we estimate, based on data from Symphony Health and our own internal estimates, treat approximately 33% of the total MDD patients in the United States who meet our labeled indication and are insured. We expect to continue to expand our direct sales and customer support team to further penetrate the market by demonstrating the benefits of our NeuroStar Advanced Therapy to psychiatrists and their MDD patients. Some of our customers have and may purchase more than one NeuroStar Advanced Therapy System. Based on our commercial data, we believe psychiatrists can recoup their initial capital investment in our system by providing a standard course of treatment to approximately 12 patients. We believe psychiatrists can generate approximately $7,500 to $10,000 of revenue per patient for a standard course of treatment, which may provide meaningful incremental income to their practices. We have a diverse customer base of psychiatrists in group psychiatric practices in the United States. No single customer accounted for more than 10% of our revenues for the years ended December 31, 2018 or 2017. Patients are [/INST] Positive. </s>
2,019
9,186
1,227,636
Neuronetics, Inc.
2020-03-03
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 our audited financial statements and related notes thereto and other financial information included elsewhere in this Annual Report on Form 10-K. In addition to historical financial information, some of the information contained in the following discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. You should review the ‘‘Risk Factors’’ section of this Annual Report on Form 10-K for a discussion of important factors that could cause our 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 commercial stage medical technology company focused on designing, developing and marketing products that improve the quality of life for patients who suffer from psychiatric disorders. Our first commercial product, the NeuroStar Advanced Therapy System, is a non-invasive and non-systemic office-based treatment that uses transcranial magnetic stimulation, or TMS, to create a pulsed, MRI-strength magnetic field that induces electrical currents designed to stimulate specific areas of the brain associated with mood. The system is cleared by the United States Food and Drug Administration, or FDA, to treat adult patients with major depressive disorder, or MDD, that have failed to achieve satisfactory improvement from prior antidepressant medication in the current MDD episode. NeuroStar Advanced Therapy is safe, clinically effective, reproducible and precise and we believe is supported by the largest clinical data set of any competing TMS system. We believe we are the market leader in TMS therapy based on our U.S. installed base of 1,085 active NeuroStar Advanced Therapy Systems in approximately 870 psychiatrist offices as of December 31, 2019 and the estimated 81,600 patients treated with approximately 2.9 million of our treatment sessions through such date. We generated revenues of $62.7 million and $52.8 million for the years ended December 31, 2019 and 2018, respectively. We designed the NeuroStar Advanced Therapy System as a non-invasive therapeutic alternative to treat patients who suffer from MDD and to address many of the key limitations of existing treatment options. We generate revenues from initial capital sales of our systems, sales of our recurring treatment sessions and from service and repair and extended warranty contracts. We derive the majority of our revenues from recurring treatment sessions. For the year ended December 31, 2019, revenues from sales of our treatment sessions and NeuroStar Advanced Therapy Systems represented 68% and 30% of our U.S. revenues, respectively. For the year ended December 31, 2018, revenues from sales of our treatment sessions and NeuroStar Advanced Therapy Systems represented 69% and 28% of our U.S. revenues, respectively. We currently sell our NeuroStar Advanced Therapy System and recurring treatment sessions in the United States through our sales and customer support team. Our sales force primarily targets 20,600 psychiatrists at 5,700 high-decile psychiatric practices that we estimate, based on data from Symphony Health and our own internal estimates, treat approximately 42% of the total MDD patients in the United States who meet our labeled indication and are insured. We expect to continue to expand our direct sales and customer support team to further penetrate the market by demonstrating the benefits of our NeuroStar Advanced Therapy to psychiatrists and their MDD patients. Some of our customers have and may purchase more than one NeuroStar Advanced Therapy System. Based on our commercial data, we believe psychiatrists can recoup their initial capital investment in our system by providing a standard course of treatment to approximately 12 patients. We believe psychiatrists can generate approximately $7,500 to $10,000 of revenue per patient for a standard course of treatment, which may provide meaningful incremental income to their practices. We have a diverse customer base of psychiatrists in group psychiatric practices in the United States. No single customer accounted for more than 10% of our revenues for the years ended December 31, 2019 or 2018. Patients are reimbursed by Medicare and the vast majority of commercial payors in the United States for treatment sessions utilizing our NeuroStar Advanced Therapy System. We market our products in a few select markets outside the United States through independent distributors. International revenues represented 3% and 2% of our total revenues for the years ended December 31, 2019 and 2018, respectively. In October 2017, we entered into an exclusive distribution agreement with Teijin Pharma Limited, or Teijin, for the distribution of our NeuroStar Advanced Therapy Systems and treatment sessions to customers who will treat patients with MDD in Japan. We received regulatory approval for our system in Japan in September 2017. We obtained reimbursement coverage for NeuroStar Advanced Therapy in Japan, which went into effect on June 1, 2019 and covers patients who are treated in the largest inpatient and outpatient psychiatric facilities in Japan. We expect our international revenues to increase as a percentage of our total revenues as we grow our presence in Japan. Our research and development efforts are focused on the following: hardware and software product developments and enhancements of our NeuroStar Advanced Therapy System and clinical development relating to additional indications, which may include bipolar depression and post-traumatic stress disorder. We outsource the manufacture of components of our NeuroStar Advanced Therapy Systems that are produced to our specifications, and individual components are either shipped directly from our third-party contract manufacturers to our customers or consolidated into pallets at our Malvern, Pennsylvania facility prior to shipment. Final installation of these systems occurs at the customer site. Our total revenues increased by $9.9 million, or 19%, from $52.8 million for the year ended December 31, 2018 to $62.7 million for the year ended December 31, 2019. For the year ended December 31, 2019, our U.S. revenues were $60.8 million, compared to $51.5 million for the year ended December 31, 2018, which represented an increase of 18% period over period. We expect to continue to incur losses for the next several years as we expand our commercial organization to support our planned sales growth and while continuing to invest in our pipeline indications. As of December 31, 2019, we had an accumulated deficit of $250.1 million. On July 2, 2018, we closed our IPO in which we issued and sold 6,325,000 shares of our common stock, which included shares sold pursuant to an option granted to the underwriters to purchase additional shares, at a public offering price of $17.00 per share. We received net proceeds $96.5 million after deducting underwriting discounts, commissions and other offering expenses paid by us. Our common stock is listed on the Nasdaq Global Market under the trading symbol “STIM.” Our primary sources of capital to date have been from our IPO, private placements of our convertible preferred securities, borrowings under our credit facilities and revenues from sales of our products. Components of Our Results of Operations Revenues To date, we have generated revenues primarily from the capital portion of our business and related sales and rentals of the NeuroStar Advanced Therapy System and the recurring revenues from our sale of treatment sessions in the United States. NeuroStar Advanced Therapy System Revenues. NeuroStar Advanced Therapy System revenues consist primarily of sales or rentals of a capital component, including upgrades to the equipment attributable to the initial sale of the system. NeuroStar Advanced Therapy Systems can be purchased outright or on a rent-to-own basis by certain customers. We had an installed base of 1085 and 907 active NeuroStar Advanced Therapy Systems as of December 31, 2019 and 2018, respectively. Treatment Session Revenues. Treatment session revenues primarily include sales of NeuroStar Treatment Sessions and SenStar treatment links. The NeuroStar Treatment Sessions are access codes that are delivered electronically in the United States. The SenStar treatment links are disposable units containing single-use access codes that are sold and used outside the United States. Access codes are purchased separately by our customers, primarily on an as-needed basis, and are required by the NeuroStar Advanced Therapy System in order to deliver treatment sessions. Other Revenues. Other revenues are derived primarily from service and repair and extended warranty contracts with our existing customers. We refer you to the section titled “-Critical Accounting Policies and Use of Estimates-Revenue Recognition” appearing elsewhere in this Annual Report on Form 10-K for additional information regarding how we account for revenues. Sales in the United States represented 97% and 98% of our total revenues for the years ending December 31, 2019 and 2018, respectively and have been generated by our direct sales force. Outside the United States, our sales are made through local third-party distributors. International revenues were 3% for the year ended December 31, 2019, compared with 2% for the year ended December 31, 2018. In 2017, we terminated our relationship with our Japanese distributor in anticipation of entering into a new distribution agreement with Teijin, which significantly impacted our international sales for the year ended December 31, 2017. We expect that both our United States and international revenues will increase in the near term as we continue to expand the installed base of NeuroStar Advanced Therapy Systems and increase the related patient utilization in the United States, as well as grow our presence in Japan. We expect our revenues to be positively impacted to the extent our direct sales force is successful in increasing the rate of adoption and utilization of treatment with TMS Therapy as an alternative to other MDD treatments. Cost of Revenues and Gross Margin Cost of revenues primarily consists of the costs of components and products purchased from our third-party contract manufacturers of our NeuroStar Advanced Therapy Systems as well as the cost of treatment packs for individual treatment sessions. We use third-party contract manufacturing partners to produce the components for and assemble the completed NeuroStar Advanced Therapy Systems. Cost of revenues also includes costs related to personnel, royalties, warranty, shipping, and our operations and field service departments. We expect our cost of revenues to increase in absolute dollars as and to the extent our revenues grow. Our gross profit is calculated by subtracting our cost of revenues from our revenues. We calculate our gross margin as our gross profit divided by our revenues. Our gross margin has been and will continue to be affected by a variety of factors, primarily product sales mix, pricing and third-party contract manufacturing costs. Our gross margins on revenues from sales of NeuroStar Advanced Therapy Systems are lower than our gross margins on revenues from sales of treatment sessions and, as a result, the sales mix between NeuroStar Advanced Therapy Systems and treatment sessions can affect the gross margin in any reporting period. Sales and Marketing Expenses Sales and marketing expenses consist of market research and commercial activities related to the sale of our NeuroStar Advanced Therapy Systems and treatment sessions and salaries and related benefits, sales commissions and share-based compensation for employees focused on these efforts. Other significant sales and marketing costs include conferences and trade shows, promotional and marketing activities, including direct and online marketing, practice support programs, television and radio media campaigns, travel and training expenses. We anticipate an increase in headcount in our commercial organization and in expenses in executing on our growth initiatives as we continue to expand our business in the United States and internationally. As a result, we expect our sales and marketing expenses to continue to increase in absolute dollars. General and Administrative Expenses General and administrative expenses consist primarily of personnel expenses, including salaries and related benefits, share-based compensation and travel expenses, for employees in executive, finance, information technology, legal and human resource functions. General and administrative expenses also include the cost of insurance, outside legal fees, accounting and other consulting services, audit fees from our independent registered public accounting firm, board of directors’ fees and other administrative costs, such as corporate facility costs, including rent, utilities, depreciation and maintenance not otherwise included in cost of revenues. We anticipate that our general and administrative expenses will increase in absolute dollars because of an expanded infrastructure and an increased headcount. We anticipate higher corporate infrastructure costs including, but not limited to, accounting, legal, human resources, consulting and investor relations fees, listing fees on the Nasdaq Global Market, costs associated with SEC reporting and compliance, as well as increased director and officer insurance premiums, as a result of becoming a public company. Research and Development Expenses Research and development expenses consist primarily of personnel expenses, including salaries and related benefits and share-based compensation for employees in clinical development, product development, regulatory and quality assurance functions, as well as expenses associated with outsourced professional scientific development services and costs of investigative sites and consultants that conduct our preclinical and clinical development programs. We typically use our employee, consultant and infrastructure resources across our research and development programs. We plan to incur research and development expenses for the near future as we expect to continue our development of TMS Therapy for the treatment of additional patient populations and new indications, which may include bipolar depression, post-traumatic stress disorder and potential other clinical indications yet to be determined, as well as for various hardware and software development projects. As a result, we expect our research and development expenses to continue to increase in absolute dollars. Interest Expense Interest expense consists of cash interest payable under our credit facility and non-cash interest attributable to the accrual of final payment fees and the amortization of deferred financing costs related to our indebtedness. Other (Income) Expense, Net Other (income) expense, net consists primarily of the revaluation related to our outstanding convertible preferred stock warrants, which were accounted for as a liability as of June 30, 2018 and marked-to-market at each reporting period, as well as gains and losses on the disposal of fixed assets and interest income earned on our money market account balances. Upon the closing of our IPO on July 2, 2018, all of our outstanding convertible preferred stock warrants converted into warrants to acquire an aggregate of 0.1 million shares of our common stock, resulting in the reclassification of the convertible preferred stock warrant liability into additional paid-in capital. Results of Operations Comparison of the Years ended December 31, 2019 and 2018 Revenues Total revenues increased by $9.9 million, or 19%, from $52.8 million for the year ended December 31, 2018 to $62.7 million for the year ended December 31, 2019. Revenues in the United States increased by $9.3 million from 2018 to 2019 due to higher unit sales of both NeuroStar Advanced Therapy Systems and treatment sessions. The year over year increase in international revenue was primarily due to multi-unit orders by Teijin Pharma Limited, our Japanese partner, during the second and third quarters of 2019. Revenues in the United States increased by $9.3 million, or 18%, from $51.5 million for the year ended December 31, 2018 to $60.8 million for the year ended December 31, 2019. NeuroStar Advanced Therapy System revenues in the United States grew by $3.4 million, or 23%, in the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase was primarily driven by a 25% increase in NeuroStar Advanced Therapy System capital revenue, which includes capital sales and sales-type leases. The increase in NeuroStar capital revenue was driven by a total of 250 NeuroStar Advanced Therapy Systems sold, which was an increase of 43% over the NeuroStar systems sold in 2018. This increase was offset by a 12% decline in average selling prices as compared to 2018 as a result of a higher mix of sales-type leases versus capital sales. We believe the growth in NeuroStar Advanced Therapy System revenues between these two periods was the result of the efforts of our expanded commercial organization and increased marketing efforts. As of December 31, 2019, we had an installed base of 1,085 active systems in the United States, compared to 907 as of December 31, 2018. Treatment sessions revenues in the United States represented 68% and 69% of total revenues in the United States for the years ended December 31, 2019 and 2018, respectively, and increased by 17% from $35.3 million for the year end December 31, 2018 to $41.1 million for the year ended December 31, 2019. The increase in U.S. treatment session revenue was primarily the result of an increase in the U.S. active installed base, which was partially offset by a decline in average U.S. treatment session revenue per active system. Average U.S. treatment session revenue per active system is calculated using the prior quarter’s ending active installed base, which was 1,032 as of September 30, 2019 and 858 as of September 30, 2018. For the full year 2019, the average U.S. treatment session revenue per active system was approximately $39,900, which was a decrease of 3% compared to the full year 2018. Cost of Revenues and Gross Margin Cost of revenues increased by $2.9 million, or 24%, from $12.4 million for the year ended December 31, 2018 to $15.4 million for the year ended December 31, 2019. The increase was primarily due to increased NeuroStar Advanced Therapy System sales. Gross margin was 75.4% for the year ended December 31, 2019 compared to 76.4% for the year ended December 31, 2018. The decrease in gross margin was the result of a higher percentage of sales-type leases combined with lower average selling prices on capital sales. This decrease was partially offset by increased leverage on our service and operations costs. Sales and Marketing Expenses Sales and marketing expenses increased by $4.7 million, or 12%, from $38.3 million for the year ended December 31, 2018 to $43.0 million for the year ended December 31, 2019. The increase was primarily due to increased personnel costs as a result of our sales and marketing expansion activities, as well as higher marketing expenses and sales commission costs, consistent with our growth in revenues. General and Administrative Expenses General and administrative expenses increased by $3.8 million, or 28%, from $13.7 million for the year ended December 31, 2018 to $17.5 million for the year ended December 31, 2019. The increase was primarily due to an increase in personnel and legal, accounting and other professional services expenses required to support the growth of our business and the infrastructure for public company reporting. Research and Development Expenses Research and development expenses increased $5.5 million, or 67%, from $8.2 million for the year ended December 31, 2018 to $13.7 million for the year ended December 31, 2019. The increase was primarily due to expenses relating to the launch of the next generation of our NeuroStar Advanced Therapy System and TrakStar practice management system, as well as increased spending in clinical development. Interest Expense Interest expense was flat at $3.7 million for the years ended December 31, 2018 and 2019. Other (Income) Expense, Net Other expense (income), net increased by $2.1 million from $0.6 million for year December 31, 2018 to ($1.6) million for the year ended December 31, 2019, primarily as a result of increased interest income earned on the Company’s money market accounts and the final revaluation of the Company’s warrants in the third quarter of 2018. Comparison of the Years ended December 31, 2018 and 2017 Revenues Total revenues increased by $12.3 million, or 31%, from $40.4 million for the year ended December 31, 2017 to $52.8 million for the year ended December 31, 2018. Revenues in the United States increased by $11.6 million from 2017 to 2018 due to higher unit sales of both NeuroStar Advanced Therapy Systems and treatment sessions. During the fourth quarter of 2017, we entered into an exclusive distribution agreement with Teijin, which we believe will allow us to increase our revenues in Japan once we obtain reimbursement in that country. Revenues in the United States increased by $11.6 million, or 29%, from $39.9 million for the year ended December 31, 2017 to $51.5 million for the year ended December 31, 2018. NeuroStar Advanced Therapy System revenues in the United States grew by $4.5 million, or 44%, in the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase in U.S. NeuroStar revenue was primarily driven by higher capital revenue growth of 59% due to higher unit sales, partially offset by an 8% decrease in average selling prices, lower upgrade, rent-to-own, and other related revenue. NeuroStar Advanced Therapy System revenues represented 28% and 25% of U.S. revenues for 2018 and 2017, respectively. We believe the growth in NeuroStar Advanced Therapy System revenues between these two periods was the result of the efforts of our expanded commercial organization and increased marketing efforts. As of December 31, 2018, we had an installed base of 907 active systems in the United States, compared to 752 as of December 31, 2017. Treatment session revenues in the United States represented 69% and 71% for the years ended December 31, 2018 and 2017, respectively, and increased by 25% from $28.4 million for the year end December 31, 2017 to $35.3 million for the year ended December 31, 2018. The increase in United States treatment session revenues was primarily the result of an approximate 25% increase in the number of treatment sessions sold, partially offset by a 5% decline in average selling price due to pre-determined volume pricing discounts within our existing customer base which are triggered when those customers surpass certain high volume thresholds, plus an increase in other treatment session revenue. Cost of Revenues and Gross Margin Cost of revenues increased by $2.8 million, or 29%, from $9.6 million for the year ended December 31, 2017 to $12.4 million for the year ended December 31, 2018. The increase was primarily due to increased NeuroStar Advanced Therapy System sales. Gross margin was 76.4% for the year ended December 31, 2018 compared to 76.2% for the year ended December 31, 2017. The gross margin was higher due to increased leverage on our service and operation costs, which were partially offset by the higher mix of NeuroStar Advanced Therapy System revenues in 2018 in relation to treatment session revenue and the reduction in average selling prices of our treatment sessions. Sales and Marketing Expenses Sales and marketing expenses increased by $10.4 million, or 37%, from $27.9 million for the year ended December 31, 2017 to $38.3 million for the year ended December 31, 2018. The increase was primarily due to increased personnel costs as a result of our sales and marketing expansion activities, as well as higher marketing expenses and sales commission costs, consistent with our growth in revenues. During 2018, we added 15 new sales territories and undertook several marketing projects to support our expansion plans, including increasing our presence at trade shows, expanding our media campaigns and enhancing our practice support program to include patient starter kits. General and Administrative Expenses General and administrative expenses increased by $5.1 million, or 59%, from $8.6 million for the year ended December 31, 2017 to $13.7 million for the year ended December 31, 2018. The increase was primarily due to an increase in personnel and legal, accounting and other professional services expenses required to support the growth of our business and ready the infrastructure for public company reporting. Research and Development Expenses Research and development expenses increased $0.3 million, or 4%, from $7.9 million for the year ended December 31, 2017 to $8.2 million for the year ended December 31, 2018. The increase was primarily due to expenses relating to the launch of the next generation of our NeuroStar Advanced Therapy System and TrakStar practice management system, which were partially offset by declines in spending relating to our adolescent study. Interest Expense Interest expense increased $0.9 million, or 31%, from $2.8 million for the year ended December 31, 2017 to $3.7 million for the year ended December 31, 2018, primarily as a result of higher cash interest expenses related to the increase in principal borrowings under our current credit facility and higher non-cash interest expenses accrued in connection with final payment fees due to the lender under the agreement. Other (Income) Expense, Net Other expense (income), net decreased by $0.9 million from ($0.3) million for year December 31, 2017 to $0.6 million for the year ended December 31, 2018. The fair value remeasurement of the liability related to our outstanding convertible preferred stock warrants decreased by $1.7 million during the year ended December 31, 2018, which was based on the closing stock price on June 29, 2018, following the pricing of our IPO on June 27, 2018. Upon closing of our IPO on July 2, 2018, all of our outstanding convertible preferred stock warrants converted into common stock warrants, resulting in the reclassification of our convertible preferred stock warrant liability into additional paid-in-capital. This decrease was partially offset by a $0.8 million of increase in interest income earned on the proceeds received from the IPO. Other expense (income), net for 2018 includes a one-time $0.1 million non-utilization fee related to the Company’s election to not draw down the Term C loan, primarily as a result of the funds received from the IPO. Liquidity and Capital Resources Overview On July 2, 2018, we closed our IPO, in which we issued and sold 6,325,000 shares of our common stock, which included shares sold pursuant to an option granted to the underwriters to purchase additional shares, at a public offering price of $17.00 per share. We received net proceeds of $96.5 million after deducting underwriting discounts, commissions and other offering expenses paid by us. As of December 31, 2019, we had cash and cash equivalents of $75.7 million and an accumulated deficit of $250.1 million, compared to cash and cash equivalents of $104.6 million and an accumulated deficit of $221.0 million as of December 31, 2018. We incurred negative cash flows from operating activities of $30.5 million and $20.6 million for the years ended December 31, 2019 and 2018, respectively. We have incurred operating losses since our inception, and we anticipate that our operating losses will continue in the near term as we seek to expand our sales and marketing initiatives to support our growth in existing and new markets, invest funds in additional research and development activities and utilize cash for other corporate purposes. Our primary sources of capital to date have been from our IPO, private placements of our convertible preferred securities, borrowings under our credit facilities and sales of our products. As of December 31, 2019, we had $30.0 million of borrowings outstanding under our credit facility, which matures in March 2022. We expect our revenues and expenses to increase in connection with our on-going activities, particularly as we continue to execute on our growth strategy, including expansion of our sales and customer support teams. We also expect to incur additional costs now that we are a public company. Based on our current business plan, we believe that our cash and cash equivalents as of December 31, 2019 and anticipated revenues from sales of our products will be sufficient to meet our anticipated cash requirements for at least the next 24 months after December 31, 2019. However, if these sources are insufficient to satisfy our liquidity requirements, we may seek to sell additional common or preferred equity or debt securities, enter into a new credit facility or another form of third-party funding or seek other debt financing. If we raise additional funds by issuing equity or equity-linked securities, our stockholders would experience dilution and any new equity securities could have rights, preferences and privileges superior to those of holders of our common stock, including the shares of common stock sold in this offering. Debt financing, if available, may involve covenants restricting our operations or our ability to incur additional debt. We cannot be assured that additional equity, equity-linked or debt financing will be available on terms favorable to us or our stockholders, or at all. It is also possible that we may allocate significant amounts of capital towards products or technologies for which market demand is lower than expected and, as a result, abandon such efforts. If we are unable to obtain adequate financing when we require it, or if we obtain financing on terms which are not favorable to us, or if we expend capital on products or technologies that are unsuccessful, our ability to continue to support our business growth and to respond to business challenges could be significantly limited, or we may be required to delay the development, commercialization and marketing of our products. Our current and future funding requirements will depend on many factors, including: • our ability to achieve revenue growth and improve operating margins; • the cost of expanding our operations and offerings, including our sales and marketing efforts; • our ability to improve or maintain coverage and reimbursement arrangements with domestic third-party and government payors; • our rate of progress in establishing coverage and reimbursement arrangements from international commercial third-party and government payors, particularly in Japan; • our rate of progress in, and cost of the sales and marketing activities associated with, establishing adoption of our products and maintaining or improving our sales to our current customers; • the cost of research and development activities, including research and development relating to additional indications, which may include bipolar depression and PTSD; • the effect of competing technological and market developments; • costs related to international expansion; and • the potential cost of and delays in product development as a result of any regulatory oversight applicable to our products. Cash Flows The following table sets forth a summary of our cash flows for the years ended December 31, 2019, 2018, and 2017: Net Cash Used in Operating Activities Net cash used in operating activities for 2019 was $30.5 million, consisting primarily of a net loss of $29.0 million and an increase in net operating assets of $6.9 million, partially offset by non-cash charges of $5.5 million. The increase in net operating assets was primarily due to an increase in accounts receivable and inventory as a result of higher sales volumes, as well as increases in prepaid commission expense as a result of the Company’s adoption of ASC Topic 606, "Revenue from Contracts with Customers". Non-cash charges consisted of depreciation and amortization, non-cash interest expense, share-based compensation, and the cost of rental units purchased by customers. Net cash used in operating activities for 2018 was $20.6 million, consisting primarily of a net loss of $24.1 million, offset by an increase in net operating liabilities of $1.6 million and non-cash charges of $5.1 million. The increase in net operating assets was primarily due to an increase in accounts receivable and inventory as a result of higher sales volumes. Non-cash charges consisted of depreciation and amortization, non-cash interest expense, share-based compensation, the cost of rental units purchased by customers and the change in the fair value of the liability related to our then-outstanding convertible preferred stock warrants. Net cash used in operating activities for 2017 was $11.1 million, consisting primarily of a net loss of $16.1 million, offset by an increase in net operating liabilities of $3.2 million and non-cash charges of $1.8 million. The increase in net operating liabilities was primarily due to an increase in deferred revenue representing the initial payment and first milestone payment received in accordance with our Japanese distribution agreement as well as expanding commercial and research activities. Non-cash charges consisted of depreciation and amortization, non-cash interest expense, share-based compensation, the cost of rental units purchased by customers and the change in the fair value of the liability related to our then-outstanding convertible preferred stock warrants. Net Cash Used in Investing Activities Net cash used in investing activities for 2019 was $0.8 million, compared to net cash used in investing activities for 2018 of $1.0 million and $0.6 million for 2017, in each case attributable to purchases of property and equipment and capitalized software costs. Net Cash Provided by Financing Activities Net cash provided by financing activities for 2019 was $2.4 million, consisting primarily from proceeds from the exercise of stock options. Net cash provided by financing activities for 2018 was $97.0 million, consisting primarily of $100.0 million of proceeds related to the closing of our IPO on July 2, 2018, partially offset by $3.5 million of payments of costs related to the IPO. Net cash provided by financing activities for 2017 was $23.8 million, consisting of $14.8 million of net proceeds from the issuance of Series G convertible preferred stock and $10.0 million of borrowings under our current credit facility, offset by payment of $1.0 million of deferred debt issuance costs incurred in connection with our March 2017 amended credit facility. Indebtedness Oxford Credit Facility In March 2017, we entered into a new loan and security agreement with Oxford for a credit facility that replaced our previous $25.0 million credit facility with Oxford and which allowed us to borrow up to $35.0 million in three tranches of term loans: a Term A Loan in the amount of $25.0 million, which was drawn down immediately upon closing in March 2017, a Term B Loan in the amount of $5.0 million, which was drawn down in December 2017, and a Term C Loan in the amount of $5.0 million, which became available to us upon the achievement of $45.0 million of trailing twelve month revenues during the second quarter of 2018. Upon achieving the required revenue milestone, we had 60 days to notify Oxford if we elected to borrow the Term C Loan. As a result of completing our IPO on July 2, 2018 and receiving the proceeds therefrom, we elected not to borrow the additional $5.0 million, and it is no longer available to us. Each term loan accrues interest from the date of borrowing through the date of repayment at a floating per annum rate of interest, which resets monthly and is equal to the greater of (a) 8.15% or (b) the 30-day U.S. LIBOR on the last business day of the month plus 7.38%. At the date of each borrowing, we were required to issue to Oxford warrants to purchase our Series F or later series of convertible preferred stock with a seven-year term and in an amount equal to 3.95% of the first $5.0 million of each tranche borrowed. The credit facility matures and all amounts borrowed thereunder are due on March 1, 2022. As of December 31, 2019, we had borrowed and had outstanding an aggregate of $30.0 million of principal under our credit facility. The Term A Loan featured an interest-only period through March 2019, during which time we were required to make monthly interest payments, after which time we were required to make monthly payments of principal and interest based on a 36-month amortization schedule. However, upon the achievement of $45.0 million of revenues during the fourth quarter of 2018, the interest-only period was extended for an additional 12 months through March 2020, after which time we will be required to make monthly payments of principal and interest based on a 24-month amortization schedule. In connection with the drawdown of the Term A Loan, we issued to Oxford a warrant to purchase shares of its Series F convertible preferred stock. This convertible preferred stock warrant converted into a warrant to purchase 20,303 shares of our common stock at an exercise price of $9.73 per share. The warrant will expire in March 2024. The Term B Loan featured an interest-only period through March 2019, during which time we were required to make monthly interest payments, after which time we were required to make monthly payments of principal and interest based on a 36-month amortization schedule. However, due to the achievement of $45.0 million of revenues during the fourth quarter of 2018, the interest-only period was extended for an additional 12 months through March 2020, after which time we will be required to make monthly payments of principal and interest based on a 24-month amortization schedule. In connection with the drawdown of the Term B Loan, we issued to Oxford a warrant to purchase shares of its Series F convertible preferred stock. This convertible preferred stock warrant converted into a warrant to purchase 20,303 shares of our common stock at an exercise price of $9.73 per share. The warrant will expire in December 2024. In addition to principal and interest payments due under the credit facility, we are required to make final payment fees to Oxford due upon the earlier of prepayment or maturity of each tranche, which increased as a result the extension of the interest-only period and are now equal to 8.5% and 7.5% of the principal amounts of the Term A Loan and Term B Loan, respectively. We accrue the estimated final payment fees using the effective interest rate, with a charge to non-cash interest expense, over the term of borrowing for each tranche. As of December 31, 2019 and 2018, the effective interest rates for the Term A Loan and Term B Loan were 11.87% and 12.14%, respectively. As of December 31, 2017, the effective interest rates for the Term A Loan and Term B Loan were 10.7% and 11.6%, respectively. If the we prepay our term loans prior to their respective scheduled maturities, we will also be required to make prepayment fees to Oxford equal to 3% if prepaid on or before the first anniversary of funding, 2% if prepaid after the first and on or before the second anniversary of funding, or 1% if prepaid after the second anniversary of funding of the principal amounts borrowed. Our obligations under the credit facility are secured by a first priority security interest in substantially all of our assets, other than our intellectual property. We have agreed not to pledge or otherwise encumber any of our intellectual property. The loan and security agreement related to our credit facility includes a financial maintenance covenant that requires us to achieve at least 75% of our trailing 12-month forecasted revenues, as measured each month in accordance with a forecast that we provided to Oxford upon signing the agreement and future forecasts that we are required to deliver to Oxford each year for the life of the credit facility, as well as customary affirmative and negative covenants. We were in compliance with all of the covenants under our credit facility as of December 31, 2018. The loan and security agreement related to our credit facility contains events of default, including, without limitation, events of default upon: (i) failure to make payment pursuant to the terms of the agreement; (ii) violation of covenants; (iii) material adverse changes to our business; (iv) attachment or levy on our assets or judicial restraint on our business; (v) insolvency; (vi) significant judgments, orders or decrees for payments by us not covered by insurance; (vii) incorrectness of representations and warranties; (viii) incurrence of subordinated debt; (ix) revocation of governmental approvals necessary for us to conduct our business; and (x) failure by us to maintain a valid and perfected lien on the collateral securing the borrowing. Based on a 24-month amortization of the outstanding principal amounts of the Term A Loan and Term B Loan beginning on April 1, 2020 as discussed above, the following table sets forth by year our required future principal payments (in thousands): On March 2, 2020, the Company entered into a loan and security agreement with Solar, as collateral agent, and the lenders identified therein, for a credit facility that replaced the Company’s previous $35.0 million credit facility with Oxford. Simultaneously with the Company’s entry into the Solar credit facility, the Company prepaid in full all outstanding obligations under, and terminated, the Oxford credit facility. Cash and Non-Cash Interest Expense For the year ended December 31, 2019, we recognized interest expense of $3.7 million, of which $2.9 million was cash and $0.8 million was non-cash interest expense related to the amortization of deferred financing costs and accrual of final payment fees. For the year ended December 31, 2018, we recognized interest expense of $3.7 million, of which $2.9 million was cash and $0.8 million was non-cash interest expense related to the amortization of deferred financing costs and accrual of final payment fees. Off-Balance Sheet Arrangements We do not maintain any off-balance sheet arrangements, partnerships or other relationships with unconsolidated entities, often referred to as structured finance or special-purpose entities, which are established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Commitments and Contractual Obligations The following table sets forth a summary of our contractual obligations as of December 31, 2019: (1) Interest payable reflects the rate in effect as of December 31, 2019. The interest rate on borrowings under the credit facility is variable and resets monthly. Lender fees reflect final payment fees due. (2) Reflects obligations primarily related to our office and warehouse/storage leases in Malvern, PA. Critical Accounting Policies and Use of Estimates The preparation of our financial statements in accordance with accounting principles generally accepted in the United States, or GAAP, and the rules and regulations of the SEC requires us to make estimates and assumptions, based on judgments considered reasonable, which 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 period. We base our estimates and assumptions 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 value of assets and liabilities that are not readily apparent from other sources. Although we believe our estimates and assumptions are reasonable when made, they are based upon information available to us at the time they are made. We evaluate our estimates and assumptions on an ongoing basis and, if necessary, make adjustments. Due to the risks and uncertainties involved in our business and evolving market conditions and given the subjective element of the estimates and assumptions made, actual results may differ from estimated results. We define our critical accounting policies as those accounting policies that are most important to the portrayal of our financial condition and results of operations and require our most difficult and subjective judgments. While our significant accounting policies are more fully described in “Note 3. Summary of Significant Accounting Policies” in our audited financial statements and related notes thereto appearing elsewhere in this Annual Report on Form 10-K, we believe the following discussion addresses our most critical accounting policies. Revenue Recognition On January 1, 2019, we adopted Accounting Standards Codification (ASC) 606, Revenue from Contracts with Customers, using the modified retrospective method. Under ASC 606, we recognize revenue when control of the promised good or service is transferred to our customers in an amount that reflects the consideration to which we expect to be entitled in exchange for those good or services. Accordingly, we determine revenue recognition by applying the following steps: • identification of the contract, or contracts, with a customer; • identification of the performance obligations in the contract; • determination of the transaction price; • allocation of the transaction price to the performance obligations in the contract; and • recognition of revenue when, or as, we satisfy a performance obligation. We primarily earn revenues are from the sale of NeuroStar Advanced Therapy Systems, consumable single use treatment sessions, and accessory products. A contract’s transaction price is allocated to each performance obligation and recognized as revenue when, or as, the performance obligation is satisfied, which generally is the point in time when the product is shipped or control is transferred. We sell to end users in the United States and to third-party distributors outside the United States and do not provide return rights. Sales to distributors outside the United States are made in U.S. dollars. Revenue attributable to the NeuroStar Advanced Therapy Systems purchased on a rent-to-own basis are accounted for either (1) as operating leases and revenue is recognized on a straight-line basis over the term of the lease; or (2) as a sales-type lease and revenue is recognized upon installation. Our NeuroStar Advanced Therapy System sales in the United States typically have a post-sale training obligation. This obligation is fulfilled after product shipment, and we defer recognizing revenue until training occurs. We defer the fair value attributable to the post shipment training and recognize such revenue when the obligation is fulfilled. We base the fair value of the training using stand-alone service rates. Our sales to our third-party distributors outside the United States do not have these post-sale obligations. In addition, we provide a one to two-year warranty for systems sold in the United States. Terms of product warranty differ amongst our third-party distributors outside the United States but are generally two years. We provide for the estimated cost to repair or replace products under any warranty at the time of sale. We also offer our customers in the United States annual service contracts. Revenue from the sale of annual service contracts is recognized on a straight-line basis over the period of the applicable contract. We also earn revenue from customers from services outside of their warranty term or annual service contracts. Such service revenue is recognized as the services are provided. JOBS Act Accounting Election We are an “emerging growth company,” as defined in the Jumpstart Our Business Startups Act of 2012, or JOBS Act, and are eligible to take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies. 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 of 1933, or Securities Act, for complying with new or revised accounting standards issued subsequent to the enactment of the JOBS Act until such time as those standards apply to private companies. Section 107 of the JOBS Act provides that we can elect to opt out of the extended transition period at any time, which election is irrevocable. We have elected to avail ourselves of this exemption from complying with new or revised accounting standards and, therefore, will not be subject to the same new or revised accounting standards as other public companies that are not emerging growth companies. Subject to certain conditions, as an emerging growth company, we may rely on certain other exemptions and reduced reporting requirements under the JOBS Act, including without limitation (i) providing an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404(b) of the Sarbanes-Oxley Act and (ii) complying 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, known as the auditor discussion and analysis. We will remain an emerging growth company until the earlier of (a) the last day of the fiscal year in which we have total annual gross revenue of $1.07 billion or more; (b) the last day of the fiscal year following the fifth anniversary of the date of the completion of our IPO; (c) the date on which we have issued more than $1.0 billion in nonconvertible debt during the previous six years; or (d) the date on which we are deemed to be a large accelerated filer under the rules of the SEC. Recent Accounting Pronouncements We refer you to “Note 4. Recent Accounting Pronouncements” in our audited financial statements and related notes thereto included elsewhere in this Annual Report on Form 10-K.
-0.088734
-0.088639
0
<s>[INST] The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our audited financial statements and related notes thereto and other financial information included elsewhere in this Annual Report on Form 10K. In addition to historical financial information, some of the information contained in the following discussion and analysis contains forwardlooking statements that involve risks, uncertainties and assumptions. You should review the ‘‘Risk Factors’’ section of this Annual Report on Form 10K for a discussion of important factors that could cause our actual results to differ materially from the results described in or implied by the forwardlooking statements contained in the following discussion and analysis. Overview We are a commercial stage medical technology company focused on designing, developing and marketing products that improve the quality of life for patients who suffer from psychiatric disorders. Our first commercial product, the NeuroStar Advanced Therapy System, is a noninvasive and nonsystemic officebased treatment that uses transcranial magnetic stimulation, or TMS, to create a pulsed, MRIstrength magnetic field that induces electrical currents designed to stimulate specific areas of the brain associated with mood. The system is cleared by the United States Food and Drug Administration, or FDA, to treat adult patients with major depressive disorder, or MDD, that have failed to achieve satisfactory improvement from prior antidepressant medication in the current MDD episode. NeuroStar Advanced Therapy is safe, clinically effective, reproducible and precise and we believe is supported by the largest clinical data set of any competing TMS system. We believe we are the market leader in TMS therapy based on our U.S. installed base of 1,085 active NeuroStar Advanced Therapy Systems in approximately 870 psychiatrist offices as of December 31, 2019 and the estimated 81,600 patients treated with approximately 2.9 million of our treatment sessions through such date. We generated revenues of $62.7 million and $52.8 million for the years ended December 31, 2019 and 2018, respectively. We designed the NeuroStar Advanced Therapy System as a noninvasive therapeutic alternative to treat patients who suffer from MDD and to address many of the key limitations of existing treatment options. We generate revenues from initial capital sales of our systems, sales of our recurring treatment sessions and from service and repair and extended warranty contracts. We derive the majority of our revenues from recurring treatment sessions. For the year ended December 31, 2019, revenues from sales of our treatment sessions and NeuroStar Advanced Therapy Systems represented 68% and 30% of our U.S. revenues, respectively. For the year ended December 31, 2018, revenues from sales of our treatment sessions and NeuroStar Advanced Therapy Systems represented 69% and 28% of our U.S. revenues, respectively. We currently sell our NeuroStar Advanced Therapy System and recurring treatment sessions in the United States through our sales and customer support team. Our sales force primarily targets 20,600 psychiatrists at 5,700 highdecile psychiatric practices that we estimate, based on data from Symphony Health and our own internal estimates, treat approximately 42% of the total MDD patients in the United States who meet our labeled indication and are insured. We expect to continue to expand our direct sales and customer support team to further penetrate the market by demonstrating the benefits of our NeuroStar Advanced Therapy to psychiatrists and their MDD patients. Some of our customers have and may purchase more than one NeuroStar Advanced Therapy System. Based on our commercial data, we believe psychiatrists can recoup their initial capital investment in our system by providing a standard course of treatment to approximately 12 patients. We believe psychiatrists can generate approximately $7,500 to $10,000 of revenue per patient for a standard course of treatment, which may provide meaningful incremental income to their practices. We have a diverse customer base of psychiatrists in group psychiatric practices in the United States. No single customer accounted for more than 10% of our revenues for the years ended December 31, 2019 or 2018. Patients are reimbursed by Medicare and the vast majority of commercial payors in the United States for treatment [/INST] Negative. </s>
2,020
7,936
1,614,067
Aridis Pharmaceuticals, Inc.
2019-03-28
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 The following discussion and analysis should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this Annual Report. This discussion and analysis and other parts of this Annual Report contain forward-looking statements based upon current beliefs, plans and expectations that involve risks, uncertainties and assumptions, such as statements regarding our plans, objectives, expectations, intentions and projections. Our actual results and the timing of selected events could differ materially from those anticipated in these forward-looking statements as a result of several factors, including those set forth under "Risk Factors" and elsewhere in this Annual Report. You should carefully read the "Risk Factors" section of this Annual Report to gain an understanding of the important factors that could cause actual results to differ materially from our forward-looking statements. Please also see the section entitled "Cautionary Note Concerning Forward-Looking Statements." All amounts in this report are in U.S. dollars, unless otherwise noted. Overview We are a late-stage biopharmaceutical company focused on the discovery and development of targeted immunotherapy using fully human monoclonal antibodies, or mAbs, to treat life-threatening infections. mAbs represent an innovative treatment approach that harnesses the human immune system to fight infections and are designed to overcome the deficiencies associated with current therapies, such as rise in drug resistance, short duration of response, negative impact on the human microbiome, and lack of differentiation among the treatment alternatives. The majority of our product candidates are derived by employing our differentiated antibody discovery platform called MabIgX. Our proprietary product pipeline is comprised of fully human mAbs targeting specific pathogens associated with life-threatening bacterial infections, primarily hospital-acquired pneumonia, or HAP, and ventilator-associated pneumonia, or VAP. Two of our product candidates have exhibited promising preclinical data and clinical data are available from two completed studies. Our lead product candidate, AR-301, targets the alpha toxin produced by gram-positive bacteria Staphylococcus aureus, or S. aureus, a common pathogen associated with HAP and VAP. We initiated a Phase 3 pivotal trial evaluating AR-301 for the treatment of HAP and VAP. To date, we have devoted substantially all of our resources to research and development efforts relating to our therapeutic candidates, including conducting clinical trials and developing manufacturing capabilities, in-licensing related intellectual property, protecting our intellectual property and providing general and administrative support for these operations. We have generated revenue from our payments under our collaboration strategic research and development contracts and federal awards and grants, as well as awards and grants from not-for-profit entities and fee for service to third party entities. Since our inception, we have funded our operations primarily through these sources and the issuance of common stock, convertible preferred stock and debt securities. We have incurred losses since our inception. Our net losses were approximately $22.1 million and $24.7 million for the years ended December 31, 2018 and 2017, respectively. As of December 31, 2018, we had an accumulated deficit of approximately $71.1 million. As of December 31, 2018, and 2017, we had $24.2 million and $25.1 million of cash and cash equivalents, respectively. Substantially all our net losses have resulted from costs incurred in connection with our research and development programs, clinical trials, intellectual property matters, strengthening our manufacturing capabilities, and from general and administrative costs associated with our operations. On August 16, 2018, we completed an initial public offering or "IPO" of our common stock, in which we sold and issued 2,000,000 shares, plus 192,824 shares subsequently sold pursuant to the partial exercise by the underwriters of their over-allotment option, at an issuance price of $13.00 per share, less underwriting discounts and commissions. As a result of the IPO and the exercise of the underwriters' over-allotment option, we received total net proceeds of approximately $25.1 million, net of underwriting and other offering expenses. We believe that our existing cash and cash equivalents will provide sufficient funds to enable us to meet our obligations into the first quarter of 2020. We have not yet achieved commercialization of our products and have a cumulative net loss from our operations. We will continue to incur net losses for the foreseeable future. Our consolidated financial statements have been prepared assuming that we will continue as a going concern. We will require additional capital to meet our long-term operating requirements. We expect to raise additional capital through the sale of equity and/or debt securities. Historically, our principal sources of cash have included proceeds from grant funding, fees for services performed, issuances of convertible debt and the sale of our preferred stock. Our principal uses of cash have included cash used in operations. We expect that the principal uses of cash in the future will be for continuing operations, funding of research and development including our clinical trials and general working capital requirements. We anticipate that our expenses will increase substantially if and as we: • continue enrollment in our ongoing clinical trials; • initiate new clinical trials; • seek to identify, assess, acquire and develop other products, therapeutic candidates and technologies; • seek regulatory and marketing approvals in multiple jurisdictions for our therapeutic candidates that successfully complete clinical studies; • establish collaborations with third parties for the development and commercialization of our products and therapeutic candidates; • make milestone or other payments under our agreements pursuant to which we have licensed or acquired rights to intellectual property and technology; • seek to maintain, protect, and expand our intellectual property portfolio; • seek to attract and retain skilled personnel; • incur the administrative costs associated with being a public company and related costs of compliance; • create additional infrastructure to support our operations as a commercial stage public company and our planned future commercialization efforts; and • experience any delays or encounter issues with any of the above. We expect to continue to incur significant expenses and increasing losses for at least the next several years. Accordingly, we anticipate that we will need to raise additional capital in addition to the net proceeds from this offering in order to obtain regulatory approval for, and the commercialization of our therapeutic candidates. Until such time that we can generate meaningful revenue from product sales, if ever, we expect to finance our operating activities through public or private equity or debt financings, government or other third-party funding and other collaborations, strategic alliances and licensing arrangements or a combination of these approaches. If we are unable to obtain funding on a timely basis, we may be required to significantly curtail, delay or discontinue one or more of our research or development programs or the commercialization of any approved therapies or products or be unable to expand our operations or otherwise capitalize on our business opportunities, as desired, which could adversely affect our business, financial condition and results of operations. Financial Overview Reverse Stock Split On August 3, 2018, we effected a 1 for 6.417896 reverse stock split of our common stock. The par value and the number of authorized shares of the common and convertible preferred stock were not adjusted as a result of the reverse stock split. All common stock share and per-share amounts for all periods presented in this Annual Report on Form 10-K have been adjusted retroactively to reflect the reverse stock split. Initial Public Offering On August 13, 2018, our registration statement on Form S-1 relating to our IPO of our common shares (the "IPO") was declared effective by the Securities and Exchange Commission ("SEC"). The IPO closed on August 16, 2018 and we issued and sold 2,000,000 common shares at a public offering price of $13.00 per share. Gross proceeds totaled $26.0 million and net proceeds totaled $22.8 million after deducting underwriting discounts and commissions of $1.8 million and other offering expenses of approximately $1.4 million. The underwriters of the IPO partially exercised their over-allotment option, and on August 30, 2018, we issued and sold 192,824 common shares at a public offering price of $13.00 per share for gross proceeds totaling approximately $2.5 million and net proceeds of approximately $2.3 million after deducting underwriting discounts and commissions of approximately $0.2 million. In connection with the IPO, the holders of a majority of the Series A Preferred Stock approved the mandatory conversion of the Series A Preferred Stock into one share of common stock for every 6.417896 shares of Series A Preferred Stock which converted immediately prior to the consummation of the IPO. Upon conversion, a total of 5,744,586 shares of common stock were issued for the converted Series A Preferred Stock which included the accrued dividends upon conversion. All warrants to purchase Series A Preferred Stock became warrants to purchase common stock, adjusted for the 1 for 6.417896 shares reverse stock split. Revenue Our sources of revenue are grants and contract services provided to third party entities related to research and development activities under specific agreements with such granting authorities and third parties. As there is a contractually agreed upon price, and collectability from the granting authorities or other entities is reasonably assured, revenue for these services are earned according to the terms of the respective agreements, usually as progress is made throughout the term of the agreement or as certain material milestones are met. We have an award agreement with the Cystic Fibrosis Foundation, or CF Foundation to support funding for the development of our Inhaled Gallium Citrate Anti-Infective program. We have a collaborative and option agreement with GlaxoSmithKline Biologicals S.A., or GSK, aimed at evaluating improved formulations for a rotavirus vaccine. These agreements contain upfront payments. We recognize revenue from upfront payments ratably over the term of our estimated period of performance under the agreements or as certain milestones are met. In addition to receiving upfront payments, we are entitled to milestone and other contingent payments upon achieving predefined objectives or the exercise of options for specified programs by our strategic partners. Such payments are recorded as revenue when we achieve the underlying milestone if there is substantive uncertainty at the date the arrangement is entered into that the event will be achieved. For the years ended December 31, 2018 and 2017, pursuant to our CF Foundation agreement we recognized revenue of $1,589,000 and $89,000, respectively. For the years ended December 31, 2018 and 2017, pursuant to our GSK agreement, we recognized revenue of $1,168,000 and $771,000, respectively. No revenue was recognized on either agreement prior to 2017. In December 2018 at a meeting of the Joint Steering Committee, it was agreed by the parties to terminate the GSK collaboration and option agreement. We expect that any revenue we generate for the foreseeable future will fluctuate from period to period as a result of the timing and amount of milestones and other payments from our agreements. Research and Development Expenses We recognize research and development expenses as they are incurred. Our research and development expenses consist primarily of: • salaries and related overhead expenses, which include stock-based compensation and benefits for personnel in research and development functions; • fees paid to consultants and contract research organizations, or CROs, including in connection with our preclinical studies and clinical trials and other related clinical trial fees, such as for investigator grants, patient screening, laboratory work, clinical trial material management and statistical compilation and analyses; • costs related to acquiring and manufacturing clinical trial materials; • costs related to compliance with regulatory requirements; and • payments related to licensed products and technologies. 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 and clinical sites. Nonrefundable advance payments for goods or services to be received in future periods for use in research and development activities are deferred and capitalized. The capitalized amounts are then expensed as the related goods are delivered and the services are performed. From our inception through December 31, 2018, we have incurred approximately $69.7 million in research and development expenses. We plan to increase our research and development expenses for the foreseeable future as we continue to develop our therapeutic programs, and subject to the availability of additional funding, further advance the development of our therapeutic candidates for additional indications and begin to conduct clinical trials. We typically use our employee and infrastructure resources across multiple research and development programs, and accordingly we have not historically allocated resources specifically to our individual clinical programs. The process of conducting the necessary clinical research to obtain regulatory approval is costly and time-consuming, and the successful development of our therapeutic 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 therapeutic candidates. General and Administrative Expenses General and administrative expenses consist primarily of costs related to executive, finance, corporate development and administrative support functions, including stock-based compensation expenses and benefits for personnel in general and administrative functions. Other significant, general and administrative expenses include rent, accounting and legal services, obtaining and maintaining patents or other intellectual property rights, the cost of various consultants, occupancy costs, insurance premiums and information systems costs. We expect that our general and administrative expenses will increase as we operate as a public company, continue to conduct our clinical trials and prepare for commercialization. We believe that these increases will likely include increased costs for director and officer liability insurance, costs related to the hiring of additional personnel to support product commercialization efforts and increased fees for outside consultants, attorneys and accountants. We also expect to incur increased costs to comply with corporate governance, internal controls, investor relations and disclosures, and similar requirements applicable to public companies. Interest and Other Income, Net Interest and other income, net consists primarily of interest on our cash balances. Critical Accounting Policies and Estimates Our management's discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements, which we have prepared in accordance with generally accepted accounting principles in the United States, or GAAP. The preparation of our 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 our financial statements, as well as the reported expenses during the reported periods. We evaluate these estimates and judgments on an ongoing basis. We base our estimates on 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. Our actual results may differ from these estimates under different assumptions or conditions. 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. We believe the critical accounting policies used in the preparation of our financial statements that require significant estimates and judgments are as follows: Use of Estimates The preparation of consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of expenses during the reporting period. Such estimates include those related to the evaluation of our ability to continue as a going concern, revenue recognition, allowance for doubtful accounts, long-lived assets, convertible debt, income taxes, assumptions used in the Black-Scholes-Merton, or BSM, model to calculate the fair value of stock-based compensation, Monte Carlo Simulation, or MSM, model to calculate the fair value of warrants, deferred tax asset valuation allowances, valuation of our common and convertible preferred stock, fair value assumptions used in the valuation of warrants issued with convertible notes and convertible preferred stock warrant liabilities, preclinical study and clinical trial accruals and various accrued liabilities. Our actual results could differ from these estimates. Revenue Recognition Revenue is recognized in accordance with the Financial Accounting Standards Board, or FASB Accounting Standards Codification, or ASC 605, Revenue Recognition which requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred and title and the risks and rewards of ownership have been transferred to the client or services have been rendered; (3) the price is fixed or determinable; and (4) collectability is reasonably assured. During 2018 and 2017, revenue includes grant awards and contract services entered into for specific research and development efforts. We recognize revenue under such awards and contracts as the related qualified research and development expenses are incurred or under the milestone method, up to the limit of the prior approval funding amounts, and when we have determined that we have earned the right to receive the recognized portion according to the terms of the original grant awarded. During 2018 and 2017, all grant revenue was derived from our award agreement with the CF Foundation. In December 2016, we received an award from the CF Foundation for approximately $2,902,000. The agreement contains an upfront payment of $200,000 which is being recognized straight-line over the term of the contract as we believe the upfront fee relates to services performed throughout the contract period and the upfront fee does not represent a substantive milestone within the agreement. Recognition of revenue for the remaining payments under the agreement will be recognized using the milestone method as substantive milestones are met since there is uncertainty as to whether the milestones will be met and our performance will be responsible for achieving the respective milestones. The milestones relate to both preclinical development and regulatory related activities. The agreement also specifies that we are obligated to cumulatively spend on the development program at least an equal amount as it received from the non-profit organization. In the event that we do not spend as much as we received under the agreement, we are obligated to return any overage to the Cystic Fibrosis Foundation. In November 2018, the CF Foundation increased the award to $7,466,000. In 2017, we entered into a collaborative research and option agreement with GSK. In accordance with the agreement, we received an upfront fee and annual fees and amounts for development work to be performed as specifically outlined under the agreement. The work to be performed was delineated into three specific research projects. In assessing the appropriate revenue recognition related to a collaboration agreement, we first determined whether the arrangement includes multiple elements, such as the delivery of intellectual property rights and research and development services. The multiple elements were analyzed to determine whether the deliverables could be separated or whether they must be accounted for as a single unit of accounting. We determined that none of the elements had stand-alone value and that the agreement qualifies for treatment as a multiple element arrangement to be accounted for as a single unit of accounting. Amounts received prior to satisfying the revenue recognition criteria are recorded as deferred revenue in our balance sheet. Recognition of revenue under the contract will be based on the terms of the contract and will be recognized under the proportional performance method derived from the completion of certain stages as defined within the contract. In December 2018 at a meeting of the Joint Steering Committee, it was agreed by the parties to terminate the GSK collaboration and option agreement. For the year ended December 31, 2018, approximately $1,168,000 was recorded as collaboration revenue related to the agreement with GSK. This included the recognition of all previously deferred revenue and $440,000 for additional authorized work performed during the term of the agreement. Research and Development Research and development costs are charged to operations as incurred. Stock-Based Compensation We recognize compensation expense for all stock-based awards to employees and directors based on the grant-date estimated fair values, net of an estimated forfeiture rate. We recognize stock-based compensation cost for employees and directors on a straight-line basis over the requisite service period for the award. Stock-based compensation expense is recognized only for those awards that are ultimately expected to vest. We estimate forfeitures based on an analysis of historical employee turnover and will continue to evaluate the appropriateness of the forfeiture rate based on actual forfeiture experience, analysis of employee turnover and other factors. We will revise the forfeiture estimate, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Changes in forfeiture estimates impact stock-based compensation cost in the period in which the change in estimate occurs. The BSM option pricing model incorporates various highly sensitive assumptions, including the fair value of our common stock, expected volatility, expected term and risk-free interest rates. The weighted average expected life of options was calculated using the simplified method as prescribed by the SEC's Staff Accounting Bulletin, Topic 14 ("SAB Topic 14"). This decision was based on the lack of relevant historical data due to our limited historical experience. In addition, due to our limited historical data, the estimated volatility also reflects the application of SAB Topic 14, incorporating the historical volatility of comparable companies whose stock prices are publicly available. The risk-free interest rate for the periods within the expected term of the option is based on the U.S. Treasury yield in effect at the time of grant. The dividend yield was zero, as we have never declared or paid dividends and have no plans to do so in the foreseeable future. We account for stock-based compensation arrangements with nonemployees by recording the expense of such services based on the estimated fair value of the common stock at the measurement date. The value of the equity instrument, including adjustment to fair value at each balance sheet date, is charged to earnings over the term of the service agreement. Due to the absence of a public market trading for our common stock prior to going public in August of 2018, it was necessary to estimate the fair value of the common stock underlying our stock-based awards when performing fair value calculations. The estimated fair value of our common stock was determined using methodologies, approaches and assumptions consistent with the American Institute of Certified Public Accountants, or AICPA, Practice Aid: Valuation of Privately-Held-Company Equity Securities Issued as Compensation. We expect to utilize fair market values as determined by trades in the public markets at such time as our shares trade publicly and an observable market exists. Fair Value of Common Stock To assist our board of directors with the determination of the exercise price of our stock options and the fair value of the common stock underlying the options, we obtained third-party valuations of our common stock as of various dates since we began granting options, with concluded fair values between $2.89 per share and $17.91 per share. Our board of directors considered the fair values of the common stock derived in the third-party valuations as one of the factors it considered when setting the exercise prices for options granted. The valuations were performed in accordance with applicable elements of the AICPA Practice Aid. The AICPA 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 AICPA Practice Aid, we considered the following methods: • Option Pricing Method. Under the option pricing method, or OPM, shares are 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. Under the probability-weighted expected return method, or PWERM, common equity value is based upon an analysis of various future outcomes, such as an initial public offering, or IPO, merger or sale, dissolution, or continued operation as a private enterprise until a later exit date. The future allocated value is based upon the probability-weighted present values of expected future investment returns, considering each of the possible outcomes available to the enterprise, as well as the rights of each security class. Our board of directors also considered a range of objective and subjective factors and assumptions in estimating the fair value of our common stock on the date of grant, including: progress of our research and development efforts; our operating results and financial condition, including our levels of available capital resources; rights and preferences of our common stock compared to the rights and preferences of our other outstanding equity securities; our stage of development and material risks related to our business; our commercial success in regard to our catheter sales; the achievement of enterprise milestones; the valuation of publicly-traded companies in the life sciences and biotechnology sectors, as well as recently completed mergers and acquisitions of peer companies; equity market conditions affecting comparable public companies; the likelihood of achieving a liquidity event for the shares of common stock, such as an initial public offering given prevailing market and biotechnology sector conditions; and that the grants involved illiquid securities in a private company. The fair value of our common stock as of December 31, 2017 was $17.20. Following the closing of our public offering in August 2018, the fair value of our common stock is determined based on the closing price of our common stock on The Nasdaq Capital Market on the date immediately prior to the date of grant. Income Taxes We account for income taxes under the liability method. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized. We assess all material positions taken in any income tax return, including all significant uncertain positions, in all tax years that are still subject to assessment or challenge by the relevant taxing authorities. Assessing an uncertain tax position begins with the initial determination of the positions sustainability and is measured at the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement. At each balance sheet date, unresolved uncertain tax positions must be reassessed, and we determine whether (i) the factors underlying the sustainability assertion have changed and (ii) the amount of the recognized benefit is still appropriate. The recognition and measurement of tax benefits requires significant judgment. Judgments concerning the recognition and measurement of a tax benefit might change as new information becomes available. Going Concern We assess and determine our ability to continue as a going concern under the provisions of ASC Topic 205-40, Presentation of Financial Statements-Going Concern, which requires us to evaluate whether there are conditions or events that raise substantial doubt about our ability to continue as a going concern within one year after the date that our annual and interim financial statements are issued. Certain additional financial statement disclosures are required if such conditions or events are identified. If and when an entity's liquidation becomes imminent, financial statements should be prepared under the liquidation basis of accounting. Determining the extent, if any, to which conditions or events raise substantial doubt about our ability to continue as a going concern, or the extent to which mitigating plans sufficiently alleviate any such substantial doubt, as well as whether or not liquidation is imminent, requires significant judgment by us. We have determined that there is substantial doubt about our ability to continue as a going concern for the one-year period following the date that our financial statements for the year ended December 31, 2018 were issued, which have been prepared assuming that we will continue as a going concern. We have not made any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the possible inability of us to continue as a going concern. Results of Operations Comparison of the Year Ended December 31, 2018 and 2017 The following table summarizes our results of operations for the year ended December 31, 2018 and 2017 (in thousands): Collaboration Revenue. Collaboration revenue increased by approximately $397,000 from $771,000 for the year ended December 31, 2017 to $1,168,000 for the year ended December 31, 2018 due to the completion of WP2 and additional authorized work performed during the term of our agreement with GSK. Grant Revenue. Grant revenue increased by approximately $1,500,000 from $89,000 for the year ended December 31, 2017 to $1,589,000 for the year ended December 31, 2018 primarily due to the achievement of four milestones and amendment of our agreement with the CF Foundation. Research and Development Expenses. Research and development expenses increased by approximately $5,562,000 from $17,438,000 for the year ended December 31, 2017 to $23,000,000 for the year ended December 31, 2018 primarily due to increased activity in our Phase 2 AR-105 and Phase 1/2a AR-501 clinical trials, manufacturing drugs for current and future trials and an increase in personnel related expenses, partially offset by a decrease in spending on our AR-301 program. General and Administrative Expenses. General and administrative expenses increased by approximately $714,000 from $3,160,000 for the year ended December 31, 2017 to $3,874,000 for the year ended December 31, 2018 primarily due to an increase in professional services, personnel related costs and other administrative expenses, partially offset by a decrease in patent expense. Interest and Other Income, net. Interest and other income, net for the year ended December 31, 2018 increased by approximately $186,000 from income of $234,000 for the year ended December 31, 2017 to income of $420,000 for the year ended December 31, 2018 primarily due to a higher average cash balance after the completion of our IPO in August 2018. Change in Fair Value of Warrant Liability. Change in fair value of warrant liability for the year ended December 31, 2018 decreased by approximately $6,784,000 from a loss of $5,152,000 for the year ended December 31, 2017 to a gain of $1,632,000 for the year ended December 31, 2018 due to a decrease in the underlying fair value of the our Series A convertible preferred stock prior to the our Series A convertible preferred stock being converted into common stock upon our IPO in August 2018. Liquidity, Capital Resources and Going Concern Our IPO closed on August 16, 2018 and we issued and sold 2,000,000 common shares at a public offering price of $13.00 per share. Gross proceeds totaled $26.0 million and net proceeds totaled $22.8 million after deducting underwriting discounts and commissions of $1.8 million and other offering expenses of approximately $1.4 million. The underwriters of the IPO partially exercised their over-allotment option, and on August 30, 2018, we issued and sold 192,824 common shares at a public offering price of $13.00 per share for gross proceeds totaling approximately $2.5 million and net proceeds of approximately $2.3 million after deducting underwriting discounts and commissions of approximately $0.2 million. We anticipate that we will continue to generate operating losses and use cash in operations through the foreseeable future. Management plans to finance operations through equity or debt financings or other capital sources, including potential collaborations or other strategic transactions. There is substantial doubt about our ability to continue as a going concern unless we are able to successfully raise additional capital. There can be no assurances that, in the event that we require additional financing, such financing will be available on terms which are favorable to us, or at all. If we are unable to raise additional funding to meet our working capital needs in the future, we will be forced to delay or reduce the scope of our research programs and/or limit or cease our operations. We believe that our existing cash and cash equivalents will provide sufficient funds to enable us to meet our obligations into the first quarter of 2020. Cash Flows Our net cash flow from operating, investing and financing activities for the periods below were as follows (in thousands): Cash Flows from Operating Activities. Net cash used in operating activities was approximately $24,271,000 for the year ended December 31, 2018, which was primarily due to our net loss of $22,105,000. The difference between our net loss and our net cash used in operating activities was due primarily to an increase in our accounts payable and accrued liabilities, partially offset by an increase in prepaid and other assets and accounts receivable and a decrease in deferred revenue, and non-cash expenses resulting from a gain in the fair value of preferred stock warrants and stock-based compensation expense. Net cash used in operating activities was approximately $17,557,000 for the year ended December 31, 2017, which was primarily due to our net loss of $24,656,000. The difference between our net loss and our net cash used in operating activities was due primarily to an increase in our accounts payable and accrued liabilities, and a non-cash loss from the change in the fair value of preferred stock warrants, partially offset by an increase in prepaid and other assets and stock-based compensation expense. Cash Flows from Investing Activities. Net cash used in investing activities of $1,677,000 during the year ended December 31, 2018 was due to the cash paid for our investment a Joint Venture company named Shenzen Arimab BioPharmaceuticals Co., Ltd., and equipment purchases. Net cash used in investing activities of $698,000 during the year ended December 31, 2017 was due to the cash paid for equipment purchases. Cash Flows from Financing Activities. Net cash provided by financing activities of $25,089,000 during the year ended December 31, 2018 was due to net proceeds received from our IPO (including over-allotment proceeds). Net cash provided by financing activities of $21,060,000 during the year ended December 31, 2017 was due to net proceeds received from the issuance of preferred stock. Future Funding Requirements To date, we have generated funds from grants and contract services performed and the issuance of convertible preferred stock. We do not know when, or if, we will generate any revenue from our development stage therapeutic programs. We do not expect to generate any revenue from sales of our therapeutic candidates unless and until we obtain regulatory approval. At the same time, we expect our expenses to increase in connection with our ongoing development activities, particularly as we continue the research, development and clinical trials of, and seek regulatory approval for, our therapeutic candidates. We expect to incur additional costs associated with operating as a public company. In addition, subject to obtaining regulatory approval of any of our therapeutic candidates, we expect to incur significant commercialization expenses for product sales, marketing, manufacturing and distribution. We anticipate that we will need additional funding in connection with our continuing operations. Additionally, if the Cystic Fibrosis Foundation does not continue to provide sufficient level of funding support, we may not be able to complete the Phase 1/2a clinical trial relating to AR-501. Our future capital requirements will depend on many factors, including: • the progress, costs, results and timing of our clinical trials; • FDA acceptance, if any, of our therapies for infectious diseases and for other potential indications; • the outcome, costs and timing of seeking and obtaining FDA and any other regulatory approvals; • the number and characteristics of product candidates that we pursue, including our product candidates in preclinical development; • the ability of our product candidates to progress through clinical development successfully; • our need to expand our research and development activities; • the costs of acquiring, licensing or investing in businesses, products, product candidates and technologies; • our ability to maintain, expand and defend the scope of our intellectual property portfolio, including the amount and timing of any payments we may be required to make, or that we may receive, in connection with the licensing, filing, prosecution, defense and enforcement of any patents or other intellectual property rights; • our need and ability to hire additional management and scientific, medical and administrative personnel; • the effect of competing technological and market developments; and • our need to implement additional internal systems and infrastructure, including financial and reporting systems. Until such time that we can generate meaningful revenue from the sales of approved therapies and products, if ever, we expect to finance our operating activities through public or private equity or debt financings, government or other third-party funding, and other collaborations, strategic alliances and licensing arrangements or a combination of these approaches. To the extent that we raise additional capital through the sale of equity or convertible debt securities, the ownership interests of our common stockholders will 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, 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 to grant licenses on terms that may not be favorable to us. 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 the rules of the SEC. JOBS Act Accounting Election 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. We are choosing to take advantage of this provision and, as a result, we will adopt the extended transition period available under the JOBS Act 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 under the JOBS Act. Recent Accounting Pronouncements Information regarding recent accounting pronouncements applicable to us is included in the notes to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K.
-0.019454
-0.019128
0
<s>[INST] FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this Annual Report. This discussion and analysis and other parts of this Annual Report contain forwardlooking statements based upon current beliefs, plans and expectations that involve risks, uncertainties and assumptions, such as statements regarding our plans, objectives, expectations, intentions and projections. Our actual results and the timing of selected events could differ materially from those anticipated in these forwardlooking statements as a result of several factors, including those set forth under "Risk Factors" and elsewhere in this Annual Report. You should carefully read the "Risk Factors" section of this Annual Report to gain an understanding of the important factors that could cause actual results to differ materially from our forwardlooking statements. Please also see the section entitled "Cautionary Note Concerning ForwardLooking Statements." All amounts in this report are in U.S. dollars, unless otherwise noted. Overview We are a latestage biopharmaceutical company focused on the discovery and development of targeted immunotherapy using fully human monoclonal antibodies, or mAbs, to treat lifethreatening infections. mAbs represent an innovative treatment approach that harnesses the human immune system to fight infections and are designed to overcome the deficiencies associated with current therapies, such as rise in drug resistance, short duration of response, negative impact on the human microbiome, and lack of differentiation among the treatment alternatives. The majority of our product candidates are derived by employing our differentiated antibody discovery platform called MabIgX. Our proprietary product pipeline is comprised of fully human mAbs targeting specific pathogens associated with lifethreatening bacterial infections, primarily hospitalacquired pneumonia, or HAP, and ventilatorassociated pneumonia, or VAP. Two of our product candidates have exhibited promising preclinical data and clinical data are available from two completed studies. Our lead product candidate, AR301, targets the alpha toxin produced by grampositive bacteria Staphylococcus aureus, or S. aureus, a common pathogen associated with HAP and VAP. We initiated a Phase 3 pivotal trial evaluating AR301 for the treatment of HAP and VAP. To date, we have devoted substantially all of our resources to research and development efforts relating to our therapeutic candidates, including conducting clinical trials and developing manufacturing capabilities, inlicensing related intellectual property, protecting our intellectual property and providing general and administrative support for these operations. We have generated revenue from our payments under our collaboration strategic research and development contracts and federal awards and grants, as well as awards and grants from notforprofit entities and fee for service to third party entities. Since our inception, we have funded our operations primarily through these sources and the issuance of common stock, convertible preferred stock and debt securities. We have incurred losses since our inception. Our net losses were approximately $22.1 million and $24.7 million for the years ended December 31, 2018 and 2017, respectively. As of December 31, 2018, we had an accumulated deficit of approximately $71.1 million. As of December 31, 2018, and 2017, we had $24.2 million and $25.1 million of cash and cash equivalents, respectively. Substantially all our net losses have resulted from costs incurred in connection with our research and development programs, clinical trials, intellectual property matters, strengthening our manufacturing capabilities, and from general and administrative costs associated with our operations. On August 16, 2018, we completed an initial public offering or "IPO" of our common stock, in which we sold and issued 2,000,000 shares, plus 192,824 shares subsequently sold pursuant to the partial exercise by the underwriters of their overallotment option, at an issuance price of $13.00 per share, less underwriting discounts and commissions. As a result of the IPO and the exercise of the underwriters' overallotment option, we received total net proceeds [/INST] Negative. </s>
2,019
6,472
1,614,067
Aridis Pharmaceuticals, Inc.
2020-04-08
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 The following discussion and analysis should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this Annual Report. This discussion and analysis and other parts of this Annual Report contain forward-looking statements based upon current beliefs, plans and expectations that involve risks, uncertainties and assumptions, such as statements regarding our plans, objectives, expectations, intentions and projections. Our actual results and the timing of selected events could differ materially from those anticipated in these forward-looking statements as a result of several factors, including those set forth under "Risk Factors" and elsewhere in this Annual Report. You should carefully read the "Risk Factors" section of this Annual Report to gain an understanding of the important factors that could cause actual results to differ materially from our forward-looking statements. Please also see the section entitled "Cautionary Note Concerning Forward-Looking Statements." All amounts in this report are in U.S. dollars, unless otherwise noted. Overview We are a late-stage biopharmaceutical company focused on the discovery and development of non-antibiotic anti-infectives. A significant focus is on targeted immunotherapy using fully human monoclonal antibodies, or mAbs, to treat life-threatening infections. mAbs represent an innovative treatment approach that harnesses the human immune system to fight infections and are designed to overcome the deficiencies associated with current therapies, such as rise in drug resistance, short duration of response, negative impact on the human microbiome, and lack of differentiation among the treatment alternatives. The majority of our product candidates are derived by employing our differentiated antibody discovery platforms. Our proprietary product pipeline is comprised of fully human mAbs targeting specific pathogens associated with life-threatening bacterial infections, primarily hospital-acquired pneumonia, or HAP, and ventilator-associated pneumonia, or VAP. Recently we announced the development of a novel antibody discovery and production platform technology called APEXTM. This technology complements and further extends the capabilities of MabIgX® to quickly screen large number of antibody producing B-cells from patients and generation of high mAb producing mammalian production cell line at a speed not previously attainable. As a result, we can significantly reduce time for antibody discovery and manufacturing compared to conventional approaches. Our lead product candidate, AR-301 has exhibited promising preclinical data and Phase 1/2a clinical data from a Phase 1/2a clinical study in patients. AR-301 targets the alpha toxin produced by gram-positive bacteria Staphylococcus aureus , or S. aureus, a common pathogen associated with HAP and VAP. In contrast to other programs targeting S. aureus toxins, we are developing AR-301 as a treatment of pneumonia, rather than prevention of S. aureus colonized patients from progression to pneumonia. In January 2019, we initiated a Phase 3 pivotal trial evaluating AR-301 for the treatment of HAP and VAP, and expect to report top-line data in the second half of 2021. To complement and diversify our portfolio of targeted monoclonal antibodies, we are developing a broad spectrum small molecule non-antibiotic anti-infective gallium citrate (AR-501). AR-501 is being developed in collaboration with the Cystic Fibrosis Foundation (CFF) as a chronic inhaled therapy to treat lung infections in cystic fibrosis. In 2018, AR-501 was granted Orphan Drug, Fast Track and Qualified Infectious Disease Product (QIDP) designations by the FDA. During the third quarter of 2019, the European Medicines Agency (EMA) granted the program Orphan Drug Designation. We initiated a Phase 1/2a clinical trial in December 2018 of the inhalable formulation of gallium citrate, which is being evaluated for the treatment of chronic lung infections associated with cystic fibrosis. We provisionally expect to report data from the Phase 1 portion of the trial into which healthy subjects were enrolled in the first half of 2020 and the Phase 2a portion with cystic fibrosis subjects in the second half of 2021. In September 2019, we reported results for our global Phase 2 clinical trial evaluating our product candidate AR-105, a fully human IgG1 monoclonal antibody for the treatment of VAP caused by gram-negative Pseudomonas aeruginosa (P. aeruginosa). The completed study did not meet its primary endpoint of demonstrating superiority in clinical cure rates on Day 21 compared to placebo. Furthermore, there was a statistically significant imbalance in all-cause mortality, as well as serious adverse event (SAE) rates between treatment groups that favored placebo. However, no SAE or mortality in the study was deemed to be drug related by the study investigators or the study's data monitoring committee. While no further development resources will be allocated towards AR-105, we will continue to analyze the full data set to better understand these top-line results. AR-105 has a different mechanism of action, directed against a different bacteria, and evaluated in a different patient population as compared to AR-301. To date, we have devoted substantially all of our resources to research and development efforts relating to our therapeutic candidates, including conducting clinical trials and developing manufacturing capabilities, in-licensing related intellectual property, protecting our intellectual property and providing general and administrative support for these operations. We have generated revenue from our payments under our collaboration strategic research and development contracts and federal awards and grants, as well as awards and grants from not-for-profit entities and fee for service to third party entities. Since our inception, we have funded our operations primarily through these sources and the issuance of common stock, convertible preferred stock and debt securities. Current clinical development activities are focused on AR-301 and AR-501. Our expenses and resulting cash burn during the year ended December 31, 2019, were largely due to costs associated with launching the Phase 3 study of AR-301 for the treatment of VAP caused by the Staphylococcus aureus bacteria, the Phase 1/2 study of AR-501 for the treatment of chronic lung infections associated with cystic fibrosis, and the Phase 1/2 study of AR-501 for the treatment of chronic lung infections associated with cystic fibrosis. These studies' startup phases, which contain a disproportionately high percentage of total study expenses, have been largely completed. We have incurred losses since our inception. Our net losses were approximately $29.7 million and $22.1 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had approximately $20.9 million of cash and cash equivalents and had an accumulated deficit of approximately $100.8 million. Substantially all our net losses have resulted from costs incurred in connection with our research and development programs, clinical trials, intellectual property matters, strengthening our manufacturing capabilities, and from general and administrative costs associated with our operations. On August 16, 2018, we completed an initial public offering or "IPO" of our common stock, in which we sold and issued 2,000,000 shares, plus 192,824 shares subsequently sold pursuant to the partial exercise by the underwriters of their over-allotment option, at an issuance price of $13.00 per share, less underwriting discounts and commissions. As a result of the IPO and the exercise of the underwriters' over-allotment option, we received total net proceeds of approximately $25.1 million, net of underwriting and other offering expenses. In July 2019, we issued and sold 801,820 shares of restricted common stock in a private placement to Serum International B.V. ("SIBV"), an affiliate of Serum Institute of India Private Limited, and received total gross proceeds of $10 million, and after deducting commissions and offering costs of approximately $816,000, the net proceeds were approximately $9.2 million. In addition, we received an upfront cash payment of $5 million upon the execution of an option agreement with SIBV and received an additional upfront payment of $10 million in October 2019 in connection with a license agreement we executed in September 2019 with Serum AMR Products ("SAMR"), a party under common ownership of SIBV, and after deducting commissions of approximately $1.2 million, the net proceeds were approximately $13.8 million. We believe that our current available cash and cash equivalents will not be sufficient to fund our planned expenditures and meeting our obligations for at least the one-year period following our consolidated financial statements issuance date. In September 2019, we entered into a Common Stock Sales Agreement (the "ATM Agreement") with Cantor Fitzgerald & Co. ("Cantor") under which we may offer and sell, from time to time, in our sole discretion, shares of common stock having an aggregate offering price of up to $25 million through Cantor as our sales agent. We will pay Cantor a commission of up to three percent (3.0%) of the gross sales proceeds of any common stock sold through Cantor under the ATM Agreement, and also provided Cantor with customary indemnification rights. Our registration statement on Form S-3 contemplated under the ATM Agreement was declared effective by the SEC on September 5, 2019. The registration statement on Form S-3 includes a base prospectus covering the offering of up to $100 million in aggregate shares of securities as defined within the prospectus and a prospectus supplement of up to a maximum aggregate offering of $25 million in common stock in accordance with the ATM Agreement. As of December 31, 2019, we have not sold any shares of common stock under the ATM Agreement. We have not yet achieved commercialization of our products and have a cumulative net loss from our operations. We will continue to incur net losses for the foreseeable future. Our consolidated financial statements have been prepared assuming that we will continue as a going concern. We will require additional capital to meet our long-term operating requirements. We expect to raise additional capital through the sale of equity and/or debt securities. Historically, our principal sources of cash have included proceeds from grant funding, fees for services performed, issuances of convertible debt and the sale of our preferred stock. Our principal uses of cash have included cash used in operations. We expect that the principal uses of cash in the future will be for continuing operations, funding of research and development including our clinical trials and general working capital requirements. Substantially all our net losses have resulted from costs incurred in connection with our research and development programs, clinical trials, intellectual property matters, building our manufacturing capabilities, and from general and administrative costs associated with our operations. We anticipate that our expenses will increase substantially if and as we: • continue enrollment in our ongoing clinical trials; • initiate new clinical trials; • seek to identify, assess, acquire and develop other products, therapeutic candidates and technologies; • seek regulatory and marketing approvals in multiple jurisdictions for our therapeutic candidates that successfully complete clinical studies; • establish collaborations with third parties for the development and commercialization of our products and therapeutic candidates; • make milestone or other payments under our agreements pursuant to which we have licensed or acquired rights to intellectual property and technology; • seek to maintain, protect, and expand our intellectual property portfolio; • seek to attract and retain skilled personnel; • incur the administrative costs associated with being a public company and related costs of compliance; • create additional infrastructure to support our operations as a commercial stage public company and our planned future commercialization efforts; • experience any delays or encounter issues with any of the above; and • experience protracted COVID-19 related delays. We expect to continue to incur significant expenses and increasing losses for at least the next several years. Accordingly, we anticipate that we will need to raise additional capital in order to obtain regulatory approval for, and the commercialization of our therapeutic candidates. Until such time that we can generate meaningful revenue from product sales, if ever, we expect to finance our operating activities through public or private equity or debt financings, government or other third-party funding and other collaborations, strategic alliances and licensing arrangements or a combination of these approaches. If we are unable to obtain funding on a timely basis, we may be required to significantly curtail, delay or discontinue one or more of our research or development programs or the commercialization of any approved therapies or products or be unable to expand our operations or otherwise capitalize on our business opportunities, as desired, which could adversely affect our business, financial condition and results of operations. Financial Overview Reverse Stock Split On August 3, 2018, we effected a 1 for 6.417896 reverse stock split of our common stock. The par value and the number of authorized shares of the common and convertible preferred stock were not adjusted as a result of the reverse stock split. All common stock share and per-share amounts for all periods presented in this Annual Report on Form 10-K have been adjusted retroactively to reflect the reverse stock split. Initial Public Offering On August 13, 2018, our registration statement on Form S-1 relating to our IPO of our common shares (the "IPO") was declared effective by the Securities and Exchange Commission ("SEC"). The IPO closed on August 16, 2018 and we issued and sold 2,000,000 common shares at a public offering price of $13.00 per share. Gross proceeds totaled $26.0 million and net proceeds totaled $22.8 million after deducting underwriting discounts and commissions of $1.8 million and other offering expenses of approximately $1.4 million. The underwriters of the IPO partially exercised their over-allotment option, and on August 30, 2018, we issued and sold 192,824 common shares at a public offering price of $13.00 per share for gross proceeds totaling approximately $2.5 million and net proceeds of approximately $2.3 million after deducting underwriting discounts and commissions of approximately $175,000. In connection with the IPO, the holders of a majority of the Series A Preferred Stock approved the mandatory conversion of the Series A Preferred Stock into one share of common stock for every 6.417896 shares of Series A Preferred Stock which converted immediately prior to the consummation of the IPO. Upon conversion, a total of 5,744,586 shares of common stock were issued for the converted Series A Preferred Stock which included the accrued dividends upon conversion. All warrants to purchase Series A Preferred Stock became warrants to purchase common stock, adjusted for the 1 for 6.417896 shares reverse stock split. SIBV License Agreement In July 2019, we entered into an option agreement with SIBV which granted SIBV the option to license multiple programs from us and access our MabIgX® platform technology for asset identification and selection. We received an upfront cash payment of $5 million upon execution of this option agreement. In connection with the option agreement, SIBV made an equity investment whereby we issued 801,820 shares of our restricted common stock in a private placement to SIBV for total gross proceeds of $10 million. In September 2019, we entered into a License, Development and Commercialization Agreement (the "License Agreement") with SAMR. Pursuant to the License Agreement, we received upfront payments totaling $15 million, of which $5 million was received in July 2019 through the option agreement referred to above, and may receive milestone payments and royalty-based payments from SAMR if certain milestones and sales levels as defined in the License Agreement are met. Given the equity investment by SIBV was negotiated in conjunction with the option agreement, which resulted in the execution of the License Agreement, all arrangements were evaluated as a single agreement and amounts were allocated to the elements of the arrangement based on their fair value. We allocated the proceeds received from the sale of the restricted common stock and upfront payment from the License Agreement, net of issuance and contract costs, of approximately $22.5 million accordingly: • we recorded approximately $5.0 million, which represented the fair value of the restricted common stock issued of $5.4 million, net of $441,000 of issuance costs, to stockholders' equity within our consolidated balance sheet; • we recorded approximately $19.6 million to deferred revenue based on the $15 million from upfront payments under the License Agreement and approximately $4.6 million from the equity allocation; and • we capitalized approximately $2.1 million to contract costs, which consists of approximately $376,000 issuance costs from the equity allocation and approximately $1.7 million in other direct costs to obtain the License Agreement. In accordance with ASC 606, we determined that no performance obligations were satisfied as of December 31, 2019, and therefore, no revenue related to the License Agreement was recognized for the year ended December 31, 2019. Critical Accounting Policies and Estimates Our management's discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements, which we have prepared in accordance with generally accepted accounting principles in the United States, or GAAP. The preparation of our 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 our consolidated financial statements, as well as the reported expenses during the reported periods. We evaluate these estimates and judgments on an ongoing basis. We base our estimates on 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. Our actual results may differ from these estimates under different assumptions or conditions. 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. We believe the critical accounting policies used in the preparation of our consolidated financial statements that require significant estimates and judgments are as follows: Use of Estimates The preparation of the consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of expenses during the reporting period. Such estimates include those related to the evaluation of our ability to continue as a going concern, best estimate of standalone selling price of revenue deliverables, long lived assets, income taxes, assumptions used in the Black Scholes Merton ("BSM") model to calculate the fair value of stock based compensation, assumptions used in the Monte Carlo Simulation ("MSM") model to calculate the fair value of warrants, deferred tax asset valuation allowances, valuation of the Company's common and convertible preferred stock, preclinical study and clinical trial accruals. Actual results could differ from those estimates. Revenue Recognition Effective January 1, 2019, we adopted Accounting Standards Codification ("ASC") 606, Revenue from Contracts with Customers ("ASC 606"), using the modified retrospective method. Under this method, results for reporting periods beginning after January 1, 2019 are presented under ASC 606, while prior period amounts are not adjusted and continue to be reported in accordance with ASC 605, Revenue Recognition ("ASC 605"). We only had one contract within the scope of ASC 606 as of the adoption date. The cumulative-effect of adopting ASC 606 on January 1, 2019, using the modified retrospective method, was immaterial. ASC 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. To determine revenue recognition for arrangements that we determine are within the scope of ASC 606, we perform 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 at a point in time, or over time, as the entity satisfies performance obligations. We only apply the five-step model to contracts when it is probable that we will collect the consideration it is entitled to in exchange for the goods or services we transfer to the customer. At contract inception, once the contract is determined to be within the scope of ASC 606, we assess the goods or services promised within each contract, determine those that are performance obligations, and assess whether each promised good or service is distinct. We then recognize as revenue the amount of the transaction price that is allocated to the respective performance obligation when (or as) the performance obligation is satisfied. As part of the accounting for customer arrangements, we must use judgment to determine: a) the number of performance obligations based on the determination under step (ii) above; b) the transaction price under step (iii) above; and c) the standalone selling price for each performance obligation identified in the contract for the allocation of the transaction price in step (iv) above. We use judgment to determine whether milestones or other variable consideration should be included in the transaction price. The transaction price is allocated to each performance obligation on a relative standalone selling price basis. In developing the standalone price for a performance obligation, we consider applicable market conditions and relevant entity-specific factors, including factors that were contemplated in negotiating the agreement with the customer and estimated costs. We recognize revenue as or when the performance obligations under the contract are satisfied. We receive payments from our customers based on payment schedules established in each contract. We record any amounts received prior to satisfying the revenue recognition criteria as deferred revenue on the consolidated balance sheet. Amounts recognized as revenue, but not yet received or invoiced are recorded within other receivables on the consolidated balance sheet. Amounts are recorded as other receivables on the consolidate balance sheet when our right to consideration is unconditional. We do not assess whether a contract has a significant financing component if the expectation at contract inception is such that the period between payment by the customer and the transfer of a majority of the promised goods or services to the customer will be one year or less. We only had one contract within the scope of ASC 606 upon adoption that had not been completed, the Development Program Letter Agreement with CFF (the "CFF Agreement"), entered into in December 2016 and amended in November 2018 to support funding for the development of our Inhaled Gallium Citrate Anti-Infective program. The most significant changes under ASC 606 relate to our determination of the transaction price at inception, determination of the standalone selling price for the performance obligation and at each reporting period the treatment of variable consideration in the form of milestone payments under the CFF Agreement. Under ASC 606, we are recognizing the revenue allocated to the one performance obligation measuring progress using the input (cost-to-cost) method, limited by the variable consideration attributed to the probable completion of certain milestones as defined in the CFF Agreement. The cumulative-effect of adopting ASC 606 on January 1, 2019 was immaterial. Under ASC 605, we recognized revenue under the milestone method up to the limit of the prior approval funding amounts, and when the Company determined that it had earned the right to receive the recognized portion according to the terms of the grant awarded. The upfront payment of $200,000 was recognized straight-line over the term of the contract as we believed the upfront fee related to services performed throughout the contract period and the upfront fee did not represent a substantive milestone within the agreement. Revenue for the year ended December 31, 2018, was recognized in accordance with ASC 605 which required that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred and title and the risks and rewards of ownership have been transferred to the client or services have been rendered; (3) the price is fixed or determinable; and (4) collectability is reasonably assured. During 2018, revenue includes grant awards and collaboration services entered into for specific research and development efforts. We recognized revenue under such awards and contracts as the related qualified research and development expenses were incurred or under the milestone method, up to the limit of the prior approval funding amounts, and when we determined that we had earned the right to receive the recognized portion according to the terms of the original grant awarded. Under the CFF Agreement, we recognized revenue of approximately $1.0 million and approximately $1.6 million for the years ended December 31, 2019 and 2018, respectively. We had a collaboration and option agreement with GlaxoSmithKline Biologicals S.A., or GSK, aimed at evaluating improved formulations for a rotavirus vaccine. In December 2018 at a meeting of the Joint Steering Committee, it was agreed by the parties to terminate the GSK collaboration and option agreement as it was considered by both parties to have been successfully completed. For the year ended December 31, 2018, pursuant to our GSK agreement, we recognized revenue of approximately $1.2 million. We expect that any revenue we generate for the foreseeable future will fluctuate from period to period as a result of the timing of when performance obligations and variable consideration criteria under the contract are satisfied. Research and Development Expenses We recognize research and development expenses to operations as they are incurred. Our research and development expenses consist primarily of: • salaries and related overhead expenses, which include stock-based compensation and benefits for personnel in research and development functions; • fees paid to consultants and contract research organizations, or CROs, including in connection with our preclinical studies and clinical trials and other related clinical trial fees, such as for investigator grants, patient screening, laboratory work, clinical trial material management and statistical compilation and analyses; • costs related to acquiring and manufacturing clinical trial materials; • costs related to compliance with regulatory requirements; and • payments related to licensed products and technologies. 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 and clinical sites. Nonrefundable advance payments for goods or services to be received in future periods for use in research and development activities are deferred and capitalized. The capitalized amounts are then expensed as the related goods are delivered or when the services are performed. We plan to increase our research and development expenses for the foreseeable future as we continue to develop our therapeutic programs, and subject to the availability of additional funding, further advance the development of our therapeutic candidates for additional indications and begin to conduct clinical trials. We typically use our employee and infrastructure resources across multiple research and development programs, and accordingly we have not historically allocated resources specifically to our individual clinical programs. The process of conducting the necessary clinical research to obtain regulatory approval is costly and time-consuming, and the successful development of our therapeutic 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 therapeutic candidates. General and Administrative Expenses General and administrative expenses consist primarily of costs related to executive, finance, corporate development and administrative support functions, including stock-based compensation expenses and benefits for personnel in general and administrative functions. Other significant, general and administrative expenses include rent, accounting and legal services, obtaining and maintaining patents or other intellectual property rights, the cost of various consultants, occupancy costs, insurance premiums and information systems costs. We expect that our general and administrative expenses will increase as we continue to operate as a public company, continue to conduct our clinical trials and prepare for commercialization. We believe that these increases will likely include increased costs for director and officer liability insurance, costs related to the hiring of additional personnel to support product commercialization efforts and increased fees for outside consultants, attorneys and accountants. We also expect to incur increased costs to comply with corporate governance, internal controls, investor relations and disclosures, and similar requirements applicable to public companies. Interest and Other Income, Net Interest and other income, net consists primarily of interest on our cash balances. Stock-Based Compensation Effective January 1, 2019, we early adopted ASU 2018-07, Compensation-Stock Compensation (Topic 718), Improvements to Nonemployee Share-Based Payment Accounting. We recognize compensation expense for all stock-based awards based on the grant-date estimated fair values, which we determine using the BSM option pricing model, on a straight-line basis over the requisite service period for the award. We account for forfeitures as they occur. The BSM option pricing model incorporates various highly sensitive assumptions, including the fair value of our common stock, expected volatility, expected term and risk-free interest rates. The weighted average expected life of options was calculated using the simplified method as prescribed by the SEC's Staff Accounting Bulletin, Topic 14 ("SAB Topic 14"). This decision was based on the lack of relevant historical data due to our limited historical experience. In addition, due to our limited historical data, the estimated volatility also reflects the application of SAB Topic 14, incorporating the historical volatility of comparable companies whose stock prices are publicly available. The risk-free interest rate for the periods within the expected term of the option is based on the U.S. Treasury yield in effect at the time of grant. The dividend yield was zero, as we have never declared or paid dividends and have no plans to do so in the foreseeable future. Due to the absence of a public market trading for our common stock prior to going public in August of 2018, it was necessary to estimate the fair value of the common stock underlying our stock-based awards when performing fair value calculations. The estimated fair value of our common stock was determined using methodologies, approaches and assumptions consistent with the American Institute of Certified Public Accountants, or AICPA, Practice Aid: Valuation of Privately-Held-Company Equity Securities Issued as Compensation. During the year ended December 31, 2018, we accounted for stock-based compensation arrangements with nonemployees by recording the expense of such services based on the estimated fair value of the common stock at the measurement date. The value of the equity instrument, including adjustment to fair value at each balance sheet date for the vested awards, is charged to operations over the term of the service agreement as earned. Fair Value of Common Stock Prior to our initial public offering in August 2018, to assist our board of directors with the determination of the exercise price of our stock options and the fair value of the common stock underlying the options, we obtained third-party valuations of our common stock as of various dates since we began granting options, with concluded fair values between $2.89 per share and $17.91 per share. Our board of directors considered the fair values of the common stock derived in the third-party valuations as one of the factors it considered when setting the exercise prices for options granted. The valuations were performed in accordance with applicable elements of the AICPA Practice Aid. The AICPA 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 AICPA Practice Aid, we considered the following methods: • Option Pricing Method. Under the option pricing method, or OPM, shares are 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. Under the probability-weighted expected return method, or PWERM, common equity value is based upon an analysis of various future outcomes, such as an initial public offering, or IPO, merger or sale, dissolution, or continued operation as a private enterprise until a later exit date. The future allocated value is based upon the probability-weighted present values of expected future investment returns, considering each of the possible outcomes available to the enterprise, as well as the rights of each security class. Our board of directors also considered a range of objective and subjective factors and assumptions in estimating the fair value of our common stock on the date of grant, including: progress of our research and development efforts; our operating results and financial condition, including our levels of available capital resources; rights and preferences of our common stock compared to the rights and preferences of our other outstanding equity securities; our stage of development and material risks related to our business; our commercial success in regard to our catheter sales; the achievement of enterprise milestones; the valuation of publicly-traded companies in the life sciences and biotechnology sectors, as well as recently completed mergers and acquisitions of peer companies; equity market conditions affecting comparable public companies; the likelihood of achieving a liquidity event for the shares of common stock, such as an initial public offering given prevailing market and biotechnology sector conditions; and that the grants involved illiquid securities in a private company. Following the closing of our public offering in August 2018, the fair value of our common stock on the date of grant is determined based on the closing price of our common stock on The Nasdaq Capital Market on the date immediately prior to the date of grant. Income Taxes We account for income taxes under the liability method. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized. For the years ended December 31, 2019 and 2018, no income tax expense or benefit was recognized, primarily due to a full valuation allowance recorded against the net deferred tax asset We assess all material positions taken in any income tax return, including all significant uncertain positions, in all tax years that are still subject to assessment or challenge by the relevant taxing authorities. Assessing an uncertain tax position begins with the initial determination of the positions sustainability and is measured at the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement. At each balance sheet date, unresolved uncertain tax positions must be reassessed, and we determine whether (i) the factors underlying the sustainability assertion have changed and (ii) the amount of the recognized benefit is still appropriate. The recognition and measurement of tax benefits requires significant judgment. Judgments concerning the recognition and measurement of a tax benefit might change as new information becomes available. Going Concern We assess and determine our ability to continue as a going concern under the provisions of ASC 205-40, Presentation of Financial Statements-Going Concern, which requires us to evaluate whether there are conditions or events that raise substantial doubt about our ability to continue as a going concern within one year after the date that our annual and interim consolidated financial statements are issued. Certain additional financial statement disclosures are required if such conditions or events are identified. If and when an entity's liquidation becomes imminent, financial statements should be prepared under the liquidation basis of accounting. Determining the extent, if any, to which conditions or events raise substantial doubt about our ability to continue as a going concern, or the extent to which mitigating plans sufficiently alleviate any such substantial doubt, as well as whether or not liquidation is imminent, requires significant judgment by us. We have determined that there is substantial doubt about our ability to continue as a going concern for at least the one-year period following our consolidated financial statements issuance date, which have been prepared assuming that we will continue as a going concern. We have not made any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the possible inability of us to continue as a going concern. 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): Grant Revenue. Grant revenue decreased by $567,000 from $1.6 million for the year ended December 31, 2018 to $1.0 million for the year ended December 31, 2019 primarily due to the completion of milestones and recognition of revenue related to those milestones related to the grant award from the CFF during 2018. Collaboration Revenue. There was no collaboration revenue in 2019. This is a decrease of $1.2 million in revenue compared to 2018. All 2018 revenue was from the GSK collaboration and option agreement which was terminated in December 2018. Research and Development Expenses. Research and development expenses increased by approximately $1.1 million from $23.0 million for the year ended December 31, 2018 to $24.1 million for the year ended December 31, 2019 due primarily to an increase in spending on clinical trial activities and drug manufacturing for our Phase 3 pivotal trial of AR-301, which was initiated in January 2019, and an increase in spending on the Phase 1/2a clinical trial of our AR-501 program, which was initiated in the fourth quarter of 2018. These increases were partially offset by a decrease in spending on clinical trial activities and drug manufacturing for our AR-105 program and a decrease in spending on toxicology studies related to our AR-501 program. General and Administrative Expenses. General and administrative expenses increased by approximately $2.2 million from $3.9 million for the year ended December 31, 2018 to $6.0 million for the year ended December 31, 2019 due primarily to increases in professional service fees, directors' and officers' related liabilities insurance expense, personnel related expenses, including stock-based compensation, Delaware franchise taxes, and patent related fees. Interest and Other Income, Net. Interest and other income, net decreased by approximately $63,000 from $420,000 for the year ended December 31, 2018 to $357,000 for the year ended December 31, 2019 due primarily to a lower average cash balance. Change in Fair Value of Warrant Liability. Change in fair value of warrant liability decreased by approximately $1.6 million from a gain of $1.6 million for the year ended December 31, 2018 to none for the year ended December 31, 2019 due to these Series A convertible preferred stock warrants were converted into common stock warrants which resulted in the warrant liability being remeasured upon our IPO in August 2018 and classified into additional paid-in-capital. Share of Loss in Equity Method Investment. Loss from equity method investment increased by $911,000 from $40,000 for the year ended December 31, 2018 to $951,000 for the year ended December 31, 2019 due to our share of loss from our minority interest calculated under the equity method. Liquidity, Capital Resources and Going Concern Our IPO closed on August 16, 2018 and we issued and sold 2,000,000 common shares at a public offering price of $13.00 per share. Gross proceeds totaled $26.0 million and net proceeds totaled $22.8 million after deducting underwriting discounts and commissions of $1.8 million and other offering expenses of approximately $1.4 million. The underwriters of the IPO partially exercised their over-allotment option, and on August 30, 2018, we issued and sold 192,824 common shares at a public offering price of $13.00 per share for gross proceeds totaling approximately $2.5 million and net proceeds of approximately $2.3 million after deducting underwriting discounts and commissions of approximately $175,000. In July 2019, we issued and sold 801,820 shares of restricted common stock in a private placement to SIBV, and received total gross proceeds of $10 million, and after deducting commissions and offering costs of approximately $816,000, the net proceeds were approximately $9.2 million. In addition, we received an upfront cash payment of $5 million upon the execution of an option agreement with SIBV and received an upfront payment of $10 million in October 2019 in connection with a License Agreement we executed in September 2019 with SAMR, and after deducting commissions of approximately $1.2 million, the net proceeds were approximately $13.8 million. In September 2019, we entered into a Common Stock Sales Agreement (the "ATM Agreement") with Cantor Fitzgerald & Co. ("Cantor") under which we may offer and sell, from time to time, in our sole discretion, shares of common stock having an aggregate offering price of up to $25 million through Cantor as our sales agent. We will pay Cantor a commission of up to three percent (3.0%) of the gross sales proceeds of any common stock sold through Cantor under the ATM Agreement, and provided Cantor with customary indemnification rights. Our registration statement on Form S-3 contemplated under the ATM Agreement was declared effective by the SEC on September 5, 2019. The registration statement on Form S-3 includes a prospectus supplement covering the offering of up to $100 million of shares of common stock in accordance with the ATM Agreement. As of December 31, 2019, we have not sold any shares of common stock under the ATM Agreement. We have had recurring losses from operations since inception and negative cash flows from operating activities during the years ended December 31, 2019 and 2018. We anticipate that we will continue to generate operating losses and use cash in operations through the foreseeable future. Management plans to finance operations through equity or debt financings or other capital sources, including potential collaborations or other strategic transactions. There can be no assurances that, in the event that we require additional financing, such financing will be available on terms which are favorable to us, or at all. If we are unable to raise additional funding to meet our working capital needs in the future, we will be forced to delay or reduce the scope of our research programs and/or limit or cease our operations. We believe that our current available cash and cash equivalents will not be sufficient to fund our planned expenditures and meeting our obligations for at least the one-year period following our consolidated financial statements issuance date. There is substantial doubt about our ability to continue as a going concern unless we are able to successfully raise additional capital. Cash Flows Our net cash flow from operating, investing and financing activities for the periods below were as follows (in thousands): Cash Flows from Operating Activities. Net cash used in operating activities was approximately $8.2 million for the year ended December 31, 2019, which was primarily due to our net loss of approximately $29.7 million, an increase of approximately $1.6 million in capitalized contract costs, resulting from the SAMR License Agreement, an increase of approximately $1.4 million in prepaid expenses, and a decrease of approximately $469,000 in accounts payable. The cash used in operating activities was partially offset by an increase of approximately $19.6 million in deferred revenue, resulting from the SAMR License Agreement, a decrease of approximately $1.7 million in accounts receivable, a decrease of approximately $438,000 in other assets, and the non-cash charges of approximately $2.0 million related to stock-based compensation, approximately $951,000 from the loss on our equity method investment, and approximately $338,000 in depreciation and amortization. Net cash used in operating activities was approximately $24.3 million for the year ended December 31, 2018, which was primarily due to our net loss of approximately $22.1 million, an increase of approximately $2.2 million in prepaid expenses, an increase of approximately $1.7 million in accounts receivables, an increase of approximately $648,000 in other assets, a decrease of approximately $97,000 in deferred revenue, and the non-cash gain of approximately $1.6 million on the change in fair value of preferred stock warrants. The cash used in operating activities was partially offset by an increase of approximately $1.3 million in accounts payable, an increase of approximately $800,000 in accrued liabilities, and the non-cash charges of approximately $1.7 million related to stock-based compensation, approximately $283,000 in depreciation and amortization, and approximately $40,000 from the loss on our equity method investment. Cash Flows from Investing Activities. Net cash used in investing activities of approximately $174,000 for the year ended December 31, 2019 was due to the purchase of equipment, primarily for diagnostic use in clinical trials. Net cash used in investing activities of approximately $1.7 million during the year ended December 31, 2018 was due to the $1.0 million cash paid for our investment in a Joint Venture company named Shenzhen Arimab BioPharmaceuticals Co., Ltd., and approximately $677,000 purchase of equipment, primarily for diagnostic use in clinical trials. Cash Flows from Financing Activities. Net cash provided by financing activities of approximately $5.0 million during the year ended December 31, 2019 was due to net proceeds received from a private placement of our restricted common stock. Net cash provided by financing activities of approximately $25.1 million during the year ended December 31, 2018 was due to net proceeds received from our IPO (including over-allotment proceeds). Future Funding Requirements To date, we have generated revenue from grants and contract services performed and funding from the issuance of convertible preferred stock and common stock sales. We do not know when, or if, we will generate any revenue from our development stage therapeutic programs. We do not expect to generate any revenue from sales of our therapeutic candidates unless and until we obtain regulatory approval. At the same time, we expect our expenses to increase in connection with our ongoing development activities, particularly as we continue the research, development and clinical trials of, and seek regulatory approval for, our therapeutic candidates. We expect to incur additional costs associated with operating as a public company. In addition, subject to obtaining regulatory approval of any of our therapeutic candidates, we expect to incur significant commercialization expenses for product sales, marketing, manufacturing and distribution. We anticipate that we will need additional funding in connection with our continuing operations. Our future funding requirements will depend on many factors, including: • the progress, costs, results and timing of our clinical trials; • FDA acceptance, if any, of our therapies for infectious diseases and for other potential indications; • the outcome, costs and timing of seeking and obtaining FDA and any other regulatory approvals; • the number and characteristics of product candidates that we pursue, including our product candidates in preclinical development; • the ability of our product candidates to progress through clinical development successfully; • our need to expand our research and development activities; • the costs of acquiring, licensing or investing in businesses, products, product candidates and technologies; • our ability to maintain, expand and defend the scope of our intellectual property portfolio, including the amount and timing of any payments we may be required to make, or that we may receive, in connection with the licensing, filing, prosecution, defense and enforcement of any patents or other intellectual property rights; • our need and ability to hire additional management and scientific, medical and administrative personnel; • the effect of competing technological and market developments; and • our need to implement additional internal systems and infrastructure, including financial and reporting systems. Until such time that we can generate meaningful revenue from the sales of approved therapies and products, if ever, we expect to finance our operating activities through public or private equity or debt financings, government or other third-party funding, and other collaborations, strategic alliances and licensing arrangements or a combination of these approaches. To the extent that we raise additional capital through the sale of equity or convertible debt securities, the ownership interests of our common stockholders will 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, 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 to grant licenses on terms that may not be favorable to us. 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 the rules of the SEC. JOBS Act Accounting Election 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. We are choosing to take advantage of this provision and, as a result, we will adopt the extended transition period available under the JOBS Act 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 under the JOBS Act. Recent Accounting Pronouncements Information regarding recent accounting pronouncements applicable to us is included in the notes to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K.
0.008731
0.00906
0
<s>[INST] FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this Annual Report. This discussion and analysis and other parts of this Annual Report contain forwardlooking statements based upon current beliefs, plans and expectations that involve risks, uncertainties and assumptions, such as statements regarding our plans, objectives, expectations, intentions and projections. Our actual results and the timing of selected events could differ materially from those anticipated in these forwardlooking statements as a result of several factors, including those set forth under "Risk Factors" and elsewhere in this Annual Report. You should carefully read the "Risk Factors" section of this Annual Report to gain an understanding of the important factors that could cause actual results to differ materially from our forwardlooking statements. Please also see the section entitled "Cautionary Note Concerning ForwardLooking Statements." All amounts in this report are in U.S. dollars, unless otherwise noted. Overview We are a latestage biopharmaceutical company focused on the discovery and development of nonantibiotic antiinfectives. A significant focus is on targeted immunotherapy using fully human monoclonal antibodies, or mAbs, to treat lifethreatening infections. mAbs represent an innovative treatment approach that harnesses the human immune system to fight infections and are designed to overcome the deficiencies associated with current therapies, such as rise in drug resistance, short duration of response, negative impact on the human microbiome, and lack of differentiation among the treatment alternatives. The majority of our product candidates are derived by employing our differentiated antibody discovery platforms. Our proprietary product pipeline is comprised of fully human mAbs targeting specific pathogens associated with lifethreatening bacterial infections, primarily hospitalacquired pneumonia, or HAP, and ventilatorassociated pneumonia, or VAP. Recently we announced the development of a novel antibody discovery and production platform technology called APEXTM. This technology complements and further extends the capabilities of MabIgX® to quickly screen large number of antibody producing Bcells from patients and generation of high mAb producing mammalian production cell line at a speed not previously attainable. As a result, we can significantly reduce time for antibody discovery and manufacturing compared to conventional approaches. Our lead product candidate, AR301 has exhibited promising preclinical data and Phase 1/2a clinical data from a Phase 1/2a clinical study in patients. AR301 targets the alpha toxin produced by grampositive bacteria Staphylococcus aureus , or S. aureus, a common pathogen associated with HAP and VAP. In contrast to other programs targeting S. aureus toxins, we are developing AR301 as a treatment of pneumonia, rather than prevention of S. aureus colonized patients from progression to pneumonia. In January 2019, we initiated a Phase 3 pivotal trial evaluating AR301 for the treatment of HAP and VAP, and expect to report topline data in the second half of 2021. To complement and diversify our portfolio of targeted monoclonal antibodies, we are developing a broad spectrum small molecule nonantibiotic antiinfective gallium citrate (AR501). AR501 is being developed in collaboration with the Cystic Fibrosis Foundation (CFF) as a chronic inhaled therapy to treat lung infections in cystic fibrosis. In 2018, AR501 was granted Orphan Drug, Fast Track and Qualified Infectious Disease Product (QIDP) designations by the FDA. During the third quarter of 2019, the European Medicines Agency (EMA) granted the program Orphan Drug Designation. We initiated a Phase 1/2a clinical trial in December 2018 of the inhalable formulation of gallium citrate, which is being evaluated for the treatment of chronic lung infections associated with cystic fibrosis. We provisionally expect to report data from the Phase 1 portion of the trial into which healthy subjects were enrolled in the [/INST] Positive. </s>
2,020
8,192
1,727,196
Scholar Rock Holding Corp
2019-03-19
2018-12-31
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The information contained in this section has been derived from our consolidated financial statements and should be read together with our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended, the “Exchange Act” and are subject to the “safe harbor” created by those sections. In particular, statements contained in this Annual Report on Form 10-K that are not historical facts, including, but not limited to statements regarding our future expectations, plans and prospects, including without limitation, our expectations regarding the potential of the TGFβ program, our collaboration with Gilead, the potential of SRK-015 as a therapy in spinal muscular atrophy and the timeline for and progress in developing SRK-015, the potential of SRK-181 as a cancer immunotherapy and the timeline for and progress in developing SRK-181, and liquidity, constitute forward-looking statements and are made under these safe harbor provisions. Some of the forward-looking statements can be identified by the use of forward-looking terms such as "believes," "expects," "may," "will," "should," "could," "seek," "intends," "plans," "estimates," "anticipates," or other comparable terms. Forward-looking statements involve inherent risks and uncertainties, which could cause actual results to differ materially from those in the forward-looking statements. We caution readers not to place undue reliance upon any such forward-looking statements, which speak only as of the date made. We urge you to consider the risks and uncertainties discussed in greater detail under the heading "Risk Factors" elsewhere in this Annual Report on Form 10-K in evaluating our forward-looking statements. We have no plans to update our forward-looking statements to reflect events or circumstances after the date of this report. As a result of many factors, including those factors set forth under the heading "Risk Factors" elsewhere in this Annual Report on Form 10-K, our actual results could 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 biopharmaceutical company focused on the discovery and development of innovative medicines for the treatment of serious diseases in which signaling by protein growth factors plays a fundamental role. Our newly elucidated understanding of the molecular mechanisms of growth factor activation enabled us to develop a proprietary platform for the discovery and development of monoclonal antibodies that locally and selectively target these signaling proteins at the cellular level. We believe this approach, acting in the disease microenvironment, avoids the historical challenges associated with inhibiting growth factors for therapeutic effect. We believe our focus on biologically validated growth factors may facilitate a more efficient development path. Our lead product candidate, SRK-015, is a highly selective, fully human, monoclonal antibody, with a unique mechanism of action that results in inhibition of the activation of the growth factor, myostatin, in skeletal muscle. We have advanced SRK-015 as a potential first muscle-directed therapy for the treatment of spinal muscular atrophy, or SMA, into clinical development. We initiated our Phase 1 clinical trial of SRK-015 in healthy volunteers in May 2018 and are initiating a Phase 2 clinical trial in SMA in the first quarter of 2019 with commencement of dosing anticipated in the second quarter of 2019. Our second product candidate is SRK-181 and is being developed for the treatment of cancers resistant to checkpoint blockade therapies, or CBTs, such as anti-PD1 antibodies. SRK-181 is a highly selective inhibitor of the activation of transforming growth factor beta-1, or TGFβ1. We intend to initiate a Phase 1 clinical trial of SRK-181 in cancer immunotherapy in mid-2020. In addition, utilizing our proprietary platform, we are continuing to create a pipeline of novel product candidates with the potential to transform the lives of patients suffering from a wide range of serious diseases, including other neuromuscular disorders, cancer, fibrosis and anemia. In May 2018, we completed an initial public offering, or IPO, of our common stock, and issued and sold 6,164,000 shares of common stock, including all additional shares available to cover over-allotments, at a public offering price of $14.00 per share, resulting in net proceeds of $77.8 million after deducting underwriting discounts and commissions and other offering expenses payable by us. Upon the closing of the IPO, all outstanding shares of convertible preferred stock converted into 15,109,950 shares of common stock and our outstanding warrant to purchase preferred stock converted into a warrant to purchase 7,614 shares of common stock. Since inception, we have incurred significant operating losses. Our net losses were $49.3 million and $25.0 million for the years ended December 31, 2018 and 2017, respectively. As of December 31, 2018, we had an accumulated deficit of $106.8 million. We expect to continue to incur significant expenses and operating losses for the foreseeable future. In addition, we anticipate that our expenses will increase significantly in connection with our ongoing activities, as we: · continue research and development activities for SRK-015, our lead product candidate, as we initiate and conduct our Phase 2 clinical trial; · continue research and development activities for SRK-181, our program focused on inhibitors of the activation of TGFβ1; · continue to discover, validate and develop additional product candidates; · maintain, expand and protect our intellectual property portfolio; · hire additional research, development and business personnel; and · create the infrastructure to support our operations as a public company. To date, we have not generated any revenue from product sales and do not expect to generate any revenue from the sale of products in the near future. If we successfully complete clinical development and obtain regulatory approval for SRK-015, SRK-181 or any of our future product candidates, we may generate revenue in the future from product sales. In addition, if we obtain regulatory approval for SRK-015, SRK-181 or any of our future product candidates, we expect to incur significant expenses related to developing our commercialization capability to support product sales, marketing and distribution activities. Financial Operations Overview Operating Expenses Research and Development Research and development expenses consist primarily of costs incurred for our research and development activities, including our product candidate discovery efforts, preclinical studies, manufacturing, and clinical trials under our research programs, which include: · employee-related expenses, including salaries, benefits and equity-based compensation expense for our research and development personnel; · expenses incurred under agreements with third parties that conduct research and development and preclinical activities on our behalf; · expenses incurred under agreements related to our clinical trials, including the costs for investigative sites and CROs, that conduct our clinical trials; · manufacturing process-development, clinical supplies and technology-transfer expenses; · consulting and professional fees related to research and development activities; · costs of purchasing laboratory supplies and non-capital equipment used in our internal research and development activities; · costs related to compliance with clinical regulatory requirements; and · facility costs and other allocated expenses, which include expenses for rent and maintenance of facilities, insurance, depreciation and other supplies. Research and development costs are expensed as incurred. Costs for certain activities are recognized based on an evaluation of the progress to completion of specific tasks. Nonrefundable advance payments for research and development goods and services to be received in the future from third parties are deferred and capitalized. The capitalized amounts are expensed as the related services are performed. A significant portion of our research and development costs have been external costs, which we track on a program-by-program basis after a clinical product candidate has been identified. Our internal research and development costs are primarily personnel-related costs, depreciation and other indirect costs. We do not track our internal research and development expenses on a program-by-program basis as they are deployed across multiple projects. 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 expect research and development costs to increase significantly for the foreseeable future as our product candidate development programs progress. However, we do not believe that it is possible at this time to accurately project total program-specific expenses through commercialization. There are numerous factors associated with the successful commercialization of any of our product candidates, including future trial design and various regulatory requirements, many of which cannot be determined with accuracy at this time based on our stage of development. Additionally, future commercial and regulatory factors beyond our control will impact our clinical development programs and plans. In addition, we expect to incur additional costs in connection with our research and development activities under our collaboration with Gilead. The successful development of SRK-015, SRK-181 and any future product candidates is highly uncertain. As such, at this time, we cannot reasonably estimate or know the nature, timing and estimated costs of the efforts that will be necessary to complete the remainder of the development of SRK-015, SRK-181 and any future product candidates. We are also unable to predict when, if ever, material net cash inflows will commence from the sale of our product candidates, if approved. This is due to the numerous risks and uncertainties associated with developing product candidates, including the uncertainty of: · the scope, progress, outcome and costs of our preclinical development activities, clinical trials and other research and development activities; · establishing an appropriate safety profile; · successful enrollment in and completion of clinical trials; · whether our product candidates show safety and efficacy in our clinical trials; · receipt of marketing approvals from applicable regulatory authorities, if any; · establishing commercial manufacturing capabilities or making arrangements with third-party manufacturers; · obtaining and maintaining patent and trade secret protection and regulatory exclusivity for our product candidates; · significant and changing government regulation; · commercializing the product candidates, if and when approved, whether alone or in collaboration with others; and · continued acceptable safety profile of the products following any regulatory approval. A change in the outcome of any of these variables with respect to the development of SRK-015, SRK-181 or any of our future product candidates would significantly change the costs and timing associated with the development of that product candidate. General and Administrative General and administrative expenses consist primarily of employee-related expenses, including salaries, benefits and equity-based compensation expenses for personnel in executive, finance, business development, investor relations, legal, information technology and human resources functions. Other significant general and administrative expenses include facility costs not otherwise included in research and development expenses, legal fees relating to patent and corporate matters and fees for accounting and consulting services. We anticipate that our general and administrative expenses will increase in the future as our business expands to support expected growth in research and development activities, including the continued development of our product candidates. These increases will likely include increased costs related to the hiring of additional personnel, as well as fees to outside consultants, among other expenses. We also anticipate increased expenses associated with being a public company, including costs for audit, legal, regulatory and tax-related services, director and officer insurance premiums and investor relations costs. Interest Income, Net Interest income, net consists primarily of interest income earned on our cash and cash equivalents and marketable securities, net of interest expense incurred on capital leases and our credit facility, including amortization of debt discount and debit issuance costs. Other Expense, Net Other expense, net consists primarily of non-cash changes in the fair value of warrants issued in connection with our credit facility. Results of Operations Comparison of the Years Ended December 31, 2018 and 2017 The following table summarizes our results of consolidated operations for the years ended December 31, 2018 and 2017 (in thousands, except percentages): *NM means not meaningful. Research and Development Research and development expense was $36.3 million for the year ended December 31, 2018 compared to $19.9 million for the year ended December 31, 2017, an increase of $16.4 million or 82.1%. The following table summarizes our research and development expense for the years ended December 31, 2018 and 2017 (in thousands, except percentages): The increase in research and development expense was primarily attributable to the following: · The $10.2 million increase in external research and development costs was primarily related to increased costs associated with our lead product candidate, SRK-015. During 2018, we conducted our Phase 1 clinical trial for SRK-015 and performed manufacturing activities to support our Phase 2 clinical trial. Increases were also associated with our other early development candidates. External costs include research, preclinical, clinical development and manufacturing costs; · The $6.2 million increase in internal research and development costs was primarily driven by an increase in employee compensation and benefits costs related to increased headcount and related overhead, as we continued to build out our research and development functions. In 2019, we expect our research and development expenses to increase, as compared to 2018 as we continue to advance the development of our product candidates, including SRK-015 through our Phase 2 clinical trial, and continue development on SRK-181. Additionally, we expect to conduct research under our Gilead collaboration. Also in 2019, we will begin to recognize revenue associated with this collaboration. General and Administrative General and administrative expense was $14.4 million for the year ended December 31, 2018 compared to $5.1 million for the year ended December 31, 2017, an increase of $9.3 million or 182.8%. The increase in general and administrative expense was primarily attributable to an increase of $4.2 million in employee compensation and benefits related to increased headcount, as well as $1.2 million in equity compensation expense for the modification of equity awards associated with the retirement of our former Chief Operating Officer. Additional increases include $2.9 million in professional services and consulting fees primarily related to increases in legal fees, accounting and audit fees, and public and investor relations fees due to costs associated with our IPO, our collaboration with Gilead, as well as ongoing business activities, and an increase in public company costs of $0.7 million, related to items such as premiums for directors and officers’ insurance and public company filings. In 2019, we expect our general and administrative expenses to increase, as compared to 2018, as we continue to invest in our internal infrastructure to support our overall company growth, and as we comply with the responsibilities of being a public company. Interest Income (Expense), Net The increase in interest income, net was attributable to increased income earned on our investment portfolio, associated with larger cash balances during the year ended December 31, 2018 as compared to the year ended December 31, 2017. We generated cash proceeds during our Series C financing round in December 2017 and our IPO in May 2018. Other Income (Expense), Net The increase in other income expense, net was attributable to increased expense associated with the change in fair value of the warrant during the year ended December 31, 2018 compared to the corresponding period in 2017. Previously, the warrant was classified as a liability, the liability was re-measured at its fair value at each balance sheet date and recorded in other expense. Subsequent to our IPO, the warrants are now classified as equity and no longer fair valued. Liquidity and Capital Resources Sources of Liquidity Since our inception, we have not generated any product revenue and have incurred significant operating losses and negative cash flows from our operations. We have funded our operations to date primarily with proceeds from the sale of our convertible preferred stock and units in private placements before our IPO, and sale of our common stock through our IPO and to Gilead in an exempt private placement. The following table provides information regarding our total cash and cash equivalents and marketable securities at December 31, 2018 and December 31, 2017 (in thousands): During the year ended December 31, 2018, our cash, cash equivalents and marketable securities balance increased approximately $117.7 million. The increase was primarily due to the payment of $80.0 million received under the Gilead collaboration, including the upfront payment and payment for the sale of common stock, as well as the net proceeds of $77.8 million from the sale of our common stock in our IPO, both of which are further discussed below. These increases were offset by the cash used to operate our business, including payments related to, among other things, research and development and general and administrative expenses as we continue to invest in our primary product candidates and support our internal research and development efforts. We also made investments in capital purchases and payments on our debt and capital leases. In December 2018, we entered into a Master Collaboration Agreement, or the Collaboration Agreement, with Gilead pursuant to which we will conduct research and pre-clinical development activities relating to the diagnosis, treatment, cure, mitigation or prevention of diseases, disorders or conditions, other than in the field of oncology in accordance with a pre-determined research plan. Pursuant to the Collaboration Agreement, Gilead made non-refundable payments of $80.0 million, including an upfront payment and an equity investment. In May 2018, we completed our IPO, in which we issued and sold 6,164,000 shares of common stock, including all additional shares available to cover over-allotments, resulting in net proceeds of $77.8 million after deducting underwriting discounts and commissions and other offering costs payable by us. Prior to the IPO, we primarily funded our operations from inception through the IPO with the net proceeds of $109.2 million from sales of our convertible preferred stock and units, as well as borrowings of $2.0 million under our credit facility with SVB. In August 2015, we entered into a credit facility with SVB for an equipment line of credit of up to $2.0 million to finance the purchase of eligible equipment. Pursuant to the credit facility, SVB was obligated to make up to five equipment advances, each in an amount of at least $0.1 million during the draw period. In August 2016, we amended the credit facility to extend the draw period to December 31, 2016. We borrowed a total of $2.0 million against the line of credit through December 31, 2016. Amounts borrowed bear interest at an annual prime rate less 0.25%. In the event of a default, and during such an event, the annual interest rate will increase by 5%. For each advance, interest-only payments were due and paid through June 2016. Principal and interest payments commenced on July 1, 2016 for a period of 36 months. A final payment fee equal to 4% of the aggregate advances is also due on June 1, 2019. We have the option to prepay the outstanding balance of the loan in full subject to a prepayment fee of 0.5% to 1.0%, depending on when the prepayment occurs. All borrowings under the credit facility mature on July 1, 2019. The loan balance at December 31, 2018 was $0.4 million. We granted SVB a security interest in all equipment financed under the credit facility. The credit facility contains negative covenants restricting our activities, including limitations on dispositions, change in business ownership or location, mergers or acquisitions, incurring indebtedness or liens, paying dividends or making investments and certain other business transactions. We also issued a warrant to SVB that is currently exercisable for 7,614 shares of our common stock at an exercise price of $3.94 per share. Cash Flows The following table provides information regarding our cash flows for the years ended December 31, 2018 and 2017 (in thousands): Net Cash Provided by (Used in) Operating Activities Net cash provided by operating activities was $24.6 million for the year ended December 31, 2018 and consisted of changes in our assets and liabilities of $67.9 million, primarily related to a change of $62.9 million from deferred revenue related to the Gilead collaboration and non-cash adjustments of $6.0 million, primarily from equity compensation, partially offset by our net loss of $49.3 million. Net cash used in operating activities was $21.7 million for the year ended December 31, 2017 and consisted of our net loss of $25.0 million, partially offset by $2.0 million in non-cash adjustments, primarily from equity compensation, and $1.3 million in changes in our assets and liabilities, primarily due to accounts payable and accrued expenses. Net Cash (Used in) Provided by Investing Activities Net cash used in investing activities was $60.2 million for the year ended December 31, 2018 compared to net cash provided by investing activities of $17.7 million for the year ended December 31, 2017. Net cash used in investing activities for the year ended December 31, 2018 was associated with the purchase of marketable securities. Net cash provided by investing activities for both periods resulted from sales and maturities of our marketable securities. Net Cash Provided by Financing Activities Net cash provided by financing activities was $94.3 million for the year ended December 31, 2018 compared to $50.5 million for the year ended December 31, 2017. Net cash provided by financing activities for the year ended December 31, 2018 consisted primarily of proceeds from our IPO and sale of common stock to Gilead. Net cash provided by financing activities for the year ended December 31, 2017 consisted of proceeds from the issuance of Series C convertible preferred shares and Series B convertible preferred units. These amounts were partially offset by principal payments made on outstanding debt. Funding Requirements We expect our expenses to increase in connection with our ongoing activities, particularly as we continue the research and development for, continue and initiate later stage clinical trials for, and seek marketing approval for, our product candidates, including SRK-015 and SRK-181, and any of our future product candidates. In addition, if we obtain marketing approval for SRK-015, SRK-181 or any of our future product candidates, we expect to incur significant commercialization expenses related to product sales, marketing, manufacturing and distribution. Furthermore, we expect to incur additional costs associated with operating as a public company. We expect that our existing cash and cash equivalents will enable us to fund our operating expenses and capital expenditure requirements into 2021. We have based this estimate on assumptions that may prove to be wrong, and we may use our available capital resources sooner than we currently expect. Our future capital requirements will depend on many factors, including: · the costs of continuing our development of our lead product candidate, SRK-015, including enrollment in the Phase 2 clinical trial we anticipate to initiate in the first half of 2019, and the costs of conducting future clinical trials, including for SRK-181; · the costs of future manufacturing; · the scope, progress, results and costs of discovery, preclinical development, laboratory testing and clinical trials for other potential product candidates we may develop, if any; · the costs of identifying and developing, or in-licensing or acquiring, additional product candidates and technologies; · the costs, timing and outcome of regulatory review of our product candidates; · our ability to establish and maintain collaborations on favorable terms, if at all; · the achievement of milestones or occurrence of other developments that trigger payments under any collaboration agreements we might have at such time; · the costs of seeking marketing approvals for our product candidates that successfully complete clinical trials, if any; · the costs and timing of future commercialization activities, including product sales, marketing, manufacturing and distribution, for any of our product candidates for which we receive marketing approval; · the amount of revenue, if any, received from commercial sales of our product candidates, should any of our product candidates receive marketing approval; · the costs of preparing, filing and prosecuting patent applications, obtaining, maintaining and enforcing our intellectual property rights and defending intellectual property-related claims; · our headcount growth and associated costs as we expand our business operations and research and development activities; · the costs of expanding our infrastructure and facilities to accommodate our growing employee base, including adding equipment and physical infrastructure to support our research and development; and · the cost of operating as a public company. Identifying potential product candidates and conducting preclinical studies and clinical trials is a time-consuming, expensive and uncertain process that takes years to complete, and we may never generate the necessary data or results required to obtain marketing approval and achieve product sales. In addition, our product candidates, if approved, may not achieve commercial success. Our commercial revenues, if any, will be derived from sales of products that we do not expect to be commercially available for many years, if at all. Accordingly, we will need to continue to rely on additional financing to achieve our business objectives. Adequate additional financing may not be available to us on acceptable terms, or at all. Until such time, if ever, as we can generate substantial product revenues, we expect to 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, common stockholder ownership interests may be diluted, and the terms of these securities may include liquidation or other preferences that could adversely affect the rights of a common stockholder. Additional debt financing, if available, may involve agreements that include restrictive covenants that limit our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends, that could adversely impact our ability to conduct our business. If we raise funds through 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. Critical Accounting Policies and Use of Estimates This management’s discussion and analysis 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 judgments and estimates that affect the reported amounts of assets, liabilities, revenues and expenses and the disclosure of contingent assets and liabilities in our consolidated financial statements. 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 judgements 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. On an ongoing basis, we evaluate our judgments and estimates in light of changes in circumstances, facts and experience. The effects of material revisions in estimates, if any, will be reflected in the consolidated financial statements prospectively from the date of change in estimates. Our 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 report, 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 Expenses As part of the process of preparing our consolidated financial statements, we are required to estimate our accrued 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 research and development expenses include the costs incurred for services performed by our vendors in connection with research and development activities for which we have not yet been invoiced. In certain instances, we prepay for services to be provided in the future. These amounts are expensed as the services are performed. We base our expenses related to research and development activities on our estimates of the services received and efforts expended pursuant to quotes and contracts with vendors that conduct research and development 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 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 balance accordingly. Nonrefundable 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 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 incurred. Determination of the Fair Value of Equity-Based Awards We determine the fair value of restricted common stock awards granted based on the fair value of our common stock less any purchase price, as applicable. We estimate the fair value of stock option awards granted using the Black-Scholes option-pricing model, which uses as inputs the fair value of our common stock and subjective assumptions we make, including the expected stock price volatility, the expected term of the award, the risk-free interest rate and expected dividends. 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 and implied volatility data, we base the estimate of expected volatility on the historical volatility of a representative group of publicly traded companies for which historical information is available. The historical volatility is generally calculated based on a period of time commensurate with the expected term assumption. We use the simplified method to calculate the expected term for options granted to employees and directors. We utilize this method as we do not have sufficient historical exercise data to provide a reasonable basis upon which to estimate the expected term. For grants to non-employees, ASU 2018-07 allows entities to use the expected term to measure non-employee options or elect to use the contractual term as the expected term, on an award-by-award basis. The risk-free interest rate is based on a U.S. treasury instrument whose term is consistent with the expected term of the stock options. The expected dividend yield is assumed to be zero as we have never paid dividends and do not have current plans to pay any dividends on our common stock. Prior to the IPO, as there had been no public market for our common units, incentive units or common stock, the estimated fair value of our common units, incentive units and common stock had been approved by our board of directors, with input from management, as of the date of each award grant, considering our most recently available independent third-party valuations of common units, incentive units and common stock, and our board of directors assessment, with input from management, of additional objective and subjective factors that we believed were relevant and which may have changed from the date of the most recent valuation through the date of the grant. These independent 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. We estimated the value of our equity using the market approach, including the guideline public company method and a precedent transaction method which "backsolves" to a preferred price. We allocated equity value to our common units, incentive units and convertible preferred units or to our shares of common stock and shares of our convertible preferred stock, as the case may be, using either an option-pricing method, or OPM, or a hybrid method, which is a hybrid between the OPM and the probability-weighted expected return method. The OPM treats common securities and preferred securities as call options on the total equity value of a company, with exercise prices based on the value thresholds at which the allocation among the various holders of a company's securities changes. Under this method, the common units and incentive units and common stock have value only if the funds available for distribution to members exceed the value of the preferred security liquidation preference at the time of the liquidity event, such as a strategic sale or a merger. The hybrid method estimates the probability-weighted value across multiple scenarios but uses the OPM to estimate the allocation of value within at least one of the scenarios. In addition to the OPM, the hybrid method considers an initial public offering, or IPO, scenario in which the shares of convertible preferred stock are assumed to convert to common stock. The future value of the common units, incentive units and common stock in the IPO scenario is discounted back to the valuation date at an appropriate risk adjusted discount rate. In the hybrid method, the present value indicated for each scenario is probability weighted to arrive at an indication of value for the common units, incentive units and common stock. Prior to the IPO, in addition to considering the results of the third-party valuations, management considered various objective and subjective factors to determine the fair value of our common units, incentive units and common stock as of each grant date, which may be a date later than the most recent third-party valuation date, including: · the prices of our preferred securities sold to or exchanged between outside investors in arm's length transactions, and the rights, preferences and privileges of our preferred securities as compared to those of our common units, incentive units or common stock, including the liquidation preferences of our preferred securities; · the progress of our research and development efforts, including the status of preclinical studies and planned clinical trials for our product candidates; · the lack of liquidity of our equity as a private company; · our stage of development and business strategy and the material risks related to our business and industry; · the achievement of enterprise milestones, including entering into collaboration and license agreements; · 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 biotechnology industry, and trends within the biotechnology industry; · the likelihood of achieving a liquidity event for the holders of our common units, incentive units and common stock, such as an IPO, or a sale of our company, given prevailing market conditions; and · the analysis of IPOs and the market performance of similar companies in the biopharmaceutical industry. The assumptions underlying these valuations represented management's best estimates, which involved inherent uncertainties and the application of management judgment. As a result, if factors or expected outcomes change and we used significantly different assumptions or estimates, our equity-based compensation expense could have been materially different. Revenue Recognition As of December 31, 2018, all of our revenue to date had been generated exclusively from our option and license agreement with Janssen as we had not yet recognized any revenue under the Gilead Collaboration, which was executed in December 2018. Revenue associated with the Gilead collaboration will begin to be recognized in 2019 and will be recognized over the period that research is performed under the collaboration. We account for revenue under ASC Topic 606, Revenue from Contracts with Customers, or ASC 606. Under ASC 606, we recognize revenue when our customer obtains control of promised goods or services, in an amount that reflects the consideration which we expect to receive in exchange for those goods or services. To determine the appropriate amount of revenue to be recognized for arrangements determined to be within the scope of ASC 606, we perform the following five steps: (i) identification of the contract(s) with the customer, (ii) identification of the promised goods or services in the contract and determination of whether the promised goods or services are performance obligations, (iii) measurement of the transaction price, (iv) allocation of the transaction price to the performance obligations, and (v) recognition of revenue when (or as) we satisfy each performance obligation. We only apply the five-step model to contracts when it is probable that we will collect the consideration we are entitled to in exchange for the goods or services we transfer to our customer. Identification of the Contract(s) with the Customer We account for a contract with a customer that is within the scope of ASC 606 when all of the following criteria are met: (i) the arrangement has been approved by the parties and the parties are committed to perform their respective obligations, (ii) each party's rights regarding the goods or services to be transferred can be identified, (iii) the payment terms for the goods or services to be transferred can be identified, (iv) the arrangement has commercial substance and (v) collection of substantially all of the consideration to which we will be entitled in exchange for the goods or services that will be transferred to the customer is probable. Identification of the Performance Obligations Performance obligations are promised goods or services in a contract to transfer a distinct good or service to the customer. Promised goods or services are considered distinct when: (i) the customer can benefit from the good or service on its own or together with other readily available resources and (ii) the promised good or service is separately identifiable from other promises in the contract. In assessing whether promised goods or services are distinct, we consider factors such as the stage of development of the underlying intellectual property, the capabilities of our customer to develop the intellectual property on their own and whether the required expertise is readily available. Options for additional license rights are considered to be marketing offers and are to be accounted for as separate contracts when the customer elects such options, unless we determine the option provides a material right which would not be provided without entering into the contract. Determination of the Transaction Price We estimate the transaction price based on the amount of consideration we expect to receive for transferring the promised goods or services in the contract. The consideration may include both fixed consideration and variable consideration. At the inception of each arrangement that includes variable consideration, we evaluate the amount of the potential payments and the likelihood that the payments will be received. We utilize either the most likely amount method or expected value method to estimate the transaction price based on which method better predicts the amount of consideration expected to be received. If it is probable that a significant revenue reversal would not occur, the variable consideration is included in the transaction price. We evaluate whether development, regulatory, and commercial milestone payments are considered probable of being reached and estimate 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 milestone value is included in the transaction price. Milestone payments that are not within our control or the licensee's control, such as regulatory approvals, are not considered probable of being achieved until those approvals are received. At the end of each reporting period, we re-evaluate the probability of achievement of such milestones and any related constraint, and if necessary, adjust our estimate of the overall transaction price. Any such adjustments are recorded on a cumulative catch-up basis, which would affect collaboration revenue and earnings in the period of adjustment. To date, no milestones have been achieved under our arrangements with customers. For sales-based royalties, including milestone payments based on the level of sales, we determine whether the sole or predominant item to which the royalties relate is a license. When the license is the sole or predominant item to which the sales-based royalty relates, we recognize revenue at the later of: (i) when the related sales occur, or (ii) when the performance obligation to which some or all of the royalty has been allocated has been satisfied (or partially satisfied). To date, we have not recognized any sales-based royalty revenue resulting from our arrangement. Allocation of Transaction Price We allocate the transaction price based on the estimated standalone selling price. We must develop assumptions that require judgment to determine the standalone selling price for each performance obligation identified in the contract. We utilize key assumptions to determine the standalone selling price, which may include other comparable transactions, pricing considered in negotiating the transaction and the estimated costs. Certain variable consideration is allocated specifically to one or more performance obligations in a contract when the terms of the variable consideration relate to the satisfaction of the performance obligation and the resulting amounts allocated to each performance obligation are consistent with the amounts we would expect to receive for satisfying each performance obligation. Recognition of Revenue We utilize judgment to determine whether the performance obligation is satisfied over time or at a point in time. We determine the appropriate method of measuring progress performance obligations satisfied over time for purposes of recognizing revenue, such as by using an input method based on costs incurred compared to the costs expected to be incurred in the future to satisfy the performance obligation. We evaluate the measure of progress each reporting period and, if necessary, adjust the measure of performance and related revenue recognition. If the license to our intellectual property is determined to be distinct from the other performance obligations identified in the arrangement, we will recognize revenue from non-refundable, up-front fees allocated to the license when the license is transferred to the customer and the customer is able to use and benefit from the license. We receive payments from customers based on billing schedules established in each contract. Up-front payments and fees are recorded as deferred revenue upon receipt or when due until we perform our obligations under these arrangements. Amounts are recorded as accounts receivable when our right to consideration is unconditional. 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 applicable SEC rules. Recent Accounting Pronouncements We have reviewed all recently issued standards and have determined that, other than Recently Issued Accounting Pronouncements as disclosed in Note 2 to our audited consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K, such standards will not have a material impact on our financial statements or do not otherwise apply to our operations.
0.002261
0.002428
0
<s>[INST] Overview We are a biopharmaceutical company focused on the discovery and development of innovative medicines for the treatment of serious diseases in which signaling by protein growth factors plays a fundamental role. Our newly elucidated understanding of the molecular mechanisms of growth factor activation enabled us to develop a proprietary platform for the discovery and development of monoclonal antibodies that locally and selectively target these signaling proteins at the cellular level. We believe this approach, acting in the disease microenvironment, avoids the historical challenges associated with inhibiting growth factors for therapeutic effect. We believe our focus on biologically validated growth factors may facilitate a more efficient development path. Our lead product candidate, SRK015, is a highly selective, fully human, monoclonal antibody, with a unique mechanism of action that results in inhibition of the activation of the growth factor, myostatin, in skeletal muscle. We have advanced SRK015 as a potential first muscledirected therapy for the treatment of spinal muscular atrophy, or SMA, into clinical development. We initiated our Phase 1 clinical trial of SRK015 in healthy volunteers in May 2018 and are initiating a Phase 2 clinical trial in SMA in the first quarter of 2019 with commencement of dosing anticipated in the second quarter of 2019. Our second product candidate is SRK181 and is being developed for the treatment of cancers resistant to checkpoint blockade therapies, or CBTs, such as antiPD1 antibodies. SRK181 is a highly selective inhibitor of the activation of transforming growth factor beta1, or TGFβ1. We intend to initiate a Phase 1 clinical trial of SRK181 in cancer immunotherapy in mid2020. In addition, utilizing our proprietary platform, we are continuing to create a pipeline of novel product candidates with the potential to transform the lives of patients suffering from a wide range of serious diseases, including other neuromuscular disorders, cancer, fibrosis and anemia. In May 2018, we completed an initial public offering, or IPO, of our common stock, and issued and sold 6,164,000 shares of common stock, including all additional shares available to cover overallotments, at a public offering price of $14.00 per share, resulting in net proceeds of $77.8 million after deducting underwriting discounts and commissions and other offering expenses payable by us. Upon the closing of the IPO, all outstanding shares of convertible preferred stock converted into 15,109,950 shares of common stock and our outstanding warrant to purchase preferred stock converted into a warrant to purchase 7,614 shares of common stock. Since inception, we have incurred significant operating losses. Our net losses were $49.3 million and $25.0 million for the years ended December 31, 2018 and 2017, respectively. As of December 31, 2018, we had an accumulated deficit of $106.8 million. We expect to continue to incur significant expenses and operating losses for the foreseeable future. In addition, we anticipate that our expenses will increase significantly in connection with our ongoing activities, as we: · continue research and development activities for SRK015, our lead product candidate, as we initiate and conduct our Phase 2 clinical trial; · continue research and development activities for SRK181, our program focused on inhibitors of the activation of TGFβ1; · continue to discover, validate and develop additional product candidates; · maintain, expand and protect our intellectual property portfolio; · hire additional research, development and business personnel; and · create the infrastructure to support our operations as a public company. To date, we have not generated any revenue from product sales and do not expect to generate any revenue from the sale of products in the near future. If we successfully complete clinical development and obtain regulatory approval for SRK015, SRK181 or any of our future product candidates, we may generate revenue in the future from product sales. In addition, if we obtain regulatory approval for SR [/INST] Positive. </s>
2,019
7,324
1,727,196
Scholar Rock Holding Corp
2020-03-12
2019-12-31
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The information contained in this section has been derived from our consolidated financial statements and should be read together with our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended, the “Exchange Act” and are subject to the “safe harbor” created by those sections. In particular, statements contained in this Annual Report on Form 10-K that are not historical facts, including, but not limited to statements regarding our future expectations, plans and prospects, including without limitation, our expectations regarding the potential of the TGFβ program, our collaboration with Gilead, the potential of SRK-015 as a therapy in SMA and the timeline for and progress in developing SRK-015, the potential of SRK-181 as a cancer immunotherapy and the timeline for and progress in developing SRK-181, and liquidity, constitute forward-looking statements and are made under these safe harbor provisions. Some of the forward-looking statements can be identified by the use of forward-looking terms such as "believes," "expects," "may," "will," "should," "could," "seek," "intends," "plans," "estimates," "anticipates," or other comparable terms. Forward-looking statements involve inherent risks and uncertainties, which could cause actual results to differ materially from those in the forward-looking statements. We caution readers not to place undue reliance upon any such forward-looking statements, which speak only as of the date made. We urge you to consider the risks and uncertainties discussed in greater detail under the heading "Risk Factors" elsewhere in this Annual Report on Form 10-K in evaluating our forward-looking statements. We have no plans to update our forward-looking statements to reflect events or circumstances after the date of this report. As a result of many factors, including those factors set forth under the heading "Risk Factors" elsewhere in this Annual Report on Form 10-K, our actual results could 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 biopharmaceutical company focused on the discovery and development of innovative medicines for the treatment of serious diseases in which signaling by protein growth factors plays a fundamental role. Our novel understanding of the molecular mechanisms of growth factor activation enabled us to develop a proprietary platform for the discovery and development of monoclonal antibodies that locally and selectively target these signaling proteins at the cellular level. We believe this approach, acting in the disease microenvironment, avoids the historical dose-limiting safety challenges associated with inhibiting growth factors for therapeutic effect. We believe our focus on biologically validated growth factors may facilitate a more efficient development path. Our first product candidate, SRK-015, is a highly selective, fully human, monoclonal antibody, with a unique mechanism of action that results in inhibition of the activation of the growth factor, myostatin, in skeletal muscle. SRK-015 is being developed as a potential first muscle-directed therapy for the treatment of SMA. SRK-015 is being evaluated in our TOPAZ Phase 2 proof-of-concept trial for the treatment of patients with Type 2 and Type 3 SMA. Enrollment in the trial was completed in January 2020 with a total of 58 patients enrolled. In November 2019, we announced preliminary PK and PD data from the first 29 patients enrolled in the TOPAZ trial that showed dose-proportional drug exposure and demonstrated target engagement, as evidenced by dose-dependent increases of up to 100-fold in the serum levels of latent myostatin following SRK-015 treatment. An interim efficacy and safety analysis of all enrolled patients following six months of treatment exposure is planned for mid-2020. Top-line results for the full 12-month treatment period are expected starting in the fourth quarter of 2020 and through the first quarter of 2021. Our second product candidate, SRK-181, is being developed for the treatment of cancers that are resistant to CPI therapies, such as anti-PD-(L)1 antibody therapies. SRK-181 is a potent and highly selective inhibitor of the activation of latent TGFβ1. In the first quarter of 2020, we initiated a Phase 1 proof-of-concept clinical trial of SRK-181 in patients with locally advanced or metastatic solid tumors that exhibit primary resistance to anti-PD-(L)1 antibodies. This two-part trial consists of a dose escalation portion (Part A) and a dose expansion portion (Part B). Part A will evaluate SRK-181 as a single-agent and in combination with an approved anti-PD-(L)1 antibody therapy) and Part B will evaluate SRK-181 in combination with an approved anti-PD-(L)1 antibody therapy in multiple tumor-specific cohorts, including urothelial carcinoma, cutaneous melanoma, non-small cell lung cancer, and other solid tumors. Initial clinical data, such as biomarker data, from Part A of the trial is expected in the second half of 2020 with clinical response and safety data from Part B of the trial anticipated throughout 2021. Utilizing our proprietary platform, we continue to create a pipeline of novel product candidates with the potential to transform the lives of patients suffering from a wide range of serious diseases, including neuromuscular disorders, cancer, fibrosis and anemia. As an example, we are discovering and developing potent and selective inhibitors of the activation of TGFβ in collaboration with Gilead for the treatment of fibrotic disease. We also intend to nominate a product candidate in 2020 that targets RGMc, a co-receptor of bone morphogenetic protein 6 (“BMP6”), another member of the TGFβ superfamily, to pursue in iron-restricted anemias. In June and July 2019, we sold 3,450,000 shares of our common stock, including the exercise of the overallotment option, through an underwritten public offering at a price of $15.00 per share. The offering was made pursuant to our effective shelf registration statement on Form S-3. As a result of the offering, we received aggregate net proceeds, after underwriting discounts and commissions and other offering expenses, of approximately $48.3 million. Since inception, we have incurred significant operating losses. Our net losses were $51.0 million and $49.3 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had an accumulated deficit of $157.8 million. We expect to continue to incur significant expenses and operating losses for the foreseeable future. In addition, we anticipate that our expenses will increase in connection with our ongoing activities, as we: · continue development activities for SRK-015, our first product candidate, including the conduct of our TOPAZ Phase 2 clinical trial; · continue research and development activities for SRK-181, including the conduct of our Phase 1 clinical trial; · continue research and development activities to support our collaboration with Gilead; · continue research and development activities to allow us to nominate a product candidate that targets RGMc to pursue in iron-restricted anemias; · continue to discover, validate and develop additional product candidates through the use of our proprietary platform; · maintain, expand and protect our intellectual property portfolio; · hire additional research, development and business personnel; and · continue to build the infrastructure to support our operations as a public company. To date, we have not generated any revenue from product sales and do not expect to generate any revenue from the sale of products in the near future. If we successfully complete clinical development and obtain regulatory approval for SRK-015, SRK-181 or any of our future product candidates, we may generate revenue in the future from product sales. In addition, if we obtain regulatory approval for SRK-015, SRK-181 or any of our future product candidates, we expect to incur significant expenses related to developing our commercialization capability to support product sales, marketing and distribution activities. Financial Operations Overview Revenue No revenues have been recorded from the sale of any commercial product. Revenue generation activities have been limited to collaborations, containing research services and the issuance of a license. Currently, revenue is being recognized related to the Gilead Collaboration Agreement which was executed in December 2018, and we began recognizing associated revenue in 2019. Under the Gilead Collaboration Agreement, Gilead has exclusive options to license worldwide rights to product candidates that emerge from three of the Company’s Gilead Programs. Revenue associated with the research and development and license performance obligations relating to the Gilead Programs is recognized as revenue as the research and development services are provided using an input method, according to the costs incurred on each Gilead Program and the costs expected to be incurred in the future to satisfy the performance obligation. The transfer of control occurs over time. In management’s judgment, this input method is the best measure of progress towards satisfying the performance obligations. We evaluate the measure of progress each reporting period and, if necessary, adjust the measure of performance and related revenue recognition. The estimated remaining costs is highly subjective, as the research is novel, therefore efforts to be successful may be significantly different than the estimated costs made at the balance sheet date. The amounts received that have not yet been recognized as revenue are recorded in deferred revenue on our consolidated balance sheet. We expect to recognize the deferred revenue according to costs incurred, over the remaining research term for each respective Gilead Program, which is up to three years from the execution of the agreement; each research term is dependent on the timing of Gilead either exercising its options for the Gilead Programs or terminating further development on the Gilead Programs prior to the expiration date of the research term. Operating Expenses Research and Development Research and development expenses consist primarily of costs incurred for our research and development activities, including our product candidate discovery efforts, preclinical studies, manufacturing, and clinical trials under our research programs, which include: · employee-related expenses, including salaries, benefits and equity-based compensation expense for our research and development personnel; · expenses incurred under agreements with third parties that conduct research and development and preclinical activities on our behalf; · expenses incurred under agreements related to our clinical trials, including the costs for investigative sites and contract research organizations (“CROs”), that conduct our clinical trials; · manufacturing process-development, clinical supplies and technology-transfer expenses; · consulting and professional fees related to research and development activities; · costs of purchasing laboratory supplies and non-capital equipment used in our internal research and development activities; · costs related to compliance with clinical regulatory requirements; and · facility costs and other allocated expenses, which include expenses for rent and maintenance of facilities, insurance, depreciation and other supplies. Research and development costs are expensed as incurred. Costs for certain activities are recognized based on an evaluation of the progress to completion of specific tasks. Nonrefundable advance payments for research and development goods and services to be received in the future from third parties are deferred and capitalized. The capitalized amounts are expensed as the related services are performed. A significant portion of our research and development costs have been external costs, which we track on a program-by-program basis after a clinical product candidate has been identified. However, we do not allocate our internal research and development expenses, consisting primarily of employee related costs, depreciation and other indirect costs, on a program-by-program basis as they are deployed across multiple projects. 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, as well as the associated clinical trial material requirements. We expect research and development costs to increase for the foreseeable future as our product candidate development programs progress, and we expect to incur additional costs in connection with our research and development activities under our collaboration with Gilead. However, we do not believe that it is possible at this time to accurately project total program-specific expenses through commercialization. There are numerous factors associated with the successful commercialization of any of our product candidates, including future trial design and various regulatory requirements, many of which cannot be determined with accuracy at this time based on our stage of development. Additionally, future commercial and regulatory factors beyond our control will impact our clinical development programs and plans. The successful development of SRK-015, SRK-181 and any future product candidates is uncertain. Accordingly, at this time, we cannot reasonably estimate or know the nature, timing and estimated costs of the efforts that will be necessary to complete the remainder of the development of SRK-015, SRK-181 and any future product candidates. We are also unable to predict when, if ever, material net cash inflows will commence from the sale of our product candidates, if approved. This is due to the numerous risks and uncertainties associated with developing product candidates, including the uncertainty of: · the scope, progress, outcome and costs of our preclinical development activities, clinical trials and other research and development activities; · establishing an appropriate safety profile; · successful enrollment in and completion of clinical trials; · whether our product candidates show safety and efficacy in our clinical trials; · receipt of marketing approvals from applicable regulatory authorities, if any; · establishing commercial manufacturing capabilities or making arrangements with third-party manufacturers; · obtaining and maintaining patent and trade secret protection and regulatory exclusivity for our product candidates; · significant and changing government regulation; · commercializing the product candidates, if and when approved, whether alone or in collaboration with others; and · continued acceptable safety profile of the products following any regulatory approval. A change in the outcome of any of these variables with respect to the development of SRK-015, SRK-181 or any of our future product candidates could significantly change the costs and timing associated with the development of that product candidate. General and Administrative General and administrative expenses consist primarily of employee-related expenses, including salaries, benefits and equity-based compensation expenses for personnel in executive, finance, business development, investor relations, legal, information technology and human resources functions. Other significant general and administrative expenses include facility costs not otherwise included in research and development expenses, legal fees relating to patent and corporate matters and fees for accounting, consulting services, and corporate expenses. We anticipate that our general and administrative expenses will increase in the future as our business expands to support expected growth in research and development activities, including the continued development of our product candidates. These increases will likely include increased costs related to the hiring of additional personnel, as well as fees to outside consultants, among other expenses. We also anticipate continued expenses associated with being a public company, including costs for audit, legal, regulatory and tax-related services, director and officer insurance premiums and investor relations costs. Other Income (Expense), Net Other income (expense), net consists primarily of interest income earned on our cash and cash equivalents and marketable securities, interest expense incurred on our credit facility, including amortization of debt discount and debt issuance costs, gains and losses on foreign currency invoices and non-cash changes in the fair value of the warrant issued in connection with our credit facility. Results of Operations Comparison of the Years Ended December 31, 2019 and 2018 The following table summarizes our results of consolidated operations for the years ended December 31, 2019 and 2018 (in thousands, except percentages): *NM means not meaningful. Revenue Revenue was $20.5 million for the year ended December 31, 2019, which was related to the Gilead Collaboration Agreement executed in December 2018. Revenue associated with the research and development and license performance obligations relating to the Gilead Programs is recognized as the research and development services are provided using a cost input method. A $25.0 million preclinical milestone was achieved in December 2019 through the successful demonstration of efficacy in preclinical in vivo proof-of-concept studies. As a result, the associated $25 million was included in the transaction price allocated to the performance obligations as of December 31, 2019. No revenue was recognized for the year ended December 31, 2018. Operating Expenses Research and Development Research and development expense was $54.2 million for the year ended December 31, 2019 compared to $36.3 million for the year ended December 31, 2018, an increase of $17.9 million, or 49.3%. The following table summarizes our research and development expense for the years ended December 31, 2019 and 2018 (in thousands, except percentages): The increase in research and development expense was primarily attributable to the following: · An increase in our external research and development costs of $10.5 million, which primarily consisted of: o Consistent with our previously stated plans to advance our immuno-oncology pipeline, we are investing in SRK-181, which we declared in early 2019 to be our next product candidate. The $14.1 million increase in costs associated with SRK-181 includes manufacturing costs in preparation for our Phase 1 clinical trial as well as a one-time option fee owed upon its product candidate declaration, partially offset by: o $2.0 million decrease in costs related to other early development candidates and unallocated costs; and o $1.6 million decrease in our costs associated with SRK-015, due to timing of manufacturing development in 2018. · $7.4 million increase in internal research and development costs, which was primarily driven by an increase in employee compensation and benefits costs, associated with increased headcount and related overhead as we continued to build out our research and development functions, in addition to an increase in facility costs as we added the additional space to our current location in July 2018. We expect our research and development expenses to increase as we continue to advance the development of our product candidates, including SRK-015, through our TOPAZ Phase 2 clinical trial, and SRK-181, through our Phase 1 clinical trial. Additionally, we expect to continue to conduct research under the Gilead collaboration. General and Administrative General and administrative expense was $20.8 million for the year ended December 31, 2019 compared to $14.4 million for the year ended December 31, 2018, an increase of $6.4 million or 44.7%. The increase in general and administrative expense was primarily attributable to an increase of $4.9 million in employee compensation and benefits, related to increased headcount, $1.0 million in professional services, and $0.5 million in other costs, such as those related to operating as a public company. The current year growth in general and administrative expense is primarily attributed to operating as a public company for a full year as compared to the prior year with the completion of our IPO in May 2018. We anticipate that our general and administrative expenses will increase in the future as our business expands to support expected growth in research and development activities, including the continued development of our product candidates. Other Income (Expense), Net The increase in other income (expense), net was attributable to increased income earned on our investment portfolio, associated with higher average cash balances and higher interest rates during the year ended December 31, 2019, as compared to the year ended December 31, 2018. This increase was partially offset with the change in fair value of the warrant during the year ended December 31, 2018. Previously, the warrant was classified as a liability and re-measured at its fair value at each balance sheet date and recorded in other expense. Subsequent to our IPO, the warrant was classified as equity and no longer valued at fair value. Liquidity and Capital Resources Sources of Liquidity Since our inception, we have not generated any product revenue and have incurred significant operating losses and negative cash flows from our operations. We have funded our operations to date primarily with proceeds from the sale of our convertible preferred stock and units in private placements before our IPO, and sale of our common stock through our IPO, to Gilead in an exempt private placement, and through a secondary public offering, as well as payments from our research collaborations. The following table provides information regarding our total cash and cash equivalents and marketable securities at December 31, 2019 and December 31, 2018 (in thousands): During the year ended December 31, 2019, our cash, cash equivalents and marketable securities balance decreased by approximately $18.2 million. The change was primarily the result of cash used to operate our business, including payments related to, among other things, research and development and general and administrative expenses as we continued to invest in our primary product candidates and supported our internal research and development efforts. We also made capital purchases and final payments on our debt. This spend was partially offset by net proceeds from the sale of our common stock in a secondary offering in June and July 2019. In June and July 2019, we sold 3,450,000 shares of our common stock through an underwritten public offering, including an overallotment option. As a result of the offering, we received aggregate net proceeds, after underwriting discounts and commissions and other offering expenses, of approximately $48.3 million. In December 2018, we entered into the Gilead Collaboration Agreement, with Gilead pursuant to which we will conduct research and pre-clinical development activities relating to the diagnosis, treatment, cure, mitigation or prevention of diseases, disorders or conditions, other than in the field of oncology in accordance with a pre-determined research plan. Pursuant to the Gilead Collaboration Agreement, Gilead made non-refundable payments of $80.0 million, including an upfront payment and an equity investment. In December 2019, we achieved a $25 million preclinical milestone for the successful demonstration of efficacy in preclinical in vivo proof-of-concept studies, and subsequently received the associated payment in January 2020. In May 2018, we completed our IPO, in which we issued and sold 6,164,000 shares of common stock, including all additional shares available to cover overallotments, resulting in net proceeds of $77.8 million after deducting underwriting discounts and commissions and other offering costs payable by us. From inception and prior to the IPO, we primarily funded our operations with the net proceeds of $109.2 million from sales of our convertible preferred stock and units. Cash Flows The following table provides information regarding our cash flows for the years ended December 31, 2019 and 2018 (in thousands): Net Cash (Used in) Provided by Operating Activities Net cash used in operating activities was $63.1 million for the year ended December 31, 2019 and consisted of our net loss of $51.0 million and changes in our assets and liabilities of $21.2 million, of which $25.0 million is a change in accounts receivable related to the milestone achieved in the Gilead collaboration. The uses of cash were partially offset by non-cash adjustments of $9.1 million, primarily from equity-based compensation. Net cash provided by operating activities was $24.6 million for the year ended December 31, 2018 and consisted of changes in our assets and liabilities of $67.9 million, primarily related to a change of $62.9 million from deferred revenue related to the Gilead collaboration and non-cash adjustments of $6.0 million, primarily from equity compensation, partially offset by our net loss of $49.3 million. Net Cash Used in Investing Activities Net cash used in investing activities was $62.2 million for the year ended December 31, 2019 compared to $60.2 million for the year ended December 31, 2018. Net cash used in investing activities for both periods was primarily associated with transactions involving our marketable securities, including purchases, sales, and maturities. Net Cash Provided by Financing Activities Net cash provided by financing activities was $48.9 million for the year ended December 31, 2019 compared to $94.3 million for the year ended December 31, 2018. Net cash provided by financing activities for the year ended December 31, 2019 consisted primarily of net proceeds from a secondary public offering of common stock in June and July 2019, in addition to proceeds from stock option exercises. Net cash provided by financing activities for the year ended December 31, 2018 consisted primarily of proceeds from our IPO and sale of common stock to Gilead. These amounts were partially offset by principal payments made on outstanding debt in both periods. Funding Requirements We expect our expenses to increase in connection with our ongoing activities, particularly as we continue the research and development for, continue and initiate later stage clinical trials for, continue to develop and optimize our manufacturing processes for, and seek marketing approval for, our product candidates, including SRK-015 and SRK-181, and any of our future product candidates. In addition, if we obtain marketing approval for SRK-015, SRK-181 or any of our future product candidates, we expect to incur significant commercialization expenses related to product sales, marketing, manufacturing and distribution. Furthermore, we expect to continue to incur costs associated with operating as a public company. We expect that our existing cash and cash equivalents will enable us to fund our operating expenses and capital expenditure requirements into the fourth quarter of 2021. However, we will require additional capital in order to complete clinical development for each of our current programs. We have based this estimate on assumptions that may prove to be wrong, and we may use our available capital resources sooner than we currently expect. Our future capital requirements will depend on many factors, including: · the costs and timing of developing of our product candidates, SRK-015 and SRK-181, including the TOPAZ Phase 2 clinical trial for SRK-015, the Phase 1 clinical trial for SRK-181, and the costs and timing of conducting future clinical trials; · the costs of future manufacturing of SRK-015, SRK-181 and any other product candidates; · the scope, progress, results and costs of discovery, preclinical development, laboratory testing and clinical trials for other potential product candidates we may develop, if any; · the costs of identifying and developing, or in-licensing or acquiring, additional product candidates and technologies; · the costs, timing and outcome of regulatory review of our product candidates; · our ability to establish and maintain collaborations on favorable terms, if at all; · the achievement of milestones or occurrence of other developments that trigger payments under any collaboration agreements, license agreements, or other agreements we might have at such time; · the costs of seeking marketing approvals for our product candidates that successfully complete clinical trials, if any; · the costs and timing of future commercialization activities, including product sales, marketing, manufacturing and distribution, for any of our product candidates for which we receive marketing approval; · the amount of revenue, if any, received from commercial sales of our product candidates, should any of our product candidates receive marketing approval; · the costs of preparing, filing and prosecuting patent applications, obtaining, maintaining and enforcing our intellectual property rights and defending intellectual property-related claims; · our headcount growth and associated costs as we expand our business operations and research and development activities; · the costs of expanding our infrastructure and facilities to accommodate our growing employee base, including adding equipment and physical infrastructure to support our research and development; and · the costs of operating as a public company. Identifying potential product candidates and conducting preclinical studies and clinical trials is a time-consuming, expensive and uncertain process that takes years to complete, and we may never generate the necessary data or results required to obtain marketing approval and achieve product sales. In addition, our product candidates, if approved, may not achieve commercial success. Our commercial revenues, if any, will be derived from sales of products that we do not expect to be commercially available for many years, if at all. Accordingly, we will need to continue to rely on additional financing to achieve our business objectives. Adequate additional financing may not be available to us on acceptable terms, or at all. Until such time, if ever, as we can generate substantial product revenues, we expect to 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, common stockholder ownership interests may be diluted, and the terms of these securities may include liquidation or other preferences that could adversely affect the rights of a common stockholder. Additional debt financing, if available, may involve agreements that include restrictive covenants that limit our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends, that could adversely impact our ability to conduct our business. If we raise funds through 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. Critical Accounting Policies and Use of Estimates This management’s discussion and analysis 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 judgments and estimates that affect the reported amounts of assets, liabilities, revenues and expenses and the disclosure of contingent assets and liabilities in our consolidated financial statements. 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 judgements 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. On an ongoing basis, we evaluate our judgments and estimates in light of changes in circumstances, facts and experience. The effects of material revisions in estimates, if any, will be reflected in the consolidated financial statements prospectively from the date of change in estimates. Our 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 report, 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 Expenses As part of the process of preparing our consolidated financial statements, we are required to estimate our accrued 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 research and development expenses include the costs incurred for services performed by our vendors in connection with research and development activities for which we have not yet been invoiced. In certain instances, we prepay for services to be provided in the future. These amounts are expensed as the services are performed. We base our expenses related to research and development activities on our estimates of the services received and efforts expended pursuant to quotes and contracts with vendors that conduct research and development 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 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 balance accordingly. Nonrefundable 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 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 incurred. Determination of the Fair Value of Equity-Based Awards We determine the fair value of restricted common stock awards granted based on the fair value of our common stock less any purchase price, as applicable. We estimate the fair value of stock option awards granted using the Black-Scholes option-pricing model, which uses as inputs the fair value of our common stock and subjective assumptions we make, including the expected stock price volatility, the expected term of the award, the risk-free interest rate and expected dividends. 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 and implied volatility data, we base the estimate of expected volatility on the historical volatility of a representative group of publicly traded companies for which historical information is available. The historical volatility is generally calculated based on a period of time commensurate with the expected term assumption. We use the simplified method to calculate the expected term for options granted to employees and directors. We utilize this method as we do not have sufficient historical exercise data to provide a reasonable basis upon which to estimate the expected term. For grants to non-employees, ASU 2018-07 allows entities to use the expected term to measure non-employee options or elect to use the contractual term as the expected term, on an award-by-award basis. The risk-free interest rate is based on a U.S. treasury instrument whose term is consistent with the expected term of the stock options. The expected dividend yield is assumed to be zero as we have never paid dividends and do not have current plans to pay any dividends on our common stock. The assumptions underlying these valuations represented management's best estimates, which involve inherent uncertainties and the application of management judgment. As a result, if factors or expected outcomes change and we used significantly different assumptions or estimates, our equity-based compensation expense could be materially different. Revenue Recognition No revenues have been recorded from the sale of any commercial product. Revenue generation activities have been limited to collaborations, containing research services and the issuance of a license. Currently, revenue is being recognized related to the Gilead Collaboration Agreement which was executed in December 2018. We began recognizing associated revenue in 2019 over the period that research is performed under the collaboration. We account for revenue under ASC Topic 606, Revenue from Contracts with Customers (“ASC 606”). Under ASC 606, we recognize revenue when our customer obtains control of promised goods or services, in an amount that reflects the consideration which we expect to receive in exchange for those goods or services. To determine the appropriate amount of revenue to be recognized for arrangements determined to be within the scope of ASC 606, we perform the following five steps: (i) identification of the contract(s) with the customer, (ii) identification of the promised goods or services in the contract and determination of whether the promised goods or services are performance obligations, (iii) measurement of the transaction price, (iv) allocation of the transaction price to the performance obligations, and (v) recognition of revenue when (or as) we satisfy each performance obligation. We only apply the five-step model to contracts when it is probable that we will collect the consideration we are entitled to in exchange for the goods or services we transfer to our customer. Identification of the Contract(s) with the Customer We account for a contract with a customer that is within the scope of ASC 606 when all of the following criteria are met: (i) the arrangement has been approved by the parties and the parties are committed to perform their respective obligations, (ii) each party's rights regarding the goods or services to be transferred can be identified, (iii) the payment terms for the goods or services to be transferred can be identified, (iv) the arrangement has commercial substance and (v) collection of substantially all of the consideration to which we will be entitled in exchange for the goods or services that will be transferred to the customer is probable. Identification of the Performance Obligations Performance obligations are promised goods or services in a contract to transfer a distinct good or service to the customer. Promised goods or services are considered distinct when: (i) the customer can benefit from the good or service on its own or together with other readily available resources and (ii) the promised good or service is separately identifiable from other promises in the contract. In assessing whether promised goods or services are distinct, we consider factors such as the stage of development of the underlying intellectual property, the capabilities of our customer to develop the intellectual property on their own and whether the required expertise is readily available. Arrangements that include rights to additional goods or services that are exercisable at a customer’s discretion are generally considered options. We assess if these options provide a material right to the customer and if so, they are considered performance obligations. The identification of material rights requires judgments related to the determination of the value of the underlying license relative to the option exercise price, including assumptions about technical feasibility and the probability of developing a candidate that would be subject to the option rights. Determination of the Transaction Price We estimate the transaction price based on the amount of consideration we expect to receive for transferring the promised goods or services in the contract. The consideration may include both fixed consideration and variable consideration. At the inception of each arrangement that includes variable consideration, we evaluate the amount of the potential payments and the likelihood that the payments will be received. We utilize either the most likely amount method or expected value method to estimate the transaction price based on which method better predicts the amount of consideration expected to be received. If it is probable that a significant revenue reversal would not occur, the variable consideration is included in the transaction price. We evaluate whether development, regulatory, and commercial milestone payments are considered probable of being reached and estimate 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 milestone value is included in the transaction price. Milestone payments that are not within our control or the licensee's control, such as regulatory approvals, are not considered probable of being achieved until those approvals are received. At the end of each reporting period, we re-evaluate the probability of achievement of such milestones and any related constraint, and if necessary, adjust our estimate of the overall transaction price. Any such adjustments are recorded on a cumulative catch-up basis, which would affect collaboration revenue and earnings in the period of adjustment. For sales-based royalties, including milestone payments based on the level of sales, we determine whether the sole or predominant item to which the royalties relate is a license. When the license is the sole or predominant item to which the sales-based royalty relates, we recognize revenue at the later of: (i) when the related sales occur, or (ii) when the performance obligation to which some or all of the royalty has been allocated has been satisfied (or partially satisfied). To date, we have not recognized any sales-based royalty revenue resulting from our arrangement. Allocation of Transaction Price We allocate the transaction price based on the estimated standalone selling price. We must develop assumptions that require judgment to determine the standalone selling price for each performance obligation identified in the contract. We utilize key assumptions to determine the standalone selling price, which may include other comparable transactions, pricing considered in negotiating the transaction and the estimated costs. Estimating costs for research and development programs is subjective as we estimate the costs anticipated to successfully complete the research performance obligations. As the research is novel, efforts to be successful may be significantly different than the estimated costs at the beginning of the contract. Certain variable consideration is allocated specifically to one or more performance obligations in a contract when the terms of the variable consideration relate to the satisfaction of the performance obligation and the resulting amounts allocated to each performance obligation are consistent with the amounts we would expect to receive for satisfying each performance obligation. Recognition of Revenue We utilize judgment to determine whether the performance obligation is satisfied over time or at a point in time. We determine the appropriate method of measuring progress performance obligations satisfied over time for purposes of recognizing revenue, such as by using an input method based on costs incurred compared to the costs expected to be incurred in the future to satisfy the performance obligation. We evaluate the measure of progress each reporting period and, if necessary, adjust the measure of performance and related revenue recognition. The estimated remaining costs is highly subjective, as the research is novel, therefore efforts to be successful may be significantly different than the estimated costs made at the balance sheet date. If the license to our intellectual property is determined to be distinct from the other performance obligations identified in the arrangement, we will recognize revenue from non-refundable, up-front fees allocated to the license when the license is transferred to the customer and the customer is able to use and benefit from the license. We receive payments from customers based on billing schedules established in each contract. Up-front payments and fees are recorded as deferred revenue upon receipt or when due until we perform our obligations under these arrangements. Amounts are recorded as accounts receivable when our right to consideration is unconditional. 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 applicable SEC rules. Recent Accounting Pronouncements We have reviewed all recently issued standards and have determined that, other than Recently Issued Accounting Pronouncements as disclosed in Note 2 to our audited consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K, such standards will not have a material impact on our financial statements or do not otherwise apply to our operations.
0.054145
0.054624
0
<s>[INST] Overview We are a biopharmaceutical company focused on the discovery and development of innovative medicines for the treatment of serious diseases in which signaling by protein growth factors plays a fundamental role. Our novel understanding of the molecular mechanisms of growth factor activation enabled us to develop a proprietary platform for the discovery and development of monoclonal antibodies that locally and selectively target these signaling proteins at the cellular level. We believe this approach, acting in the disease microenvironment, avoids the historical doselimiting safety challenges associated with inhibiting growth factors for therapeutic effect. We believe our focus on biologically validated growth factors may facilitate a more efficient development path. Our first product candidate, SRK015, is a highly selective, fully human, monoclonal antibody, with a unique mechanism of action that results in inhibition of the activation of the growth factor, myostatin, in skeletal muscle. SRK015 is being developed as a potential first muscledirected therapy for the treatment of SMA. SRK015 is being evaluated in our TOPAZ Phase 2 proofofconcept trial for the treatment of patients with Type 2 and Type 3 SMA. Enrollment in the trial was completed in January 2020 with a total of 58 patients enrolled. In November 2019, we announced preliminary PK and PD data from the first 29 patients enrolled in the TOPAZ trial that showed doseproportional drug exposure and demonstrated target engagement, as evidenced by dosedependent increases of up to 100fold in the serum levels of latent myostatin following SRK015 treatment. An interim efficacy and safety analysis of all enrolled patients following six months of treatment exposure is planned for mid2020. Topline results for the full 12month treatment period are expected starting in the fourth quarter of 2020 and through the first quarter of 2021. Our second product candidate, SRK181, is being developed for the treatment of cancers that are resistant to CPI therapies, such as antiPD(L)1 antibody therapies. SRK181 is a potent and highly selective inhibitor of the activation of latent TGFβ1. In the first quarter of 2020, we initiated a Phase 1 proofofconcept clinical trial of SRK181 in patients with locally advanced or metastatic solid tumors that exhibit primary resistance to antiPD(L)1 antibodies. This twopart trial consists of a dose escalation portion (Part A) and a dose expansion portion (Part B). Part A will evaluate SRK181 as a singleagent and in combination with an approved antiPD(L)1 antibody therapy) and Part B will evaluate SRK181 in combination with an approved antiPD(L)1 antibody therapy in multiple tumorspecific cohorts, including urothelial carcinoma, cutaneous melanoma, nonsmall cell lung cancer, and other solid tumors. Initial clinical data, such as biomarker data, from Part A of the trial is expected in the second half of 2020 with clinical response and safety data from Part B of the trial anticipated throughout 2021. Utilizing our proprietary platform, we continue to create a pipeline of novel product candidates with the potential to transform the lives of patients suffering from a wide range of serious diseases, including neuromuscular disorders, cancer, fibrosis and anemia. As an example, we are discovering and developing potent and selective inhibitors of the activation of TGFβ in collaboration with Gilead for the treatment of fibrotic disease. We also intend to nominate a product candidate in 2020 that targets RGMc, a coreceptor of bone morphogenetic protein 6 (“BMP6”), another member of the TGFβ superfamily, to pursue in ironrestricted anemias. In June and July 2019, we sold 3,450,000 shares of our common stock, including the exercise of the overallotment option, through an underwritten public offering at a price of $15.00 per share. The offering was made pursuant to our effective shelf registration statement on Form S3 [/INST] Positive. </s>
2,020
7,180
1,682,852
Moderna, Inc.
2019-03-13
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 related notes and other financial information appearing elsewhere in this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10-K, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties. As a result of many factors, including those factors set forth in the “Risk Factors” section of this Annual Report on Form 10-K, our actual results could 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 clinical stage biotechnology company pioneering messenger RNA (mRNA) therapeutics and vaccines to create a new generation of potentially transformative medicines to improve the lives of patients. mRNA medicines are designed to direct the body’s cells to produce intracellular, membrane or secreted proteins that have a therapeutic or preventive benefit with the potential to address a broad spectrum of diseases. Our platform builds on continuous advances in basic and applied mRNA science, delivery technology and manufacturing, providing us the capability to pursue in parallel a robust pipeline of new development candidates. We are developing therapeutics and vaccines for infectious diseases, immuno-oncology, rare diseases and cardiovascular diseases, independently and with our strategic collaborators. We have designed our strategy and operations to realize the full potential value and impact of mRNA over a long time horizon across a broad array of human diseases. We built and continue to invest in a platform to advance the technological frontier of mRNA medicines. We have made forward investments in scalable infrastructure and capabilities to pursue a pipeline of potential medicines that reflect the breadth of the mRNA opportunity. We have a diverse development pipeline of 20 development candidates, 11 of which are in clinical studies. Our therapeutic and vaccine development programs span infectious diseases, oncology, cardiovascular diseases, and rare genetic diseases. We have established strategic alliances with leading biopharmaceutical companies, including AstraZeneca, Merck & Co., or Merck, and Vertex Pharmaceuticals, or Vertex, as well as government-sponsored and private organizations focused on global health initiatives, including Biomedical Advanced Research and Development Authority, or BARDA, Defense Advanced Research Projects Agency, or DARPA, and the Bill & Melinda Gates Foundation. As we unlock the inherent advantages of mRNA, we aim to address as many diseases and impact as many patients as our technology, talent, and capital permit. The broad potential applications of mRNA medicines have led us to raise significant capital and adopt a long-term approach to capital allocation that balances near-term risks and long-term value creation. As of December 31, 2018, we have raised over $3.2 billion in total funding from a wide range of strategic sources, including $2.4 billion of financing from private equity financings and our initial public offering, or IPO, and $0.8 billion in upfront payments, milestone payments and option exercise payments from AstraZeneca, Merck, Alexion Pharma Holdings, or Alexion, and Vertex. As of December 31, 2018, we had cash, cash equivalents and investments of approximately $1.7 billion. We use this capital to fund operations and investing activities across research for technology creation, drug discovery and clinical development programs, infrastructure and capabilities to enable the Research Engine and Early Development Engine (which includes our manufacturing facility in Norwood), our digital infrastructure, creation of our portfolio of intellectual property, and administrative support. On December 11, 2018, we completed our IPO, whereby we sold 26,275,993 shares of common stock at a price of $23.00 per share. The aggregate net proceeds from the IPO were $563.0 million, net of underwriting discounts, commissions and offering expenses. Upon the closing of the IPO, all outstanding shares of redeemable convertible preferred stock converted into 236,012,913 shares of common stock. As of December 31, 2018, we had 328,798,904 shares outstanding shares of our common stock. Since our inception, we have incurred significant operating losses. Our net losses were $384.7 million, $255.9 million and $216.2 million for the years ended December 31, 2018, 2017 and 2016, respectively. As of December 31, 2018 , our accumulated deficit was $1.0 billion . We expect to continue to incur significant expenses and operating losses for the foreseeable future. In addition, we anticipate that our expenses will increase significantly in connection with our ongoing activities, as we: • continue our platform research and drug discovery and development efforts; • conduct clinical studies for our investigational medicines; • manufacture clinical study materials and develop large-scale manufacturing capabilities; • seek regulatory approval for our investigational medicines; • maintain, expand, and protect our intellectual property; • hire additional personnel to support our program development effort to obtain regulatory approval and secure additional facilities for operations; and • operate as a public company. We do not expect to generate revenue from the sale of potential mRNA medicines unless and until we successfully complete clinical development and obtain regulatory approval for one or more of our investigational medicines. If we seek to obtain regulatory approval for and commercialize any of our investigational medicines, we expect to incur significant commercialization expenses. As a result, we will need substantial additional funding to support our continued operations and pursue our growth strategy. Until we can generate significant revenue from sales of our medicines, if ever, we expect to finance our operations through a combination of public or private equity offerings and debt financings, government funding arrangements, strategic alliances and marketing, distribution, and licensing arrangements. We may be unable to raise additional funds or enter into such other agreements on favorable terms, or at all. If we fail to raise capital or enter into such agreements as, and when, needed, we may have to significantly delay, scale back, or discontinue the development and commercialization of one or more of our programs. Because of the numerous risks and uncertainties associated with pharmaceutical development, we are unable to predict the timing or amount of increased expenses or when or if we will be able to achieve or maintain profitability. Even if we are able to generate revenues from the sale of our medicines, we may not become profitable. If we fail to become profitable or are unable to sustain profitability on a continuing basis, then we may be unable to continue our operations at planned levels and be forced to reduce our operations. Financial Operations Overview Revenue To date, we have not generated any revenue from the sale of potential mRNA medicines. Our revenue has been primarily derived from strategic alliances with strategic collaborators and government-sponsored and private organizations to discover, develop, and commercialize potential mRNA medicines. The following is a summary of revenue recognized for the years ended December 31, 2018, 2017 and 2016 (in thousands): _______ (1) Includes collaboration revenue from an affiliate. Total revenue for the years ended December 31, 2018, 2017 and 2016 was $135.1 million, $205.8 million and $108.4 million, respectively. Cash received from strategic alliances was $57.6 million, $43.1 million and $324.2 million for the years ended December 31, 2018, 2017 and 2016, respectively. The timing of revenue recognition is not directly correlated to the timing of cash receipts. Total deferred revenue related to our strategic alliances as of December 31, 2018 and 2017 was $274.4 million and $339.7 million, respectively. The following table summarizes collaboration revenue for the years ended December 31, 2018, 2017 and 2016 (in thousands): Collaboration revenue for the years ended December 31, 2018, 2017 and 2016 was generated primarily from our strategic alliances with AstraZeneca, Merck, Vertex and Alexion. Our arrangements with Alexion were terminated in October 2017 and all rights to mRNA researched, developed, or supplied as part of the programs with Alexion reverted to us. Grant revenue is generated primarily from contracts with DARPA, BARDA, and the Bill & Melinda Gates Foundation, to develop mRNA medicines. For further information on our revenue recognition policies, see the section of this Annual Report on Form 10-K titled “Critical accounting policies and significant judgments and estimates-Revenue recognition.” Our ability to generate revenue from sales of mRNA medicines and become profitable depends upon our ability to successfully develop and commercialize mRNA medicines. For the foreseeable future, we do not expect to generate revenue from product sales. To the extent that existing or potential future strategic alliances generate revenue, our revenue may vary due to many uncertainties in the development of our mRNA medicines under these strategic alliances and other factors. We expect to incur losses for the foreseeable future, and we expect these losses to increase as we continue our research and development efforts. We expect our programs to mature and advance to later stage clinical development, and we expect expenses to increase as we seek regulatory approvals for our investigational medicines and begin to commercialize any approved mRNA medicines. Research and development expenses The nature of our business and primary focus of our activities generate a significant amount of research and development costs. Research and development expenses represent costs incurred by us for the following: • cost to develop our platform; • discovery efforts leading to development candidates; • preclinical, nonclinical, and clinical development costs for our programs; • cost to develop our manufacturing technology and infrastructure; and • digital infrastructure costs. The costs above comprise the following categories: • personnel-related expenses, including salaries, benefits, and stock-based compensation expense; • expenses incurred under agreements with third parties, such as consultants, investigative sites, contract research organizations, or CROs, that conduct our preclinical and clinical studies, and in-licensing arrangements; • costs of acquiring, developing, and manufacturing materials for preclinical and clinical studies, including both internal manufacturing and third-party contract manufacturing organizations, or CMOs; • expenses incurred for the procurement of materials, laboratory supplies, and non-capital equipment used in the research and development process; and • facilities, depreciation, and amortization, and other direct and allocated expenses incurred as a result of research and development activities. We use our employee and infrastructure resources for the advancement of our platform, and for discovering and developing programs. Due to the number of ongoing programs and our ability to use resources across several projects, indirect or shared operating costs incurred for our research and development programs are not recorded or maintained on a program- or modality-specific basis. The following table reflects our research and development expenses, including direct program specific expenses summarized by modality and indirect or shared operating costs summarized under other research and development expenses during the years ended December 31, 2018, 2017 and 2016 (in thousands): __________ (1) Includes a total of 21, 18 and 12 development candidates at December 31, 2018, 2017 and 2016, respectively. As of February 15, 2019, we have a total of 20 development candidates, as there will be no further development of our first Zika candidate, mRNA-1325. Program-specific expenses include external costs and allocated manufacturing costs of mRNA supply and consumables, and reflect these expenses beginning in the period the program was internally advanced to development. (2) Relates to in-licensing agreements entered into in June 2017 with Cellscript, LLC and its affiliate mRNA RiboTherapeutics, Inc. to sublicense certain patent rights. A “modality” refers to a group of programs with common product features and the associated combination of enabling mRNA technologies, delivery technologies, and manufacturing processes. The program-specific expenses by modality summarized in the table above include expenses we directly attribute to our programs, which consist primarily of external costs, such as fees paid to outside consultants, central laboratories, investigative sites, and CROs in connection with our preclinical studies and clinical trials, and allocated manufacturing costs of mRNA supply and consumables. Costs to acquire and manufacture mRNA supply for preclinical studies and clinical trials are recognized and included in unallocated manufacturing expenses when incurred, and subsequently allocated to program-specific manufacturing costs after completion of the program-specific production. The timing of allocating manufacturing costs to program-specific costs varies depending on the program development and production schedule. We do not allocate personnel-related costs, including stock-based compensation, costs associated with our general platform research, technical development, and other shared costs on a program-specific basis. These costs were therefore excluded from the summary of program-specific expenses summary by modality. Discovery program expenses are costs associated with research activities for our programs in the preclinical discovery stage, and primarily consist of external costs for CROs and lab services, and allocated manufacturing cost of preclinical mRNA supply and consumables. Platform research expenses are mainly costs to develop technical advances in mRNA science, delivery science, and manufacturing process design. These costs include personnel-related costs, computer equipment, facilities, preclinical mRNA supply and consumables, and other administrative costs to support our platform research. Technology development and unallocated manufacturing expenses are primarily related to non-program-specific manufacturing process development and manufacturing costs. Shared discovery and development expenses are research and development costs such as personnel-related costs and other costs, which are not otherwise included in development programs, discovery programs, platform research, technical development and unallocated manufacturing expenses, stock-based compensation, and other expenses. We have developed six modalities. As of February 15, 2019, we had 11 programs in clinical trials and a total of 20 development candidates, summarized by modality as follows: • Prophylactic vaccines included eight development candidates: RSV vaccine (mRNA-1777), CMV vaccine (mRNA-1647), hMPV+PIV3 vaccine (mRNA-1653), VZV vaccine (mRNA-1278), H10N8 vaccine (mRNA-1440), H7N9 vaccine (mRNA-1851), Zika vaccine (mRNA-1893), and Chikungunya vaccine (mRNA-1388). We currently have seven programs for which the Phase 1 trial is either ongoing or has been completed; • Cancer vaccines included two development candidates: Personalized cancer vaccine, or PCV, (mRNA-4157) and KRAS vaccine (mRNA-5671). We are collaborating with Merck on both programs. PCV is in a Phase 1 clinical trial and we and Merck have submitted a protocol to the FDA for a randomized Phase 2 clinical trial of mRNA-4157, and the KRAS vaccine has an open IND; • Intratumoral immuno-oncology included three development candidates: OX40L (mRNA-2416), OX40L+IL23+IL36γ (Triplet) (mRNA-2752), and IL12 (MEDI1191). The OX40L and OX40L+IL23+IL36γ programs are currently in Phase 1 clinical trials and the IND for a Phase 1 clinical trial of IL12 is open; • Localized regenerative therapeutics included one development candidate, VEGF-A (AZD8601). The program is being led by AstraZeneca through clinical development and is in a Phase 2a clinical trial; • Systemic secreted therapeutics included three development candidates: antibody against Chikungunya virus (mRNA-1944), Relaxin (AZD7970), and Fabry disease (mRNA-3630). The antibody against Chikungunya virus development candidate is in collaboration with DARPA and the program is in a Phase 1 clinical trial. The Relaxin program in collaboration with AstraZeneca and the Fabry disease program are both in preclinical development; and • Systemic intracellular therapeutics included three development candidates: MMA (mRNA-3704), PA (mRNA-3927), and PKU (mRNA-3283). The MMA program has an open IND, and the PA and PKU programs are in preclinical development. The largest component of our total operating expenses has historically been our investment in research and development activities, including development of our platform, mRNA technologies, and manufacturing technologies. We expense research and development costs as incurred and cannot reasonably estimate the nature, timing, and estimated costs required to complete the development of the development candidates and investigational medicines we are currently developing or may develop in the future. There are numerous risks and uncertainties associated with the research and development of such development candidates and investigational medicines, including, but not limited to: • scope, progress, and expense of developing ongoing and future development candidates and investigational medicines; • entry in and completion of related preclinical studies; • enrollment in and completion of subsequent clinical trials; • safety and efficacy of investigational medicines resulting from these clinical trials; • changes in laws or regulations relevant to the investigational medicines in development; • receipt of the required regulatory approvals; and • commercialization, including establishing manufacturing and marketing capabilities. A change in expectations or outcomes of any of the known or unknown risks and uncertainties may materially impact our expected research and development expenditures. Continued research and development is central to the ongoing activities of our business. Investigational medicines 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 expect our costs to continue to increase in the future as our investigational medicines progress through the development phases and as we identify and develop additional programs. However, we do not believe that it is possible at this time to accurately project total program-specific expenses through commercialization. There are numerous factors associated with the successful commercialization of any of our investigational medicines, including future trial design and various regulatory requirements, many of which cannot be determined with accuracy at this time due to the early stage of development of our investigational medicines. Additionally, future commercial and regulatory factors beyond our control will impact our clinical development programs and plans. General and administrative expenses General and administrative expenses consist primarily of personnel-related costs, including stock-based compensation, for executives, finance, legal, human resources, business development and other administrative and operational functions, professional fees, accounting and legal services, information technology and facility-related costs, and expenses associated with obtaining and maintaining intellectual property, or IP. These costs relate to the operation of the business, unrelated to the research and development function, or any individual program. We anticipate general and administrative expenses will increase as research and development expands. These increases will likely relate to additional personnel and increased costs related to finance, legal and IP-related matters along with increased expenses related to operating as a publicly traded company, such as fees related to audit, legal, and tax services, regulatory compliance programs, and investor relations. In addition, if we obtain regulatory approval for any of our investigational medicines and do not enter into a third-party commercialization collaboration, we expect to incur significant expenses related to building a sales and marketing team to support medicine sales, marketing, and distribution activities. We have a broad IP portfolio covering our development and commercialization of mRNA vaccine and therapeutic programs, including those related to mRNA design, formulation, and manufacturing platform technologies. We regularly file patent applications to protect innovations arising from our research and development. We also hold trademarks and trademark applications in the United States and foreign jurisdictions. Costs to secure and defend our IP are expensed as incurred, and are classified as general and administrative expenses. General and administrative expenses, including IP-related expenses, totaled $94.3 million, $64.7 and $57.5 for the years ended December 31, 2018, 2017 and 2016, respectively. IP-related expenses, including our internal personnel-related costs, were $11.9 million, $10.7 million and $10.9 million, for the years ended December 31, 2018, 2017 and 2016, respectively. We did not incur litigation expenses related to our IP during the years ended December 31, 2018, 2017 and 2016. Other income (expense), net Interest income Interest income consists of interest generated from our investments in cash and cash equivalents, money market funds, and high-quality fixed income securities. Other income (expense) Other income (expense), net consists of gains (losses) from the sale of investments in marketable securities, interest expense, and other income and expense unrelated to our core operations. 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 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 judgments and estimates that affect the reported amounts of assets, liabilities, revenues, and expenses and the disclosure of contingent assets and liabilities in our consolidated financial statements. 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. On an ongoing basis, we evaluate our judgments and estimates in light of changes in circumstances, facts, and experience. The effects of material revisions in estimates, if any, are reflected in the consolidated financial statements prospectively from the date of change in estimates. While our significant accounting policies are described in more detail in the notes to our consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K, we believe the following accounting policies used in the preparation of our consolidated financial statements require the most significant judgments and estimates. Revenue recognition We have primarily generated revenue from our strategic alliances. Our strategic alliances with strategic collaborators typically contain multiple elements, including research and other licenses, options to obtain development and commercialization rights, research and development services, obligations to develop and manufacture preclinical and clinical material, and options to obtain additional research and development services and preclinical and clinical material. Such arrangements provide for various types of payments to us, including upfront fees, funding of research and development services and preclinical and clinical material, technical, development, regulatory, and commercial milestone payments, licensing fees, option exercise fees, and royalty and earnout payments on product sales. Such payments are often not commensurate with the timing of revenue recognition and therefore result in deferral of revenue recognition. We analyze our strategic alliance arrangements to assess whether they are within the scope of Financial Standards Accounting Board, or FASB, Accounting Standards Codification, or ASC, Topic 808, Collaborative Arrangements, or ASC 808 to determine whether such arrangements involve joint operating activities performed by parties that are both active participants in the activities and exposed to significant risks and rewards that are dependent on the commercial success of such activities. This assessment is performed throughout the life of the arrangement based on changes in the responsibilities of all parties in the arrangement. For strategic alliance arrangements that are deemed to be within the scope of ASC 808, we assess which elements of the arrangement are deemed to be within the scope of ASC 808, and we recognize our allocation of shared costs incurred with respect to the jointly conducted activities as a component of the related expense in the period incurred. We also consider the guidance in FASB ASC Topic 605-45, Revenue Recognition-Principal Agent Considerations, or ASC 605-45 in determining the appropriate treatment for the transactions between us and our strategic collaborators, including the accounting treatment for arrangements in which we are reimbursed for research services performed by a third party. Generally, transactions under our strategic alliance arrangements are recorded on either a gross or net basis based on the nature and contractual terms of the arrangement along with an evaluation of the indicators to identify the principal participant of the arrangement which could require significant judgment. For those elements of the arrangement that are accounted for under ASC 605, revenue is recognized for each unit of accounting when all of the following criteria are met: • persuasive evidence of an arrangement; • delivery has occurred or services have been rendered; • the seller’s price to the buyer is fixed or determinable; and • collectability is reasonably assured. Further, we analyze multiple element arrangements in accordance with FASB ASC Topic 605-25, Revenue Recognition-Multiple Element Arrangements, or ASC 605-25. The evaluation involves subjective determinations and requires management to make judgments about individual deliverables and whether such deliverables represent separate units of accounting, or whether they must be accounted for as a single unit of accounting. Deliverables are considered separate units of accounting provided that: (i) the delivered item(s) has value to the customer on a standalone basis, and (ii) if the arrangement includes a general right of return relative to the delivered item(s), delivery or performance of the undelivered item(s) is considered probable and substantially controlled by us. In assessing whether an item has standalone value, we consider factors such as the research, manufacturing, and commercialization capabilities of the strategic collaborator, and the availability of the associated expertise in the general marketplace. In addition, we consider whether the strategic collaborator can use the other deliverable(s) for their intended purpose without the receipt of the remaining element(s), whether the value of the deliverable is dependent on the undelivered item(s), and whether there are other vendors that can provide the undelivered element(s). Arrangement consideration that is fixed or determinable is allocated among the separate units of accounting based on the relative selling price method and the applicable revenue recognition criteria in ASC 605-25 are applied to determine the appropriate period and pattern of recognition. We determine the selling price of a unit of accounting following the hierarchy of evidence prescribed by ASC 605-25. Accordingly, we determine the estimated selling price for units of accounting within each arrangement using vendor-specific objective evidence, or VSOE, of selling price if available, third-party evidence, or TPE, of selling price if VSOE is not available, or best estimate of selling price, or BESP, if neither VSOE nor TPE is available. We typically use BESP to estimate the selling price, because we generally do not have VSOE nor TPE of selling price for our units of accounting. Determining the BESP for a unit of accounting requires significant judgment. In developing the BESP for a unit of accounting, we consider applicable market conditions and relevant entity-specific factors, including factors that were contemplated in negotiating the agreement with the strategic collaborator and estimated costs. We validate the BESP for units of accounting by evaluating whether changes in the key assumptions used to determine the BESP will have a significant effect on the allocation of arrangement consideration between multiple units of accounting. We recognize arrangement consideration allocated to each unit of accounting when all of the revenue recognition criteria under ASC 605-25 are satisfied for that particular unit of accounting. We will recognize revenue associated with licenses, options, or the discount related to an option upon (i) delivery of the license or (ii) the earlier of exercise or expiration of the option, if the underlying license has standalone value from the other deliverables to be provided after delivering that license. If the license does not have standalone value, the amounts allocated to the license will be combined with the related undelivered items as a single unit of accounting and recognized over the estimated period of performance or delivery of the combined unit of accounting. Revenue related to the units of accounting that contain several deliverables is recognized as the last to be delivered element is provided, which is generally over the period that research services are provided. If there is no discernible pattern of performance or objectively measurable performance measures do not exist, we recognize revenue on a straight-line basis over the expected period of performance. Conversely, if the pattern of performance can be determined and objectively measurable performance measures exist, then we recognize revenue under the arrangement using the proportional performance method. Revenue recognized is limited to the lesser of the cumulative amount of payments received or the cumulative revenue earned determined using the straight-line method or proportional performance, as applicable, as of the period end date. Our third-party arrangements may include options for our strategic collaborators to acquire development and commercialization rights to our mRNA programs or, with respect to specific targets or options, to receive research and development services or pre-clinical or clinical materials from us. Options are considered substantive if, at the inception of the arrangement, we are at risk as to whether the strategic collaborator will choose to exercise the option. The evaluation of whether an option is substantive requires significant judgment. In determining if the option is substantive, we consider the overall objective of the arrangement, the benefit the third party might obtain from the arrangement without exercising the option, the likelihood that the option will be exercised, or if the third party is required or compelled through significant incentive to exercise the option. When an option is considered substantive, we do not consider the option or item underlying the option to be a deliverable at inception of the arrangement and the associated option fee is not included in the allocable arrangement consideration, assuming the option is not priced at a significant and incremental discount. Conversely, if we determine that an option is not substantive, we will consider the item underlying the option to be a deliverable at the inception of the arrangement and the associated option exercise fee is included in the allocable arrangement consideration. In addition, if the price of the option includes a significant and incremental discount, then the option is not considered substantive. Our arrangements may include additional payments that are subject to achievement of milestone events, including specific technical, development, regulatory, and commercial milestones. At the inception of an arrangement that includes milestone payments, we evaluate whether each milestone is substantive and at risk to both parties on the basis of the contingent nature of the milestone. This evaluation includes an assessment of whether: (i) the consideration is commensurate with either our performance to achieve the milestone or the enhancement of the value of the delivered item(s) as a result of a specific outcome resulting from our performance to achieve the milestone, (ii) the consideration relates solely to past performance, and (iii) the consideration is reasonably relative to all of the deliverables and payment terms within the arrangement. We evaluate factors such as scientific, clinical, regulatory, commercial, and other risks that must be overcome to achieve the respective milestones and the level of effort and investment required to achieve the respective milestones in making this assessment. There is considerable judgment involved in determining whether a milestone satisfies all of the criteria required to conclude that a milestone is substantive. In accordance with FASB ASC Topic 605-28, Revenue Recognition-Milestone Method, or ASC 605-28, a technical, development, or regulatory milestone that is considered substantive will be recognized as revenue in its entirety upon successful accomplishment of the milestone. Amounts received from milestones that are not considered substantive would be considered additional arrangement consideration and allocated to the identified units of accounting. Revenue from commercial milestone payments will be accounted for as royalties and recorded as revenue upon achievement of the milestone, assuming all other revenue recognition criteria are met. We will recognize royalty revenue in the period of sale of the related medicine(s), based on the underlying contract terms, provided that the reported sales are reliably measurable, we have no remaining undelivered elements, and assuming all other revenue recognition criteria are met. Our contracts with DARPA, BARDA, and the Bill & Melinda Gates Foundation provide for reimbursed costs, which may include overhead and general and administrative costs as well as a related profit margin. We recognize revenue from these contracts as we perform services under the arrangements so long as an agreement has been executed and the fees for the services are fixed or determinable, legally billable, and reasonably assured of collection. Recognized amounts reflect our performance under the agreements. We do not recognize revenue under these agreements for amounts related to contract periods where funding is not yet committed, as fees above committed funding thresholds would not be considered fixed or determinable, or reasonably assured of collection. Revenues and related expenses are presented gross in the consolidated statements of operations as we have determined we are the primary obligor under the arrangements relative to the research and development services we perform as lead technical expert. Research and development costs As part of the process of preparing our financial statements, we are required to estimate our accrued research and development expenses, a significant portion of which are clinical study expenses conducted by third-party service providers. 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 in arrears for services performed or when contractual milestones are met. Examples of estimated accrued research and development expenses include fees paid to: • CROs to conduct our clinical trials; • investigative sites in connection with clinical trials; • vendors for laboratory services, supplies, and distribution of materials in connection with clinical trials; and • vendors in connection with preclinical development activities. We base our expenses related to clinical trials on our estimates of the services received and efforts expended pursuant to contracts with CROs that conduct and manage clinical trials on our behalf. The financial terms of these contracts 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 expense. Payments under some of these contracts depend on factors such as the successful enrollment of subjects and the completion of clinical trial milestones. 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 and adjust accordingly. We make estimates of our research and development accrued expenses as of each balance sheet date in our financial statements based on facts and circumstances known to us at that time. We recognize costs for certain development activities based on an evaluation of the progress to completion of specific tasks using information and data provided to us by our vendors and our clinical sites, such as number of sites activated, number of patient enrollments and visits, and patient duration. We determine accrual estimates through financial models that take into account discussions with applicable personnel and service providers as to the progress or state of completion of trials. We periodically confirm the accuracy of these estimates with the service providers and make adjustments, if necessary. Upon settlement, these costs may differ materially from the amounts accrued in our consolidated financial statements. Our historical accrual estimates have not been materially different from our actual costs. However, due to the nature of estimates, we cannot provide assurance that we will not make changes to our estimates in the future as we become aware of additional information about the status or conduct of our research activities and clinical trials. Stock-based compensation We issue stock-based awards to employees and non-employees, generally in the form of stock options and restricted stock units. Historically, we also granted unit options and incentive units to our employees and non-employees, which were exchanged into options and restricted stock awards in connection with the series of transactions pursuant to which Moderna LLC became a wholly-owned subsidiary of Moderna Therapeutics, Inc., or the 2016 Reorganization (please refer to Note 1 to our consolidated financial statements). We measure and recognize compensation expense for our stock-based awards granted to our employees and non-employee directors based on the estimated grant date fair value in accordance with FASB ASC Topic 718, Compensation-Stock Compensation, or ASC 718. We account for stock-based awards to non-employees in accordance with FASB ASC Topic 505-50, Equity-Based Payments to Non-Employees, which requires the fair value of the unvested portion of the equity awards granted to non-employees to be re-measured as of each reporting date. Our stock-based awards are subject to either service or performance-based vesting conditions. We recognize compensation expense related to awards to employees and non-employee directors with service-based vesting on a straight-line basis based on the grant date fair value over the requisite service period, which is generally the vesting period. Compensation expense related to awards to employees and non-employee directors with performance-based vesting conditions is recognized based on the grant date fair value over the requisite service period using an accelerated attribution method to the extent the achievement of the performance condition is probable. Compensation expense related to awards to non-employees with service-based vesting conditions is recognized on the then-current fair value at each reporting date prior to the measurement date over the requisite service period, which is generally the vesting period. Compensation expense related to awards to non-employees with performance-based vesting conditions is recognized based on the then-current grant date fair value at each reporting date prior to the measurement date over the requisite service period using an accelerated attribution method to the extent the achievement of the performance condition is probable. As of January 1, 2017, we made an accounting policy election to recognize forfeitures of stock-based awards as they occur upon adoption of FASB ASU No. 2016-09, Compensation-Stock Compensation. We classify stock-based compensation expense in our consolidated statements of operations in the same manner in which the award recipient’s salary and related costs are classified or in which the award recipient’s service payments are classified. In future periods, we expect stock-based compensation expense to increase, due in part to our existing unrecognized stock-based compensation expense and as we grant additional stock-based awards to continue to attract and retain our employees. We determine the fair value of restricted stock and restricted stock units, based on the fair value of our common stock. We estimate the fair value of our stock options and, prior to the 2016 Reorganization, unit options and incentive units using the Black-Scholes option pricing model, which requires inputs of subjective assumptions, including: (i) the expected volatility of our stock (or, prior to the 2016 Reorganization, units); (ii) the expected term of the award; (iii) the risk-free interest rate; (iv) expected dividends; and (v) the fair value of common stock (or, prior to the 2016 Reorganization, units). Due to the lack of company specific historical and implied volatility data, we based our estimate of expected volatility on the estimate and expected volatilities of a guideline group of publicly traded companies. For these analyses, we select companies with comparable characteristics to ours including enterprise value, risk profiles, and with historical share price information sufficient to meet the expected life of the stock-based awards. We compute the historical volatility data using the daily closing prices for the selected companies’ shares during the equivalent period of the calculated expected term of our stock-based awards. We will continue to apply this process until a sufficient amount of historical information regarding the volatility of our own stock price becomes available. We estimate the expected term of our stock options granted to employees and non-employee directors using the simplified method, whereby, the expected term equals the average of the vesting term and the original contractual term of the option. We utilize this method as we do not have sufficient historical exercise data to provide a reasonable basis upon which to estimate the expected term. For stock options granted to non-employees, we utilize the contractual term of the option as the basis for the expected term assumption. For the determination of the risk-free interest rates we utilize the U.S. Treasury yield curve for instruments in effect at the time of measurement with a term commensurate with the expected term assumption. The expected dividend yield is assumed to be zero as we have never paid dividends and do not have current plans to pay any dividends on our common stock. Historically, for periods prior to our IPO, the fair value of our equity instruments underlying our stock-based awards were determined on each grant date by our board of directors based on valuation estimates from management considering our most recently available independent third-party valuation of our equity instruments. Our board of directors also assessed and considered, with input from management, additional objective and subjective factors that we believed were relevant and which may have changed from the date of the most recent valuation through the grant date. Income taxes We account for income taxes based on an asset and liability approach. We recognize deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. We determine our deferred tax assets and liabilities based on differences between financial reporting and tax bases of assets and liabilities, which are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Realization of our deferred tax assets is dependent upon the generation of future taxable income, the amount and timing of which are uncertain. Valuation allowances are provided, if, based upon the weight of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. As of December 31, 2018, we continued to maintain a full valuation allowance against all of our deferred tax assets based on management’s evaluation of all available evidence. We may become subject to income tax audits and adjustments by local tax authorities. The nature of uncertain tax positions is subject to significant judgment by management and subject to change, which may be substantial. We develop our assessment of uncertain tax positions, and the associated cumulative probabilities, using internal expertise and assistance from third-party experts. As additional information becomes available, estimates are revised and refined. Differences between estimates and final settlement may occur resulting in additional tax expense. We record reserves for potential tax payments to various tax authorities related to uncertain tax positions. These reserves are based on a determination of whether and how much of a tax benefit taken by us in our tax filings or positions is more likely than not to be realized following resolution of any potential contingencies present related to the tax benefit. Potential interest and penalties associated with such uncertain tax positions is recorded as a component of income tax expense. To date, no amount has been recorded for uncertain tax positions. On December 22, 2017, the Tax Cuts and Jobs Act (the TCJA) was enacted. The TCJA, among other things, contains significant changes to corporate taxation, including reduction of the corporate tax rate from a top marginal rate of 35% to a flat rate of 21%, limitation of the tax deduction for interest expense to 30% of adjusted earnings (except for certain small businesses), limitation of the deduction for net operating losses to 80% of current year taxable income and elimination of net operating loss carrybacks, one time taxation of offshore earnings at reduced rates regardless of whether they are repatriated, elimination of U.S. tax on foreign earnings (subject to certain important exceptions), immediate deductions for certain new investments instead of deductions for depreciation expense over time, and modifying or repealing many business deductions and credits. Due to the timing of the enactment and the complexity involved in applying the provisions of the TCJA, we made reasonable estimates and recognized the effects of the TCJA in our consolidated financial statements as of December 31, 2017. The TCJA resulted in a $64.1 million reduction to deferred tax assets and a corresponding reduction in our valuation allowance. As we collected and prepared necessary data, and interpreted the additional guidance of the TCJA, we completed our analysis to determine the effects of the TCJA as of December 31, 2018. No material adjustments were made in 2018. Recently issued 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, such standards will not have a material impact on our financial statements or do not otherwise apply to our operations. Results of operations The following table summarizes our consolidated statements of operations for each period presented (in thousands): Revenue The following table summarizes our revenue by source for each period presented (in thousands): Total revenue decreased by $70.8 million, or 34% in 2018, primarily due to decreases in both collaboration revenue and grant revenue. Collaboration revenue decreased by $54.5 million, or 31% in 2018 mainly driven by higher revenue in 2017 due to the accelerated recognition of $70 million of revenue upon the termination of the Alexion strategic alliance arrangement in October 2017, partially offset by increases in collaboration revenue, primarily from AstraZeneca and to a lesser extent from Merck. Grant revenue decreased by $16.3 million, or 56% in 2018 largely attributable to a decrease in revenue of $13.4 million from the BARDA contract, primarily due to revisions to the Zika program and a focus on preclinical studies of mRNA-1893, a follow on to mRNA-1325. Total revenue increased by $97.4 million, or 90% in 2017, due to increases in both collaboration revenue and grant revenue recognized in 2017. Collaboration revenue increased by $75.4 million, or 74% in 2017, mainly driven by $70.3 million of revenue recognized as a result of the termination of the Alexion strategic alliance arrangements. Grant revenue increased by $22.0 million, or 321% in 2017, largely attributable to the recognition of a full year of revenue from the BARDA contract, which was entered in the second half of 2016 in support of the development of an mRNA vaccine for Zika. Operating expenses The following table summarizes our operating expenses for each period presented (in thousands): Research and development expenses Research and development expenses increased by $43.6 million, or 11% in 2018, primarily attributable to an increase in personnel related costs of $26.6 million, an increase in stock-based compensation of $16.0 million, an increase in consulting and outside services of $13.1 million, an increase in facility and equipment related costs of $12.4 million, and an increase in depreciation and amortization expense of $4.3 million. The increases in personnel related costs and stock-based compensation were largely driven by an increase in the number of employees supporting our research and development programs. These increases were partially offset by a decrease of $31.0 million in costs related to in-licensing agreements executed in 2017 with Cellscript, LLC and its affiliate mRNA RiboTherapeutics, Inc. to sublicense certain patent rights. Research and development expenses increased by $135.7 million, or 49% in 2017, primarily attributable to $53.0 million in costs related to in-licensing agreements executed in 2017 with Cellscript, LLC and its affiliate mRNA RiboTherapeutics, Inc. to sublicense certain patent rights, an increase in clinical trial and manufacturing costs of $45.1 million for our preclinical studies and clinical trials, and an increase in personnel related costs of $36.5 million due to an increase in the number of employees supporting our research and development programs. General and administrative expenses General and administrative expenses increased by $29.5 million, or 46% in 2018, primarily due to an increase in stock-based compensation of $16.5 million, an increase in personnel related costs of $7.2 million, and an increase in consulting and outside services of $3.5 million. The increase in stock-based compensation was mainly attributable to certain performance-based equity awards with vesting or commencement contingent on our IPO and an increase in the number of employees. The increase in personnel related costs were primarily driven by an increase in the number of employees. These increases and the increase in consulting and outside services were in support of our public company readiness. General and administrative expenses increased by $7.3 million, or 13% in 2017, mainly due to an increase in personnel related costs of $6.7 million, driven by an increase in the number of employees. Other income (expense), net The following table summarizes other income (expense), net for each period presented (in thousands): Other income, net increased by $15.5 million, or 116% in 2018, primarily due to an increase of $11.8 million in interest income from our investments in marketable securities, driven by an overall higher market interest rate and a higher weighted average balance of cash and investments, primarily from net proceeds from the issuance of redeemable convertible preferred stock. Other income (expense), net increased by $5.6 million mainly due to a $7.0 million cash receipt as consideration for the waiver of a third party's previously negotiated commitment. This increase was partially offset by higher interest expense of $3.0 million related to our Norwood lease financing obligation. We began recording interest expense upon the completion of our Norwood manufacturing facility in July 2018. Please refer to Note 7 to the consolidated financial statements. Other income, net increased by $4.8 million, or 55% in 2017, primarily due to an increase of $3.9 million in interest income from our investment in marketable securities, driven by an overall higher market interest rate and a higher weighted average balance of cash and investments during 2017 compared to 2016, and a decrease of $1.3 million in loss from the sale of our investments in marketable securities in 2017 compared to 2016. Liquidity and capital resources We have historically funded our operations primarily from the sale of equity instruments and from proceeds from certain strategic alliance arrangements and grant agreements. As of December 31, 2018, we have raised an aggregate of $2.4 billion of proceeds through private equity financing and from our IPO, and $0.8 billion from upfront payments, milestone payments, and option exercise fees related to our strategic alliances. As of December 31, 2018, we had cash, cash equivalents and investments of $1.7 billion. Cash and cash equivalents and investments are invested in accordance with our investment policy, primarily with a view to liquidity and capital preservation. Investments, consisting primarily of government and corporate debt securities are stated at fair value. As of December 31, 2018, we had current and non-current investments of approximately $863.1 million and $173.0 million, respectively. We began construction of our Norwood manufacturing facility, or Norwood, in the second half of 2016. Our capital expenditures related to Norwood were $86.5 million, $59.9 million and $18.2 million for the years ended December 31, 2018, 2017, and 2016, respectively. Cash disbursements related to Norwood were $94.5 million, $41.2 million and $3.1 million for the years ended December 31, 2018, 2017, and 2016, respectively. Norwood officially opened in July 2018. On January 30, 2018 and February 15, 2018, we issued Series G preferred stock for total gross proceeds of $560.0 million. On May 7, 2018, we issued Series H preferred stock for gross proceeds of $125.0 million of which $13.0 million is determined to be a premium and recorded to deferred revenue as part of the Merck PCV/SAV agreement executed contemporaneously with our Series H redeemable convertible preferred stock issuance. Please refer to Note 3 to our consolidated financial statements. On December 11, 2018, we closed our IPO, whereby we sold 26,275,993 shares of common stock at a price of $23.00 per share. The shares began trading on the NASDAQ Global Select Market on December 7, 2018. The aggregate net proceeds received by us from the IPO were $563.0 million, net of underwriting discounts, commissions and offering expenses payable by us. Cash flow The following table summarizes the primary sources and uses of cash for each period presented (in thousands): Operating activities We derive cash flows from operations primarily from cash collected from certain strategic alliances. Our cash flows from operating activities are significantly influenced by our use of cash for operating expenses and working capital to support the business. We have historically experienced negative cash flows from operating activities as we have invested early in our mRNA technologies, digital infrastructure, manufacturing technology, and infrastructure. Net cash used in operating activities in 2018 was $330.9 million and consisted of net loss of $384.7 million less non-cash adjustments of $96.5 million, plus a net change in assets and liabilities of $42.6 million. Non-cash items primarily included stock-based compensation of $72.6 million and depreciation and amortization of $24.9 million. The net change in assets and liabilities was primarily due to a decrease in deferred revenue of $65.3 million, and an increase in prepaid expenses and other assets of $5.3 million, partially offset by an increase in accounts payable of $15.0 million and an increase in accrued liabilities of $8.8 million. Net cash used in operating activities in 2017 was $331.5 million and consisted of net loss of $255.9 million less non-cash adjustments of $61.7 million, plus a net change in assets and liabilities of $137.2 million. Non-cash items primarily included stock-based compensation of $40.1 million and depreciation and amortization of $20.5 million. The net change in assets and liabilities in 2017 was primarily due to a decrease in deferred revenue of $162.3 million mainly driven by revenue recognition of $70.3 million resulting from termination of Alexion strategic alliance arrangements, a decrease in accounts payable of $12.8 million, partially offset by an increase in accrued liabilities of $34.4 million including a $25.0 million in-license payment accrual. Net cash provided by operating activities in 2016 was $66.7 million and consisted of net loss of $216.2 million less non-cash adjustments of $57.0 million, plus a net change in assets and liabilities of $226.0 million. Non-cash items primarily included stock-based compensation of $39.4 million and depreciation and amortization of $15.1 million. The net change in assets and liabilities in 2016 was mainly driven by an increase in deferred revenue of $164.1 million largely attributable to the upfront payments of $200.0 million and $20.0 million received in 2016 under the strategic alliance arrangements with Merck and Vertex, respectively, a decrease in accounts receivable of $52.3 million mainly attributable to the collection of $60.0 million milestone payment in 2016 under the AstraZeneca strategic alliance arrangements, an increase in accounts payable of $5.9 million, and an increase in accrued liabilities of $5.3 million. Investing activities Our primary investing activities consist of purchases, sales, and maturities of our investments and capital expenditures for manufacturing, laboratory, computer equipment, and software. Net cash used in investing activities in 2018 was $372.5 million, which included purchases of marketable securities of $1,227.7 million and capital expenditures of $105.8 million, partially offset by proceeds from maturities of marketable securities of $783.4 million and proceeds from sales of marketable securities of $177.0 million. Net cash provided by investing activities in 2017 was $416.1 million, which included proceeds from maturities of marketable securities of $800.4 million, proceeds from sales of marketable securities of $402.5 million, partially offset by purchases of marketable securities of $727.2 million, and capital expenditures of $58.4 million. Net cash used in investing activities in 2016 was $648.6 million, which included purchases of marketable securities of $1,415.5 million, capital expenditures of $33.1 million, and an increase in restricted cash of $8.9 million, partially offset by proceeds from maturities of marketable securities of $675.2 million, and proceeds from sales of marketable securities of $133.7 million. Financing activities We generated cash from financing activities of $1,226.8 million in 2018, primarily from net proceeds from the issuance of redeemable convertible preferred stock of $661.1 million and net proceeds from the issuance of common stock of $563.0 million in connection with our IPO. We had insignificant financing activities in 2017. We generated cash from financing activities of $472.9 million in 2016 primarily from net proceeds from the issuance of preferred stock of $473.5 million. Operation and funding requirements Since our inception, we have incurred significant losses and negative cash flows from operations due to our significant research and development expenses. We have an accumulated deficit of $1,006.6 million and $621.9 million as of December 31, 2018 and 2017, respectively. We expect to continue to incur significant losses in the foreseeable future and expect our expenses to increase in connection with our ongoing activities, particularly as we continue research and development of our development candidates and clinical activities for our investigational medicines. In addition, we expect to incur additional costs associated with operating as a public company. Our expenses will also increase if, and as, we: • leverage our platform to expand our programs or advance our programs into preclinical and clinical development; • further develop our current programs; • seek to research and develop additional programs; • seek to research and develop additional modalities of mRNA medicines; • seek regulatory approvals for any investigational medicines that successfully complete clinical trials; • increase manufacturing capacity and production volume; • hire additional clinical, manufacturing, quality control, and scientific personnel, expand our operational, financial, and management systems, and increase personnel, including personnel to support our clinical development and manufacturing efforts and our operations as a public company; • establish a sales, marketing, medical affairs, and distribution infrastructure to commercialize any investigational medicine for which we may obtain marketing approval and intend to commercialize on our own or jointly; • maintain, expand, and protect our intellectual property portfolio; and • acquire or in-license other programs and technologies. We are subject to all the risks related to the development and commercialization of novel medicines, and we may encounter unforeseen expenses, difficulties, complications, delays, and other unknown factors that may adversely affect our business. Our forecast of the period of time through which our financial resources will be adequate to support our operations is a forward-looking statement and involves risks and uncertainties, and actual results could vary as a result of a number of factors. 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. We believe that our cash, cash equivalents, and investments as of December 31, 2018, will be sufficient to enable us to fund our projected operations through at least the next 12 months. Our future funding requirements will depend on many factors, including, but not limited to: • the rate of progress in the development of our development candidates; • the initiation, progress, timing, costs, and results of clinical trials for our investigational medicines and future investigational medicines; • the number and characteristics of programs that we develop; • the costs of development efforts for our programs that are not subject to reimbursement from our strategic collaborators; • the costs of mRNA materials; • the costs necessary to obtain regulatory approvals, if any, for our investigational medicines in the United States and other jurisdictions, and the costs of post-marketing studies that could be required by regulatory authorities in jurisdictions where approval is obtained; • the continuation of our existing strategic alliances and entry into new collaborations; • the cost and timing of completion of additional manufacturing facilities and activities, including potential commercial-scale manufacturing; • the costs we incur in maintaining business operations; • the costs associated with being a public company; • the revenue from any future sales of any approved mRNA medicines for which we are entitled to a profit share, royalties and milestones; • the time and unreimbursed costs necessary to commercialize mRNA medicines in territories in which our investigational medicines are approved for sale; • the effect of competing technological and market developments; and • the costs we incur in the filing, prosecution, maintenance, and defense of our extensive patent portfolio and other intellectual property rights. Until we can generate a sufficient amount of revenue from our programs, we expect to finance future cash needs through public or private equity or debt offerings and potential future strategic alliances from which we receive upfront fees, milestone payments, and other forms of consideration. Additional capital may not be available on reasonable terms, if at all. If we are unable to raise additional capital in sufficient amounts or on terms acceptable to us, we may have to significantly delay, scale back, or discontinue the development or commercialization of one or more of our investigational medicines, or slow down or cease work on one or more of our programs. If we raise additional funds through the issuance of additional equity or debt securities, it could result in dilution to our existing stockholders or increased fixed payment obligations, and any such securities may have rights senior to those of our common stock. If we incur indebtedness, we could become subject to covenants that would restrict our operations and potentially impair our competitiveness, such as limitations on our ability to incur additional debt, limitations on our ability to acquire, sell or license intellectual property rights and other operating restrictions that could adversely impact our ability to conduct our business. If we raise funds through strategic alliances or marketing, distribution, or licensing arrangements with third parties, we may have to relinquish valuable rights to our technologies, future revenue streams, research programs, or investigational medicines or grant licenses on terms that may not be favorable to us. Any of these events could significantly harm our business, financial condition, and prospects. 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. Contractual obligations and commitments 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 (in thousands): _______ (1) We lease land and a building located in Norwood, MA. The Norwood leases for the building facilities, land, and adjacent land, will each expire in September 2032 with options to extend each of the terms for two extension periods of ten years each at then market-based rent. The amounts in the table above represent the fixed contractual lease obligations, and do not include the optional extensions. Please refer to Note 7 to our consolidated financial statements. (2) We have various lease agreements for office and laboratory space in Cambridge, MA, expiring at various times through December 2027. (3) The amounts represent non-cancellable fixed payment obligations under certain clinical service agreements. (4) We have license agreements with a non-cancelable fixed payment obligation with Cellscript, LLC and its affiliate mRNA RiboTherapeutics, Inc. We have not included variable and contingent payments including annual license maintenance fees, potential milestone payments, and royalty payments because each of these amounts are not fixed and estimable. Cellscript, LLC and its affiliate mRNA RiboTherapeutics, Inc. are, however, eligible to receive, on a product-by-product basis, milestone payments upon the achievement of development, regulatory and commercial milestones totaling up to $25.5 million for therapeutic and prophylactic products and $0.5 million for diagnostic products. Additionally, we have other in-license agreements with third parties which require us to make future development, regulatory and commercial milestone payments for specified products associated with the agreements. The achievement of these milestones has not occurred and such milestone payments are immaterial. Under our strategic collaboration agreements, we are committed to perform certain research, development, and manufacturing activities. Please refer to Note 3 to the consolidated financial statements. As part of our personalized mRNA cancer vaccines, or PCV, collaboration and license agreement with Merck, we are committed to perform certain research, development, and manufacturing activities related to PCV products through an initial Phase 2 clinical trial up to a budgeted amount of $200.0 million as of December 31, 2018. In April 2018, we amended the PCV agreement with Merck and the budgeted commitment increased to $243.0 million. Please refer to Note 3 to the consolidated financial statements. The expenses we expect to incur as part of our commitments under the PCV and other collaboration agreements were not included in the above table as we are not able to determine the timing and amounts of such expenses. We have agreements with certain vendors for various services, including services related to clinical operations and support, which we are not contractually able to terminate for convenience. Certain agreements provide for termination rights subject to termination fees or wind down costs. Under such agreements, we are contractually obligated to make certain payments to vendors, mainly to reimburse them for their unrecoverable outlays incurred prior to cancellation. The exact amounts of such obligations are dependent on the timing of termination, and the exact terms of the relevant agreement and cannot be reasonably estimated. At December 31, 2018, we had cancelable open purchase orders of $64.2 million in total under such agreements for our clinical operations and support. These amounts represent only our estimate of those items for which we had a contractual commitment to pay at December 31, 2018, assuming we would not cancel these agreements. The actual amounts we pay in the future to the vendors under such agreements may differ from the cancelable open purchase order amounts of $64.2 million. In addition to the above obligations, we enter into a variety of agreements and financial commitments in the normal course of business. The terms generally allow us the option to cancel, reschedule, and adjust our requirements based on our business needs, prior to the delivery of goods or performance of services. It is not possible to predict the maximum potential amount of future payments under these agreements due to the conditional nature of our obligations and the unique facts and circumstances involved in each particular agreement. In February 2019, we entered into a lease agreement for office and laboratory space located in Norwood, MA, or the new Norwood lease. The rent payment obligation for the new Norwood lease will commence fourteen months after the date the premises are delivered to us and expire in 2031. Contemporaneously, we entered into a sublease agreement to sublease a portion of the new Norwood lease space to a third party. The following table summarizes our contractual obligations in connection the new Norwood lease and the effects that such obligations are expected to have on our liquidity and cash flows in future periods from December 31, 2018 (in thousands): JOBS Act and emerging growth company status In April 2012, the JOBS Act was enacted. As an "emerging growth company," or EGC under the JOBS Act, we may delay the adoption of certain accounting standards until such time as those standards apply to private companies. Other exemptions and reduced reporting requirements under the JOBS Act for EGCs include an exemption from the requirement to provide an auditor’s report on internal controls over financial reporting pursuant to Section 404(b) of the Sarbanes-Oxley Act of 2002, an exemption from any requirement that may be adopted by the Public Company Accounting Oversight Board regarding mandatory audit firm rotation, and less extensive disclosure about our executive compensation arrangements. Additionally, the JOBS Act provides that an EGC can take advantage of an extended transition period for complying with new or revised accounting standards. This allows an EGC to delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have elected to avail ourselves of this exemption and, therefore, while we are an EGC we will not be subject to new or revised accounting standards at the same time that they become applicable to other public companies that are not EGCs. We will remain classified as an EGC until the earlier of (i) the last day of our first fiscal year in which we have total annual gross revenues of $1.07 billion or more, (ii) December 31, 2023, being the last day of the fiscal year following the fifth anniversary of the completion of our IPO, (iii) the date on which we have issued more than $1.0 billion of non-convertible debt instruments during the previous three fiscal years, or (iv) the date on which we are deemed a “large accelerated filer” under the rules of the SEC .
0.073998
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<s>[INST] Overview We are a clinical stage biotechnology company pioneering messenger RNA (mRNA) therapeutics and vaccines to create a new generation of potentially transformative medicines to improve the lives of patients. mRNA medicines are designed to direct the body’s cells to produce intracellular, membrane or secreted proteins that have a therapeutic or preventive benefit with the potential to address a broad spectrum of diseases. Our platform builds on continuous advances in basic and applied mRNA science, delivery technology and manufacturing, providing us the capability to pursue in parallel a robust pipeline of new development candidates. We are developing therapeutics and vaccines for infectious diseases, immunooncology, rare diseases and cardiovascular diseases, independently and with our strategic collaborators. We have designed our strategy and operations to realize the full potential value and impact of mRNA over a long time horizon across a broad array of human diseases. We built and continue to invest in a platform to advance the technological frontier of mRNA medicines. We have made forward investments in scalable infrastructure and capabilities to pursue a pipeline of potential medicines that reflect the breadth of the mRNA opportunity. We have a diverse development pipeline of 20 development candidates, 11 of which are in clinical studies. Our therapeutic and vaccine development programs span infectious diseases, oncology, cardiovascular diseases, and rare genetic diseases. We have established strategic alliances with leading biopharmaceutical companies, including AstraZeneca, Merck & Co., or Merck, and Vertex Pharmaceuticals, or Vertex, as well as governmentsponsored and private organizations focused on global health initiatives, including Biomedical Advanced Research and Development Authority, or BARDA, Defense Advanced Research Projects Agency, or DARPA, and the Bill & Melinda Gates Foundation. As we unlock the inherent advantages of mRNA, we aim to address as many diseases and impact as many patients as our technology, talent, and capital permit. The broad potential applications of mRNA medicines have led us to raise significant capital and adopt a longterm approach to capital allocation that balances nearterm risks and longterm value creation. As of December 31, 2018, we have raised over $3.2 billion in total funding from a wide range of strategic sources, including $2.4 billion of financing from private equity financings and our initial public offering, or IPO, and $0.8 billion in upfront payments, milestone payments and option exercise payments from AstraZeneca, Merck, Alexion Pharma Holdings, or Alexion, and Vertex. As of December 31, 2018, we had cash, cash equivalents and investments of approximately $1.7 billion. We use this capital to fund operations and investing activities across research for technology creation, drug discovery and clinical development programs, infrastructure and capabilities to enable the Research Engine and Early Development Engine (which includes our manufacturing facility in Norwood), our digital infrastructure, creation of our portfolio of intellectual property, and administrative support. On December 11, 2018, we completed our IPO, whereby we sold 26,275,993 shares of common stock at a price of $23.00 per share. The aggregate net proceeds from the IPO were $563.0 million, net of underwriting discounts, commissions and offering expenses. Upon the closing of the IPO, all outstanding shares of redeemable convertible preferred stock converted into 236,012,913 shares of common stock. As of December 31, 2018, we had 328,798,904 shares outstanding shares of our common stock. Since our inception, we have incurred significant operating losses. Our net losses were $384.7 million, $255.9 million and $216.2 million for the years ended December 31, 2018, 2017 and 2016, respectively. As of December 31, 2018 , our accumulated deficit was $1.0 billion . We expect to continue to incur significant expenses and operating losses for the foreseeable future. In [/INST] Positive. </s>
2,019
11,153
1,682,852
Moderna, Inc.
2020-02-27
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 related notes and other financial information appearing elsewhere in this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10-K, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties. As a result of many factors, including those factors set forth in the “Risk Factors” section of this Annual Report on Form 10-K, our actual results could 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 clinical stage biotechnology company pioneering messenger RNA (mRNA) therapeutics and vaccines to create a new generation of transformative medicines to improve the lives of patients. mRNA medicines are designed to direct the body’s cells to produce intracellular, membrane or secreted proteins that have a therapeutic or preventive benefit with the potential to address a broad spectrum of diseases. Our platform builds on continuous advances in basic and applied mRNA science, delivery technology and manufacturing, providing us the capability to pursue in parallel a robust pipeline of new development candidates. We are developing therapeutics and vaccines for infectious diseases, immuno-oncology, rare diseases, autoimmune diseases and cardiovascular diseases, independently and with our strategic collaborators. We have designed our strategy and operations to realize the full potential value and impact of mRNA over a long time horizon across a broad array of human diseases. We built and continue to invest in a platform to advance the technological frontier of mRNA medicines. We have made forward investments in scalable infrastructure and capabilities to pursue a pipeline of potential medicines that reflect the breadth of the mRNA opportunity. We have a diverse development pipeline of 24 development candidates across our 23 programs, of which 12 are in clinical studies. We have established strategic alliances with leading biopharmaceutical companies, including AstraZeneca, Merck & Co., or Merck, and Vertex Pharmaceuticals, or Vertex, as well as government-sponsored and private organizations focused on global health initiatives, including Biomedical Advanced Research and Development Authority, or BARDA, Defense Advanced Research Projects Agency, or DARPA, the Bill & Melinda Gates Foundation, or Gates Foundation, and the Coalition for Epidemic Preparedness Innovations, or CEPI. As we unlock the inherent advantages of mRNA, we aim to address as many diseases and impact as many patients as our technology, talent, and capital permit. The broad potential applications of mRNA medicines have led us to raise significant capital and adopt a long-term approach to capital allocation that balances near-term risks and long-term value creation. As of December 31, 2019, we had cash, cash equivalents and investments of approximately $1.26 billion. In addition, in February 2020, we raised approximately $549.9 million, net of underwriting discounts, commissions and estimated offering expenses, through a follow-on public equity offering and the subsequent exercise of the underwriters' option to purchase additional shares. We use this capital to fund operations and investing activities across research for technology creation, drug discovery and clinical development programs, infrastructure and capabilities to enable the Research Engine and Early Development Engine (which includes our Moderna Technology Center, or MTC, manufacturing facility in Norwood), our digital infrastructure, creation of our portfolio of intellectual property, and administrative support. Since our inception, we have incurred significant operating losses. Our net losses were $514.0 million, $384.7 million and $255.9 million for the years ended December 31, 2019, 2018 and 2017, respectively. As of December 31, 2019, our accumulated deficit was $1.50 billion. We expect to continue to incur significant expenses and operating losses for the foreseeable future. In addition, we anticipate that our expenses will increase significantly in connection with our ongoing activities, as we: • continue our platform research and drug discovery and development efforts; • conduct clinical studies for our investigational medicines; • manufacture clinical study materials and develop large-scale manufacturing capabilities; • seek regulatory approval for our investigational medicines; • maintain, expand, and protect our intellectual property; • hire additional personnel to support our program development effort to obtain regulatory approval and secure additional facilities for operations; and • continue to operate as a public company. We do not expect to generate revenue from the sale of potential mRNA medicines unless and until we successfully complete clinical development and obtain regulatory approval for one or more of our investigational medicines. If we seek to obtain regulatory approval for and commercialize any of our investigational medicines, we expect to incur significant commercialization expenses. As a result, we will need substantial additional funding to support our continued operations and pursue our growth strategy. Until we can generate significant revenue from sales of our medicines, if ever, we expect to finance our operations through a combination of public or private equity offerings, structured financings and debt financings, government funding arrangements, strategic alliances and marketing, distribution, and licensing arrangements. We may be unable to raise additional funds or enter into such other agreements on favorable terms, or at all. If we fail to raise capital or enter into such agreements as, and when, needed, we may have to significantly delay, scale back, or discontinue the development and commercialization of one or more of our programs. Because of the numerous risks and uncertainties associated with pharmaceutical development, we are unable to predict the timing or amount of increased expenses or when or if we will be able to achieve or maintain profitability. Even if we are able to generate revenues from the sale of our medicines, we may not become profitable. If we fail to become profitable or are unable to sustain profitability on a continuing basis, then we may be unable to continue our operations at planned levels and be forced to reduce our operations. Financial Operations Overview Revenue To date, we have not generated any revenue from the sale of potential mRNA medicines. Our revenue has been primarily derived from strategic alliances with strategic collaborators and government-sponsored and private organizations to discover, develop, and commercialize potential mRNA medicines. The following is a summary of revenue recognized for the years ended December 31, 2019, 2018 and 2017 (in thousands): _______ (1) Includes collaboration revenue from a related party. Total revenue for the years ended December 31, 2019, 2018 and 2017 was $60.2 million, $135.1 million and $205.8 million, respectively. Cash received from strategic alliances was $22.9 million, $57.6 million and $43.1 million for the years ended December 31, 2019, 2018 and 2017, respectively. The timing of revenue recognition is not directly correlated to the timing of cash receipts. Total deferred revenue related to our strategic alliances as of December 31, 2019 and 2018 was $202.3 million and $274.4 million, respectively. The following table summarizes collaboration revenue for the years ended December 31, 2019, 2018 and 2017 (in thousands): Collaboration revenue for the years ended December 31, 2019, 2018 and 2017 was generated primarily from our strategic alliances with AstraZeneca, Merck, Vertex and Alexion. Our arrangements with Alexion were terminated in October 2017 and all rights to mRNA researched, developed, or supplied as part of the programs with Alexion reverted to us. Grant revenue is generated primarily from contracts with DARPA, BARDA, and Gates Foundation, to develop mRNA medicines. For further information on our revenue recognition policies, see the section of this Annual Report on Form 10-K titled “Critical accounting policies and significant judgments and estimates - Revenue recognition.” Our ability to generate revenue from sales of mRNA medicines and become profitable depends upon our ability to successfully develop and commercialize mRNA medicines. For the foreseeable future, we do not expect to generate revenue from product sales. To the extent that existing or potential future strategic alliances generate revenue, our revenue may vary due to many uncertainties in the development of our mRNA medicines under these strategic alliances and other factors. We expect to incur losses for the foreseeable future, and we expect these losses to increase as we continue our research and development efforts. We expect our programs to mature and advance to later stage clinical development, and we expect expenses to increase as we seek regulatory approvals for our investigational medicines and begin to commercialize any approved mRNA medicines. Research and development expenses The nature of our business and primary focus of our activities generate a significant amount of research and development costs. Research and development expenses represent costs incurred by us for the following: • cost to develop our platform; • discovery efforts leading to development candidates; • preclinical, nonclinical, and clinical development costs for our programs; • cost to develop our manufacturing technology and infrastructure; and • digital infrastructure costs. The costs above comprise the following categories: • personnel-related expenses, including salaries, benefits, and stock-based compensation expense; • expenses incurred under agreements with third parties, such as consultants, investigative sites, contract research organizations, or CROs, that conduct our preclinical and clinical studies, and in-licensing arrangements; • costs of acquiring, developing, and manufacturing materials for preclinical and clinical studies, including both internal manufacturing and third-party contract manufacturing organizations, or CMOs; • expenses incurred for the procurement of materials, laboratory supplies, and non-capital equipment used in the research and development process; and • facilities, depreciation, and amortization, and other direct and allocated expenses incurred as a result of research and development activities. We use our employee and infrastructure resources for the advancement of our platform, and for discovering and developing programs. Due to the number of ongoing programs and our ability to use resources across several projects, indirect or shared operating costs incurred for our research and development programs are not recorded or maintained on a program- or modality-specific basis. The following table reflects our research and development expenses, including direct program specific expenses summarized by modality and indirect or shared operating costs summarized under other research and development expenses during the years ended December 31, 2019, 2018 and 2017 (in thousands): __________ (1) Includes a total of 21, 21 and 18 development candidates at December 31, 2019, 2018 and 2017, respectively. (2) Relates to in-licensing agreements entered into in June 2017 with Cellscript, LLC and its affiliate mRNA RiboTherapeutics, Inc. to sublicense certain patent rights. A “modality” refers to a group of programs with common product features and the associated combination of enabling mRNA technologies, delivery technologies, and manufacturing processes. The program-specific expenses by modality summarized in the table above include expenses we directly attribute to our programs, which consist primarily of external costs, such as fees paid to outside consultants, central laboratories, investigative sites, and CROs in connection with our preclinical studies and clinical trials, and allocated manufacturing costs of mRNA supply and consumables. Costs to acquire and manufacture mRNA supply for preclinical studies and clinical trials are recognized and included in unallocated manufacturing expenses when incurred, and subsequently allocated to program-specific manufacturing costs after completion of the program-specific production. The timing of allocating manufacturing costs to program-specific costs varies depending on the program development and production schedule. We do not allocate personnel-related costs, including stock-based compensation, costs associated with our general platform research, technical development, and other shared costs on a program-specific basis. These costs were therefore excluded from the summary of program-specific expenses summary by modality. Discovery program expenses are costs associated with research activities for our programs in the preclinical discovery stage, and primarily consist of external costs for CROs and lab services, and allocated manufacturing cost of preclinical mRNA supply and consumables. Platform research expenses are mainly costs to develop technical advances in mRNA science, delivery science, and manufacturing process design. These costs include personnel-related costs, computer equipment, facilities, preclinical mRNA supply and consumables, and other administrative costs to support our platform research. Technology development and unallocated manufacturing expenses are primarily related to non-program-specific manufacturing process development and manufacturing costs. Shared discovery and development expenses are research and development costs such as personnel-related costs and other costs, which are not otherwise included in development programs, discovery programs, platform research, technical development and unallocated manufacturing expenses, stock-based compensation, and other expenses. We have developed six modalities. As of February 14, 2020, we had 12 programs in clinical trials and a total of 24 development candidates across our 23 programs, summarized by modality as follows: • Prophylactic vaccines included nine development candidates across eight programs: RSV vaccine (mRNA-1777 and mRNA-1172 or V172), CMV vaccine (mRNA-1647), hMPV/PIV3 vaccine (mRNA-1653), H7N9 vaccine (mRNA-1851), Zika vaccine (mRNA-1893), EBV vaccine (mRNA-1189), pediatric RSV vaccine (mRNA-1345), and SARS-CoV-2 vaccine (mRNA-1273). The CMV vaccine is currently in a Phase 2 clinical trial and in preparation for a Phase 3 clinical trial. The EBV, pediatric RSV and SARS-CoV-2 vaccines are in preclinical development. The rest of the programs in this modality either have ongoing or completed Phase 1 clinical trials. • Cancer vaccines included two development candidates: Personalized cancer vaccine (PCV) (mRNA-4157) and KRAS vaccine (mRNA-5671 or V941). We are collaborating with Merck on both programs. PCV is in a Phase 2 clinical trial and the KRAS vaccine is in a Phase 1 clinical trial. • Intratumoral immuno-oncology included three development candidates: OX40L (mRNA-2416), OX40L/IL-23/IL-36γ (Triplet) (mRNA-2752), and IL-12 (MEDI1191). OX40L is currently being evaluated in a Phase 1/2 trial that includes a Phase 2 expansion cohort in patients with advanced ovarian carcinoma. Triplet and IL-12 are in Phase 1 clinical trials. • Localized regenerative therapeutics included one development candidate, VEGF-A (AZD8601). The program is being led by AstraZeneca through clinical development and is in a Phase 2a clinical trial. • Systemic secreted and cell surface therapeutics included five development candidates: antibody against Chikungunya virus (mRNA-1944), Relaxin (AZD7970), Fabry disease (mRNA-3630), IL-2 (mRNA-6231), and PD-L1 (mRNA-6981). The antibody against Chikungunya virus development candidate is in collaboration with DARPA and the program is in a Phase 1 clinical trial. Relaxin, in collaboration with AstraZeneca, Fabry disease, IL-2 and PD-L1 are in preclinical development. • Systemic intracellular therapeutics included four development candidates: MMA (mRNA-3704), PA (mRNA-3927), PKU (mRNA-3283), and GSD1a (mRNA-3745). The MMA program has enrolled the first patient for a Phase 1/2 clinical trial. The U.S. Food and Drug Administration (the “FDA”) has completed its review of the IND for mRNA-3927 allowing the PA program to proceed to a Phase 1/2 clinical trial. The PKU and GSD1a programs are in preclinical development. The largest component of our total operating expenses has historically been our investment in research and development activities, including development of our platform, mRNA technologies, and manufacturing technologies. We expense research and development costs as incurred and cannot reasonably estimate the nature, timing, and estimated costs required to complete the development of the development candidates and investigational medicines we are currently developing or may develop in the future. There are numerous risks and uncertainties associated with the research and development of such development candidates and investigational medicines, including, but not limited to: • scope, progress, and expense of developing ongoing and future development candidates and investigational medicines; • entry in and completion of related preclinical studies; • enrollment in and completion of subsequent clinical trials; • safety and efficacy of investigational medicines resulting from these clinical trials; • changes in laws or regulations relevant to the investigational medicines in development; • receipt of the required regulatory approvals; and • commercialization, including establishing manufacturing and marketing capabilities. A change in expectations or outcomes of any of the known or unknown risks and uncertainties may materially impact our expected research and development expenditures. Continued research and development is central to the ongoing activities of our business. Investigational medicines 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 expect our costs to continue to increase in the future as our investigational medicines progress through the development phases and as we identify and develop additional programs. However, we do not believe that it is possible at this time to accurately project total program-specific expenses through commercialization. There are numerous factors associated with the successful commercialization of any of our investigational medicines, including future trial design and various regulatory requirements, many of which cannot be determined with accuracy at this time due to the early stage of development of our investigational medicines. Additionally, future commercial and regulatory factors beyond our control will impact our clinical development programs and plans. General and administrative expenses General and administrative expenses consist primarily of personnel-related costs, including stock-based compensation, for executives, finance, legal, human resources, business development and other administrative and operational functions, professional fees, accounting and legal services, information technology and facility-related costs, and expenses associated with obtaining and maintaining intellectual property, or IP. These costs relate to the operation of the business, unrelated to the research and development function, or any individual program. We anticipate general and administrative expenses will increase if research and development expands. These increases will likely relate to additional personnel and increased costs related to finance, legal and IP-related matters along with increased expenses related to operating as a publicly traded company, such as fees related to audit, legal, and tax services, regulatory compliance programs, and investor relations. In addition, if we obtain regulatory approval for any of our investigational medicines and do not enter into a third-party commercialization collaboration, we expect to incur significant expenses related to building a sales and marketing team to support medicine sales, marketing, and distribution activities. We have a broad IP portfolio covering our development and commercialization of mRNA vaccine and therapeutic programs, including those related to mRNA design, formulation, and manufacturing platform technologies. We regularly file patent applications to protect innovations arising from our research and development. We also hold trademarks and trademark applications in the United States and foreign jurisdictions. Costs to secure and defend our IP are expensed as incurred, and are classified as general and administrative expenses. General and administrative expenses, including IP-related expenses, totaled $109.6 million, $94.3 million and $64.7 million for the years ended December 31, 2019, 2018 and 2017, respectively. IP-related expenses, including our internal personnel-related costs, were $13.4 million, $11.9 million and $10.7 million, for the years ended December 31, 2019, 2018 and 2017, respectively. We did not incur litigation expenses related to our IP during the years ended December 31, 2019, 2018 and 2017. Interest income Interest income consists of interest generated from our investments in cash and cash equivalents, money market funds, and high-quality fixed income securities. Other (expense) income, net Other (expense) income, net consists of gains (losses) from the sale of investments in marketable securities, interest expense, and other income and expense unrelated to our core operations. 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 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 judgments and estimates that affect the reported amounts of assets, liabilities, revenues, and expenses and the disclosure of contingent assets and liabilities in our consolidated financial statements. 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. On an ongoing basis, we evaluate our judgments and estimates in light of changes in circumstances, facts, and experience. The effects of material revisions in estimates, if any, are reflected in the consolidated financial statements prospectively from the date of change in estimates. While our significant accounting policies are described in more detail in the notes to our consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K, we believe the following accounting policies used in the preparation of our consolidated financial statements require the most significant judgments and estimates. Revenue recognition We have primarily generated revenue from our strategic alliances. Our strategic alliances with strategic collaborators typically contain multiple elements, including research and other licenses, options to obtain development and commercialization rights, research and development services, obligations to develop and manufacture preclinical and clinical material, and options to obtain additional research and development services and preclinical and clinical material. Such arrangements provide for various types of payments to us, including upfront fees, funding of research and development services and preclinical and clinical material, technical, development, regulatory, and commercial milestone payments, licensing fees, option exercise fees, and royalty and earnout payments on product sales. Such payments are often not commensurate with the timing of revenue recognition and therefore result in deferral of revenue recognition. On January 1, 2019, we adopted Accounting Standards Codification (ASC) Topic 606, Revenue from Contracts with Customers (ASC 606), which supersedes all existing revenue recognition requirements in the historical accounting and most industry specific guidance. ASC 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. We analyze our collaboration arrangements to assess whether they are within the scope of ASC Topic 808, Collaborative Arrangements (ASC 808) to determine whether such arrangements involve joint operating activities performed by parties that are both active participants in the activities and exposed to significant risks and rewards that are dependent on the commercial success of such activities. To the extent the arrangement is within the scope of ASC 808, we assess whether aspects of the arrangement between us and our collaboration partner are within the scope of other accounting literature. If we conclude that some or all aspects of the arrangement represent a transaction with a customer, we account for those aspects of the arrangement within the scope of ASC 606. If we conclude that some or all aspects of the arrangement are within the scope of ASC 808 and do not represent a transaction with a customer, we recognize our allocation of the shared costs incurred with respect to the jointly conducted activities as a component of the related expense in the period incurred. Pursuant to ASC 606, a customer is a party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration. Under ASC 606, an entity recognizes revenue when its customer obtains control of promised goods or services, in an amount that reflects the consideration which the entity expects to receive in exchange for those goods or services. To determine the appropriate amount of revenue to be recognized for arrangements that we determine are within the scope of ASC 606, we perform the following steps: (i) identify the contract(s) with the 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) each performance obligation is satisfied. ASC 606 requires significant judgment and estimates and results in changes to, but not limited to: (i) the determination of the transaction price, including estimates of variable consideration, (ii) the allocation of the transaction price, including the determination of estimated selling price, and (iii) the pattern of recognition, including the application of proportional performance as a measure of progress on service-related promises and application of point-in-time recognition for supply-related promises. The transaction price is generally comprised of an upfront payment due at contract inception and variable consideration in the form of payments for our services and materials and milestone payments due upon the achievement of specified events. Other payments the Company could be entitled to include tiered royalties earned when customers recognize net sales of licensed products. We consider the existence of any significant financing component within our arrangements and have determined that a significant financing component does not exist in our arrangements as substantive business purposes exist to support the payment structure other than to provide a significant benefit of financing. We measure the transaction price based on the amount of consideration to which we expect to be entitled in exchange for transferring the promised goods and/or services to the customer. We utilize either the expected value method or the most likely amount method to estimate the amount of variable consideration, depending on which method is expected to better predict the amount of consideration to which we will be entitled. Amounts of variable consideration are included in the transaction price to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved. With respect to arrangements that include payments for a development or regulatory milestone payment, we evaluate whether the associated event is considered probable of achievement and estimate the amount to be included in the transaction price using the most likely amount method. Milestone payments that are not within our control or the licensee, such as those dependent upon receipt of regulatory approval, are not considered to be probable of achievement until the triggering event occurs. At the end of each reporting period, we re-evaluate the probability of achievement of each milestone and any related constraint, and if necessary, adjust our estimate of the overall transaction price. Any such adjustments are recorded on a cumulative catch-up basis, which would affect revenue and net loss in the period of adjustment. For arrangements that include sales-based royalties, including milestone payments based upon the achievement of a certain level of product sales, wherein the license is deemed to be the sole or predominant item to which the payments relate, we recognize revenue upon the later of: (i) when the related sales occur or (ii) when the performance obligation to which some or all of the payment has been allocated has been satisfied (or partially satisfied). Consideration that would be received for optional goods and/or services is excluded from the transaction price at contract inception. We generally allocate the transaction price to each performance obligation based on a relative standalone selling price basis. We develop assumptions that require judgment to determine the standalone selling price for each performance obligation in consideration of applicable market conditions and relevant entity-specific factors, including factors that were contemplated in negotiating the agreement with the customer and estimated research and development costs. However, in certain instances, we allocate variable consideration entirely to one or more performance obligation if the terms of the variable consideration relate to the satisfaction of the respective performance obligation and the amount allocated is consistent with the amount we would expect to receive for the satisfaction of the respective performance obligation. We recognize revenue based on the amount of the transaction price that is allocated to each respective performance obligation when or as the performance obligation is satisfied by transferring a promised good or service to the customer. For performance obligations that are satisfied at a point in time, we recognize revenue when control of the goods and/or services is transferred to the customer. For performance obligations that are satisfied over time, we recognize revenue by measuring the progress toward complete satisfaction of the performance obligation using a single method of measuring progress which depicts the performance in transferring control of the associated goods and/or services to the customer. We generally use input methods to measure the progress toward the complete satisfaction of performance obligations satisfied over time. With respect to arrangements containing a license to our intellectual property that is determined to be distinct from the other performance obligations identified in the arrangement, we recognize revenue from amounts allocated to the license when the license is transferred to the licensee and the licensee is able to use and benefit from the license. For licenses that are bundled with other promises, we utilize judgment to assess the nature of the combined performance obligation to determine whether the combined performance obligation is satisfied over time or at a point in time and, if over time, the appropriate method of measuring progress for purposes of recognizing revenue. Significant management judgment is required in determining the level of effort required under an arrangement and the period over which we are expected to complete our performance obligations under an arrangement. We evaluate the measure of progress each reporting period and, if necessary, adjust the measure of performance and related revenue recognition. Any such adjustments are recorded on a cumulative catch-up basis, which would affect revenue and net loss in the period of adjustment. Research and development costs As part of the process of preparing our financial statements, we are required to estimate our accrued research and development expenses, a significant portion of which are clinical study expenses conducted by third-party service providers. 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 in arrears for services performed or when contractual milestones are met. Examples of estimated accrued research and development expenses include fees paid to: • CROs to conduct our clinical trials; • investigative sites in connection with clinical trials; • vendors for laboratory services, supplies, and distribution of materials in connection with clinical trials; and • vendors in connection with preclinical development activities. We base our expenses related to clinical trials on our estimates of the services received and efforts expended pursuant to contracts with CROs that conduct and manage clinical trials on our behalf. The financial terms of these contracts 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 expense. Payments under some of these contracts depend on factors such as the successful enrollment of subjects and the completion of clinical trial milestones. 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 and adjust accordingly. We make estimates of our research and development accrued expenses as of each balance sheet date in our financial statements based on facts and circumstances known to us at that time. We recognize costs for certain development activities based on an evaluation of the progress to completion of specific tasks using information and data provided to us by our vendors and our clinical sites, such as number of sites activated, number of patient enrollments and visits, and patient duration. We determine accrual estimates through financial models that take into account discussions with applicable personnel and service providers as to the progress or state of completion of trials. We periodically confirm the accuracy of these estimates with the service providers and make adjustments, if necessary. Upon settlement, these costs may differ materially from the amounts accrued in our consolidated financial statements. Our historical accrual estimates have not been materially different from our actual costs. However, due to the nature of estimates, we cannot provide assurance that we will not make changes to our estimates in the future as we become aware of additional information about the status or conduct of our research activities and clinical trials. Stock-based compensation We issue stock-based awards to employees and non-employees, generally in the form of stock options and restricted stock units. We measure and recognize compensation expense for our stock-based awards granted to our employees and non-employee directors based on the estimated grant date fair value in accordance with ASC 718, Compensation-Stock Compensation. Our stock-based awards are subject to either service or performance-based vesting conditions. We recognize compensation expense related to awards to employees and non-employee directors with service-based vesting on a straight-line basis based on the grant date fair value over the requisite service period, which is generally the vesting period. Compensation expense related to awards to employees and non-employee directors with performance-based vesting conditions is recognized based on the grant date fair value over the requisite service period using an accelerated attribution method to the extent the achievement of the performance condition is probable. We made an accounting policy election to recognize forfeitures of stock-based awards as they occur. We classify stock-based compensation expense in our consolidated statements of operations in the same manner in which the award recipient’s salary and related costs are classified or in which the award recipient’s service payments are classified. In future periods, we expect stock-based compensation expense to increase, due in part to our existing unrecognized stock-based compensation expense and as we grant additional stock-based awards to continue to attract and retain our employees. We determine the fair value of restricted stock and restricted stock units, based on the fair value of our common stock. We estimate the fair value of our stock options using the Black-Scholes option pricing model, which requires inputs of subjective assumptions, including: (i) the expected volatility of our stock; (ii) the expected term of the award; (iii) the risk-free interest rate; (iv) expected dividends; and (v) the fair value of common stock. Due to the lack of company specific historical and implied volatility data, we based our estimate of expected volatility on the estimate and expected volatilities of a guideline group of publicly traded companies. For these analyses, we select companies with comparable characteristics to ours including enterprise value, risk profiles, and with historical share price information sufficient to meet the expected life of the stock-based awards. We compute the historical volatility data using the daily closing prices for the selected companies’ shares during the equivalent period of the calculated expected term of our stock-based awards. We will continue to apply this process until a sufficient amount of historical information regarding the volatility of our own stock price becomes available. We estimate the expected term of our stock options granted to employees and non-employee directors using the simplified method, whereby, the expected term equals the average of the vesting term and the original contractual term of the option. We utilize this method as we do not have sufficient historical exercise data to provide a reasonable basis upon which to estimate the expected term. For stock options granted to non-employees, we utilize the contractual term of the option as the basis for the expected term assumption. For the determination of the risk-free interest rates we utilize the U.S. Treasury yield curve for instruments in effect at the time of measurement with a term commensurate with the expected term assumption. The expected dividend yield is assumed to be zero as we have never paid dividends and do not have current plans to pay any dividends on our common stock. Income taxes We account for income taxes based on an asset and liability approach. We recognize deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. We determine our deferred tax assets and liabilities based on differences between financial reporting and tax bases of assets and liabilities, which are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Realization of our deferred tax assets is dependent upon the generation of future taxable income, the amount and timing of which are uncertain. Valuation allowances are provided, if, based upon the weight of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. As of December 31, 2019, we continued to maintain a full valuation allowance against all of our deferred tax assets based on management’s evaluation of all available evidence. We may become subject to income tax audits and adjustments by local tax authorities. The nature of uncertain tax positions is subject to significant judgment by management and subject to change, which may be substantial. We develop our assessment of uncertain tax positions, and the associated cumulative probabilities, using internal expertise and assistance from third-party experts. As additional information becomes available, estimates are revised and refined. Differences between estimates and final settlement may occur resulting in additional tax expense. We record reserves for potential tax payments to various tax authorities related to uncertain tax positions. These reserves are based on a determination of whether and how much of a tax benefit taken by us in our tax filings or positions is more likely than not to be realized following resolution of any potential contingencies present related to the tax benefit. Potential interest and penalties associated with such uncertain tax positions is recorded as a component of income tax expense. To date, no amount has been recorded for uncertain tax positions. Recently issued 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, such standards will not have a material impact on our financial statements or do not otherwise apply to our operations. Results of operations The following tables summarize our consolidated statements of operations for each period presented (in thousands): Revenue Total revenue decreased by $74.9 million, or 55% in 2019, primarily due to a decrease in collaboration revenue. Collaboration revenue decreased by $74.5 million, or 61% in 2019, mainly due to decreased revenue across all our strategic alliances, particularly AstraZeneca and Merck, largely driven by our adoption of ASC 606 and the completion of the initial four-year research period under the 2016 Merck Agreement. See Note 2 to our consolidated financial statements for further information on our adoption of ASC 606. Grant revenue remained relatively flat in 2019. There was a decrease in revenue from DARPA as the research and development activities under the DARPA awards were substantially concluded at the end of 2018, offset by increases in revenue from Gates Foundation and BARDA. Total revenue decreased by $70.8 million, or 34% in 2018, primarily due to decreases in both collaboration revenue and grant revenue. Collaboration revenue decreased by $54.5 million, or 31% in 2018, mainly driven by higher revenue in 2017 due to accelerated recognition of $70.3 million of revenue upon the termination of the Alexion strategic alliance arrangement in October 2018. Grant revenue decreased by $16.3 million, or 56% in 2018, largely attributable to a decrease in revenue of $13.4 million from the BARDA contract, primarily due to revisions to the Zika program and a focus on preclinical studies of mRNA-1893, a follow on to mRNA-1325. Operating expenses Research and development expenses Research and development expenses increased by $42.2 million, or 9% in 2019. The increase was primarily attributable to an increase in personnel related costs of $37.4 million, an increase in clinical trial and manufacturing costs of $16.9 million, an increase in stock-based compensation of $10.6 million, and an increase in depreciation and amortization of $5.2 million. The increases were partially offset by a decrease in in-licensing costs of $22.0 million related to in-licensing agreements executed in 2017 with Cellscript, LLC and its affiliate mRNA RiboTherapeutics, Inc. (Cellscript) to sublicense certain patent rights, and a decrease in lab supplies and materials of $8.2 million. The increases in personnel related costs and stock-based compensation were largely driven by an increase in the number of employees supporting our research and development programs. The in-licensing costs decreased in 2019 as the sublicense grant fees were fully recognized at the end of 2018. Research and development expenses increased by $43.6 million, or 11% in 2018. The increase was primarily attributable to an increase in personnel related costs of $26.6 million, an increase in stock-based compensation of $16.0 million, an increase in consulting and outside services of $13.1 million, an increase in facility and equipment related costs of $12.4 million, and an increase in depreciation and amortization expense of $4.3 million. The increases in personnel related costs and stock-based compensation were largely driven by an increase in the number of employees supporting our research and development programs. These increases were partially offset by a decrease of $31.0 million in costs related to in-licensing agreements executed in 2017 with Cellscript. General and administrative expenses General and administrative expenses increased by $15.4 million, or 16% in 2019. The increase was primarily due to an increase in insurance costs of $5.2 million, an increase in consulting and outside services of $4.9 million, an increase in information technology and facility-related costs of $4.0 million and an increase in personnel related costs of $2.5 million. The increases in insurance costs, consulting and outside services and personnel related costs were primarily driven by an increase in the number of employees and costs in support of being a publicly traded company. General and administrative expenses increased by $29.5 million, or 46% in 2018. The increase was primarily due to an increase in stock-based compensation of $16.5 million, an increase in personnel related costs of $7.2 million, and an increase in consulting and outside services of $3.5 million. The increase in stock-based compensation was mainly attributable to certain performance-based equity awards with vesting or commencement contingent on our initial public offering (IPO) and an increase in the number of employees. The increase in personnel related costs were primarily driven by an increase in the number of employees. These increases and the increase in consulting and outside services were in support of our public company readiness. Interest income Interest income generated from our investments in marketable securities increased by $11.5 million, or 43%, in 2019, mainly driven by a higher weighted average balance of cash and investments, primarily from the net proceeds of our IPO. Interest income from our investments in marketable securities increased by $11.8 million, or 77% in 2018, mainly driven by an overall higher market interest rate and a higher weighted average balance of cash and investments in 2018, primarily from net proceeds from the issuance of redeemable convertible preferred stock. Other (expense) income, net The following tables summarizes other (expense) income, net for each period presented (in thousands): Total other expense, net increased by $9.4 million in 2019. The increase was mainly attributable to a one-time $7.0 million cash receipt in 2018 as consideration for the waiver of a third party's previously negotiated commitment, and higher interest expense in 2019 of $3.5 million related to our financing lease liabilities. We started recording the interest expense in July 2018 upon the completion of our Moderna Technology Center manufacturing facility, or MTC South Please refer to Note 7 to our consolidated financial statements. Total other income, net increased by $3.7 million in 2018. The increase was primarily due to an increase of $5.6 million in other income, net mainly attributable to a $7.0 million cash receipt as consideration for the waiver of a third party's previously negotiated commitment. This increase was partially offset by higher interest expense of $3.0 million related to our MTC South lease financing obligation. We began recording interest expense upon the completion of our MTC South in July 2018. (Benefit from) provision for income taxes There were no significant income tax benefits or provisions in 2019, 2018 and 2017. Liquidity and capital resources We have historically funded our operations primarily from the sale of equity instruments and from proceeds from certain strategic alliance arrangements and grant agreements. As of December 31, 2019, we had cash, cash equivalents and investments of $1.26 billion. Cash and cash equivalents and investments are invested in accordance with our investment policy, primarily with a view to liquidity and capital preservation. Investments, consisting primarily of government and corporate debt securities are stated at fair value. As of December 31, 2019, we had current and non-current investments of approximately $867.1 million and $160.0 million, respectively. We began construction of our MTC South manufacturing facility, in the second half of 2016. Our capital expenditures related to MTC South were $3.9 million, $86.5 million and $59.9 million for the years ended December 31, 2019, 2018, and 2017, respectively. Cash disbursements related to MTC South were $14.6 million, $94.5 million and $41.2 million for the years ended December 31, 2019, 2018, and 2017, respectively. MTC South officially opened in July 2018. The remaining manufacturing equipment and processes which were still in progress at the time when MTC South opened were completed during 2019. In the second quarter of 2019, we entered into an additional lease for office and laboratory space nearby, or MTC North, also located in Norwood. We have designed and started construction of MTC North in the fourth quarter of 2019. Our capital expenditures and cash disbursements related to MTC North were $1.9 million and $0.5 million, for the year ended December 31, 2019, respectively. On January 30, 2018 and February 15, 2018, we issued Series G preferred stock for total gross proceeds of $560.0 million. On May 7, 2018, we issued Series H preferred stock for gross proceeds of $125.0 million of which $13.0 million was determined to be a premium and recorded to deferred revenue as part of the Merck PCV/SAV agreement executed contemporaneously with our Series H redeemable convertible preferred stock issuance. Please refer to Note 3 to our consolidated financial statements. On December 11, 2018, we closed our IPO, whereby we sold 26,275,993 shares of common stock at a price of $23.00 per share. The shares began trading on the NASDAQ Global Select Market on December 7, 2018. The aggregate net proceeds received by us from the IPO were $563.0 million, net of underwriting discounts, commissions and offering expenses. On February 14, 2020, we sold 26,315,790 shares of common stock at a price of $19.00 per share through a public equity offering. The aggregate net proceeds from the offering were approximately $478.1 million, net of underwriting discounts, commissions and estimated offering expenses. In addition, the underwriters have exercised their option to purchase an additional 3,947,368 shares of common stock at the public offering price less the underwriting discount, resulting in additional net proceeds of $71.8 million. Cash flow The following table summarizes the primary sources and uses of cash for each period presented (in thousands): Operating activities We derive cash flows from operations primarily from cash collected from certain strategic alliances. Our cash flows from operating activities are significantly influenced by our use of cash for operating expenses and working capital to support the business. We have historically experienced negative cash flows from operating activities as we have invested in our mRNA technologies, development pipeline, digital infrastructure, manufacturing technology, and infrastructure. Net cash used in operating activities in 2019 was $459.0 million and consisted of net loss of $514.0 million less non-cash adjustments of $108.7 million, plus a net change in assets and liabilities of $53.7 million. Non-cash items primarily included stock-based compensation of $81.1 million, depreciation and amortization of $31.0 million, and amortization of investment premiums and discounts of $3.7 million. The net change in assets and liabilities was primarily due to a decrease in deferred revenue of $44.1 million, a decrease in accounts payable of $24.0 million, a decrease in other liabilities of $6.2 million, an increase in right-of-use assets, operating leases of $5.7 million and an decrease in accrued liabilities of $3.4 million, partially offset by an increase in operating lease liabilities, non-current of $12.6 million, a decrease in prepaid expenses and other assets of $9.8 million and a decrease in accounts receivable of $6.7 million. Net cash used in operating activities in 2018 was $330.9 million and consisted of net loss of $384.7 million less non-cash adjustments of $96.5 million, plus a net change in assets and liabilities of $42.6 million. Non-cash items primarily included stock-based compensation of $72.6 million and depreciation and amortization of $24.9 million. The net change in assets and liabilities was primarily due to a decrease in deferred revenue of $65.3 million, and an increase in prepaid expenses and other assets of $5.3 million, partially offset by an increase in accounts payable of $15.0 million and an increase in accrued liabilities of $8.8 million. Net cash used in operating activities in 2017 was $331.5 million and consisted of net loss of $255.9 million less non-cash adjustments of $61.7 million, plus a net change in assets and liabilities of $137.2 million. Non-cash items primarily included stock-based compensation of $40.1 million and depreciation and amortization of $20.5 million. The net change in assets and liabilities in 2017 was primarily due to a decrease in deferred revenue of $162.3 million mainly driven by revenue recognition of $70.3 million resulting from termination of Alexion strategic alliance arrangements, a decrease in accounts payable of $12.8 million, partially offset by an increase in accrued liabilities of $34.4 million including a $25.0 million in-license payment accrual. Investing activities Our primary investing activities consist of purchases, sales, and maturities of our investments and capital expenditures for manufacturing, laboratory, computer equipment, and software. Net cash used in investing activities in 2019 was $14.9 million, which included purchases of marketable securities of $1.15 billion and purchases of property and equipment of $31.6 million, partially offset by proceeds from maturities of marketable securities of $993.2 million and proceeds from sales of marketable securities of $168.7 million. Net cash used in investing activities in 2018 was $373.1 million, which included purchases of marketable securities of $1.23 billion and purchases of property and equipment of $105.8 million, partially offset by proceeds from maturities of marketable securities of $783.4 million and proceeds from sales of marketable securities of $177.0 million Net cash provided by investing activities in 2017 was $417.4 million, which included proceeds from maturities of marketable securities of $800.4 million, proceeds from sales of marketable securities of $402.5 million, partially offset by purchases of marketable securities of $727.2 million, and purchases of property and equipment of $58.4 million. Financing activities We generated cash from financing activities of $51.1 million in 2019, primarily from net proceeds from the issuance of common stock under our equity plans of $47.3 million, and net proceeds from the purchase of common stock from our employee stock purchase plan of $2.9 million. We generated cash from financing activities of $1.23 billion in 2018, primarily from net proceeds from the issuance of redeemable convertible preferred stock of $661.1 million and net proceeds from the issuance of common stock of $563.0 million in connection with our IPO. We had insignificant financing activities in 2017. Operation and funding requirements Since our inception, we have incurred significant losses and negative cash flows from operations due to our significant research and development expenses. We have an accumulated deficit of $1.50 billion and $1.01 billion as of December 31, 2019 and 2018, respectively. We expect to continue to incur significant losses in the foreseeable future and expect our expenses to increase in connection with our ongoing activities, particularly as we continue research and development of our development candidates and clinical activities for our investigational medicines. In addition, we expect to incur additional costs associated with operating as a public company. Our expenses will also increase if, and as, we: • leverage our platform to expand our programs or advance our programs into preclinical and clinical development; • further develop our current programs; • seek to research and develop additional programs; • seek to research and develop additional modalities of mRNA medicines; • seek regulatory approvals for any investigational medicines that successfully complete clinical trials; • increase manufacturing capacity and production volume; • hire additional clinical, manufacturing, quality control, and scientific personnel, expand our operational, financial, and management systems, and increase personnel, including personnel to support our clinical development and manufacturing efforts and our operations as a public company; • establish a sales, marketing, medical affairs, and distribution infrastructure to commercialize any investigational medicine for which we may obtain marketing approval and intend to commercialize on our own or jointly; • maintain, expand, and protect our intellectual property portfolio; and • acquire or in-license other programs and technologies. We are subject to all the risks related to the development and commercialization of novel medicines, and we may encounter unforeseen expenses, difficulties, complications, delays, and other unknown factors that may adversely affect our business. Our forecast of the period of time through which our financial resources will be adequate to support our operations is a forward-looking statement and involves risks and uncertainties, and actual results could vary as a result of a number of factors. 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. We believe that our cash, cash equivalents, and investments as of December 31, 2019, will be sufficient to enable us to fund our projected operations through at least the next 12 months. Our future funding requirements will depend on many factors, including, but not limited to: • the rate of progress in the development of our development candidates; • the initiation, progress, timing, costs, and results of clinical trials for our investigational medicines and future investigational medicines; • the number and characteristics of programs that we develop; • the costs of development efforts for our programs that are not subject to reimbursement from our strategic collaborators; • the costs of mRNA materials; • the costs necessary to obtain regulatory approvals, if any, for our investigational medicines in the United States and other jurisdictions, and the costs of post-marketing studies that could be required by regulatory authorities in jurisdictions where approval is obtained; • the continuation of our existing strategic alliances and entry into new collaborations; • the cost and timing of completion of additional manufacturing facilities and activities, including potential commercial-scale manufacturing; • the costs we incur in maintaining business operations; • the costs associated with being a public company; • the revenue from any future sales of any approved mRNA medicines for which we are entitled to a profit share, royalties and milestones; • the time and unreimbursed costs necessary to commercialize mRNA medicines in territories in which our investigational medicines are approved for sale; • the effect of competing technological and market developments; and • the costs we incur in the filing, prosecution, maintenance, and defense of our extensive patent portfolio and other intellectual property rights. Until we can generate a sufficient amount of revenue from our programs, we expect to finance future cash needs through public or private equity offerings, structured financings or debt financings and potential future strategic alliances from which we receive upfront fees, milestone payments, and other forms of consideration. Additional capital may not be available on reasonable terms, if at all. If we are unable to raise additional capital in sufficient amounts or on terms acceptable to us, we may have to significantly delay, scale back, or discontinue the development or commercialization of one or more of our investigational medicines, or slow down or cease work on one or more of our programs. If we raise additional funds through the issuance of additional equity or debt securities, it could result in dilution to our existing stockholders or increased fixed payment obligations, and any such securities may have rights senior to those of our common stock. If we incur indebtedness, we could become subject to covenants that would restrict our operations and potentially impair our competitiveness, such as limitations on our ability to incur additional debt, limitations on our ability to acquire, sell or license intellectual property rights and other operating restrictions that could adversely impact our ability to conduct our business. If we raise funds through strategic alliances or marketing, distribution, or licensing arrangements with third parties, we may have to relinquish valuable rights to our technologies, future revenue streams, research programs, or investigational medicines or grant licenses on terms that may not be favorable to us. Any of these events could significantly harm our business, financial condition, and prospects. 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. Contractual obligations and commitments 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 (in thousands): _______ (1) The amounts in the table include a total payment of $218.8 million associated with our MTC South lease for the two extension periods of ten years each at our option. For accounting purpose, the lease term is the non-cancelable period of the lease and includes options to extend or terminate the lease when it is reasonably certain that an option will be exercised. Please refer to Note 7 to our consolidated financial statements. (2) The amounts represent non-cancelable fixed payment obligations under certain clinical service agreements. Under our strategic collaboration agreements, we are committed to perform certain research, development, and manufacturing activities. As part of our personalized mRNA cancer vaccines, or PCV, collaboration and license agreement with Merck, we are committed to perform certain research, development, and manufacturing activities related to PCV products through an initial Phase 2 clinical trial up to a budgeted amount of $243.0 million as of December 31, 2019. Please refer to Note 3 to the consolidated financial statements. The expenses we expect to incur as part of our commitments under the PCV and other collaboration agreements were not included in the above table as we are not able to determine the timing and amounts of such expenses. We have agreements with certain vendors for various services, including services related to clinical operations and support and contract manufacturing, which we are not contractually able to terminate for convenience. Certain agreements provide for termination rights subject to termination fees or wind down costs. Under such agreements, we are contractually obligated to make certain payments to vendors, mainly to reimburse them for their unrecoverable outlays incurred prior to cancellation. The exact amounts of such obligations are dependent on the timing of termination, and the exact terms of the relevant agreement and cannot be reasonably estimated. At December 31, 2019, we had cancelable open purchase orders of $105.9 million in total under such agreements for our clinical operations and support and contract manufacturing. These amounts represent only our estimate of those items for which we had a contractual commitment to pay at December 31, 2019, assuming we would not cancel these agreements. The actual amounts we pay in the future to the vendors under such agreements may differ from the cancelable open purchase order amounts of $105.9 million. In addition to the above obligations, we enter into a variety of agreements and financial commitments in the normal course of business. The terms generally allow us the option to cancel, reschedule, and adjust our requirements based on our business needs, prior to the delivery of goods or performance of services. It is not possible to predict the maximum potential amount of future payments under these agreements due to the conditional nature of our obligations and the unique facts and circumstances involved in each particular agreement.
-0.062134
-0.061818
0
<s>[INST] Overview We are a clinical stage biotechnology company pioneering messenger RNA (mRNA) therapeutics and vaccines to create a new generation of transformative medicines to improve the lives of patients. mRNA medicines are designed to direct the body’s cells to produce intracellular, membrane or secreted proteins that have a therapeutic or preventive benefit with the potential to address a broad spectrum of diseases. Our platform builds on continuous advances in basic and applied mRNA science, delivery technology and manufacturing, providing us the capability to pursue in parallel a robust pipeline of new development candidates. We are developing therapeutics and vaccines for infectious diseases, immunooncology, rare diseases, autoimmune diseases and cardiovascular diseases, independently and with our strategic collaborators. We have designed our strategy and operations to realize the full potential value and impact of mRNA over a long time horizon across a broad array of human diseases. We built and continue to invest in a platform to advance the technological frontier of mRNA medicines. We have made forward investments in scalable infrastructure and capabilities to pursue a pipeline of potential medicines that reflect the breadth of the mRNA opportunity. We have a diverse development pipeline of 24 development candidates across our 23 programs, of which 12 are in clinical studies. We have established strategic alliances with leading biopharmaceutical companies, including AstraZeneca, Merck & Co., or Merck, and Vertex Pharmaceuticals, or Vertex, as well as governmentsponsored and private organizations focused on global health initiatives, including Biomedical Advanced Research and Development Authority, or BARDA, Defense Advanced Research Projects Agency, or DARPA, the Bill & Melinda Gates Foundation, or Gates Foundation, and the Coalition for Epidemic Preparedness Innovations, or CEPI. As we unlock the inherent advantages of mRNA, we aim to address as many diseases and impact as many patients as our technology, talent, and capital permit. The broad potential applications of mRNA medicines have led us to raise significant capital and adopt a longterm approach to capital allocation that balances nearterm risks and longterm value creation. As of December 31, 2019, we had cash, cash equivalents and investments of approximately $1.26 billion. In addition, in February 2020, we raised approximately $549.9 million, net of underwriting discounts, commissions and estimated offering expenses, through a followon public equity offering and the subsequent exercise of the underwriters' option to purchase additional shares. We use this capital to fund operations and investing activities across research for technology creation, drug discovery and clinical development programs, infrastructure and capabilities to enable the Research Engine and Early Development Engine (which includes our Moderna Technology Center, or MTC, manufacturing facility in Norwood), our digital infrastructure, creation of our portfolio of intellectual property, and administrative support. Since our inception, we have incurred significant operating losses. Our net losses were $514.0 million, $384.7 million and $255.9 million for the years ended December 31, 2019, 2018 and 2017, respectively. As of December 31, 2019, our accumulated deficit was $1.50 billion. We expect to continue to incur significant expenses and operating losses for the foreseeable future. In addition, we anticipate that our expenses will increase significantly in connection with our ongoing activities, as we: continue our platform research and drug discovery and development efforts; conduct clinical studies for our investigational medicines; manufacture clinical study materials and develop largescale manufacturing capabilities; seek regulatory approval for our investigational medicines; maintain, expand, and protect our intellectual property; hire additional personnel to support our program development effort to obtain regulatory approval and secure additional facilities for operations; and continue to operate as a public company. We do not expect to generate revenue from the sale of potential mRNA medicines unless and until we successfully complete clinical development and obtain regulatory approval for one or more of our investigational medicines. If we seek to obtain regulatory approval for and commercialize any of our investigational medicines, we expect to incur [/INST] Negative. </s>
2,020
9,886
1,720,635
nVent Electric plc
2019-02-19
2018-12-31
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 refers to and should be read in conjunction with the audited consolidated and combined financial statements and the corresponding notes included in Item 8. Forward-looking statements This report contains statements that we believe to be "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. All statements, other than statements of historical fact are forward-looking statements. Without limitation, any statements preceded or followed by or that include the words "targets," "plans," "believes," "expects," "intends," "will," "likely," "may," "anticipates," "estimates," "projects," "should," "would," "positioned," "strategy," "future," "forecast" or words, phrases or terms of similar substance or the negative thereof, are forward-looking statements. These forward-looking statements are not guarantees of future performance and are subject to risks, uncertainties, assumptions and other factors, some of which are beyond our control, which could cause actual results to differ materially from those expressed or implied by such forward-looking statements. These factors include; adverse effects on our business operations or financial results as a result of the consummation of the separation (as defined below); the ability of our business to operate independently following the separation; overall global economic and business conditions impacting our business; the ability to achieve the benefits of our restructuring plans; the ability to successfully identify, finance, complete and integrate acquisitions; competition and pricing pressures in the markets we serve, including the impacts of tariffs; the strength of housing and related markets; volatility in currency exchange rates and commodity prices; inability to generate savings from excellence in operations initiatives consisting of lean enterprise, supply management and cash flow practices; increased risks associated with operating foreign businesses; the ability to deliver backlog and win future project work; failure of markets to accept new product introductions and enhancements; the impact of changes in laws and regulations, including those that limit U.S. tax benefits; the outcome of litigation and governmental proceedings; and the ability to achieve our long-term strategic operating goals. Additional information concerning these and other factors is contained in our filings with the U.S. Securities and Exchange Commission (the "SEC"), including this Annual Report on Form 10-K. All forward-looking statements speak only as of the date of this report. nVent Electric plc assumes no obligation, and disclaims any obligation, to update the information contained in this report. Overview nVent is a leading global provider of electrical connection and protection solutions. We believe our inventive electrical solutions enable safer systems and ensure a more secure world. We design, manufacture, market, install, and service high performance products and solutions that connect and protect some of the world’s most sensitive equipment, buildings, and critical processes. We offer a comprehensive range of enclosures, electrical connections and fastening, and thermal management solutions across industry-leading brands that are recognized globally for quality, reliability, and innovation. We classify our operations into business segments based primarily on types of products offered and markets served. We operate across three segments: Enclosures, Thermal Management, and Electrical & Fastening Solutions, which contributed 46%, 28% and 26% of total revenues during 2018, respectively. We classify our operations into business segments based primarily on types of products offered and markets served: • Enclosures - The Enclosures segment provides inventive solutions that protect, connect and manage heat in critical electronics, communication, control, and power equipment. From metallic and non-metallic enclosures to cabinets, subracks and backplanes, it offers the physical infrastructure to host, connect and protect server and network equipment, as well as indoor and outdoor protection for broadband voice, data and video surveillance applications in industrial, infrastructure, commercial, and energy verticals. • Thermal Management - The Thermal Management segment provides electric thermal solutions that connect and protect critical buildings, infrastructure, industrial processes and people. Its thermal management systems include heat tracing, floor heating, fire-rated and specialty wiring, sensing and snow melting and de-icing solutions for use in industrial, energy, commercial & residential and infrastructure verticals. Its highly reliable and easy to install solutions lower total cost of ownership to building owners, facility managers, operators and end users. • Electrical & Fastening Solutions - The Electrical & Fastening Solutions segment provides fastening solutions that connect and protect electrical and mechanical systems and civil structures. Its engineered electrical and fastening products are used across a wide range of verticals, including commercial, industrial, infrastructure and energy. On April 30, 2018, Pentair plc ("Pentair" or "Parent") completed the separation of its Water business and its Electrical business into two independent, publicly-traded companies (the "separation"). To effect the separation, Pentair distributed to its shareholders one ordinary share of nVent for every ordinary share of Pentair held as of the record date of April 17, 2018. As a result of the distribution, nVent is now an independent publicly-traded company and began regular way trading under the symbol "NVT" on the New York Stock Exchange on May 1, 2018. The Company was incorporated in Ireland on May 30, 2017. Although our jurisdiction of organization is Ireland, we manage our affairs so that we are centrally managed and controlled in the United Kingdom (the "U.K.") and therefore have tax residency in the U.K. Key trends and uncertainties regarding our existing business The following trends and uncertainties affected our financial performance in 2018 and 2017, and will likely impact our results in the future: • We have identified specific product and geographic market opportunities that we find attractive and continue to pursue, both within and outside the U.S. We are reinforcing our businesses to more effectively address these opportunities through research and development and additional sales and marketing resources. Unless we successfully penetrate these markets, our organic sales growth will likely be limited or may decline. • We have experienced material and other cost inflation. We strive for productivity improvements and we implement increases in selling prices to help mitigate this inflation. We expect the current economic environment, including the impacts of tariffs, will result in continuing price volatility for many of our raw materials and purchased components and we are uncertain as to the timing and impact of these market changes. • During 2018 and 2017, we continued execution of certain business restructuring initiatives aimed at reducing our fixed cost structure and realigning our business. In 2019, our operating objectives include the following: • Achieving differentiated revenue growth through new products and solutions and market expansion in key developing regions; • Driving operating excellence through lean enterprise initiatives, with specific focus on sourcing and supply management, cash flow management and lean operations; • Optimizing our technological capabilities to increasingly generate innovative new and connected products and enhance the customer experience; and • Focusing on developing global talent in light of our global presence. The financial statements for periods prior to April 30, 2018 were prepared on a stand-alone basis derived from the consolidated financial statements and records of Pentair as if nVent were operated on a stand-alone basis. For periods prior to the separation, the consolidated and combined financial statements of nVent include general corporate expenses of Pentair for certain support functions that were provided on a centralized basis, such as expenses related to executive management, finance, audit, legal, information technology, human resources, communications, facilities and employee benefits and compensation. These general corporate expenses are included in the Consolidated and Combined Statements of Income and Comprehensive Income within Selling, general and administrative expense and Other expense. These expenses were allocated to nVent on the basis of direct usage when identifiable, with the remainder allocated based on a proportional basis of net sales, headcount or other measures. nVent considers the allocation methodology regarding Pentair’s general corporate expenses to be reasonable for periods presented prior to the separation. Nevertheless, the consolidated and combined financial statements of nVent for periods prior to the separation may not reflect the actual expenses that would have been incurred and may not reflect nVent’s consolidated and combined results of operations, financial position and cash flows had it been a stand-alone company during the periods presented. CONSOLIDATED AND COMBINED RESULTS OF OPERATIONS The consolidated and combined results of operations were as follows: N.M. Not Meaningful Net sales The components of the consolidated net sales change were as follows: The 5.5 percent increase in net sales in 2018 from 2017 was primarily the result of: • organic sales growth of approximately 2.5% from our industrial business and 2.0% from our commercial & residential business, which includes selective increases in selling prices; and • favorable foreign currency effects. These increases were partially offset by: • slowdown in capital spending impacting the energy business, driving lower organic sales of approximately 1.0%. The 0.9 percent decrease in net sales in 2017 from 2016 was primarily the result of: • sales decline from our energy business of approximately 5.0% as a result of the impact of three large Canadian Oil Sands projects in our Thermal Management segment in 2016 that did not recur in 2017; and • sales decline in our infrastructure business of approximately 1.0% driven by performance in both Enclosures and Electrical & Fastening Solutions. These decreases were partially offset by: • increased sales volume from our industrial business of approximately 3.0%, primarily as a result of increased volumes in the U.S.; • increased sales related to a business acquisition that occurred in the first quarter of 2017; and • favorable foreign currency effects. Gross profit The 0.5 percentage point decrease in gross profit as a percentage of sales in 2018 from 2017 was primarily the result of: • inflationary increases related to certain raw materials, labor and freight costs. This decrease was partially offset by: • organic sales growth in our industrial and commercial & residential businesses, which resulted in increased leverage on fixed expenses included in cost of goods sold; and • higher contribution margin as a result of savings generated from our lean and supply management practices. The 0.6 percentage point increase in gross profit as a percentage of sales in 2017 from 2016 was primarily the result of: • favorable mix as a result of the decline in lower margin long-cycle energy sales and growth in higher margin product sales; and • higher contribution margin as a result of savings generated from our lean and supply management practices. These increases were partially offset by: • inflationary increases related to labor costs and certain raw materials; and • higher cost of sales due to manufacturing footprint rationalization and a new U.S. distribution center. Selling, general and administrative ("SG&A") The 0.5 percentage point increase in SG&A expense as a percentage of sales in 2018 from 2017 was driven by: • $45.0 million of non-recurring separation related costs incurred in 2018 to prepare and establish nVent to operate as an independent stand-alone public company, primarily related to information technology, legal, advisory and other professional fees, compared to $16.1 million in 2017; • increased investment in sales and marketing to drive growth; and • increased corporate expenses incurred to operate as an independent public company. These increases were partially offset by: • organic sales growth in our industrial and commercial & residential businesses, which resulted in increased leverage on operating expenses; and • restructuring costs of $7.7 million in 2018, compared to $13.0 million in 2017. The 1.1 percentage point increase in SG&A expense as a percentage of sales in 2017 from 2016 was driven by the following: • $16.1 million of non-recurring separation costs incurred in 2017 to prepare nVent to operate as an independent stand-alone public company, primarily related to legal, advisory and other professional fees; and • lower sales volume in our energy and infrastructure businesses, which resulted in decreased leverage on operating expenses. These increases were partially offset by: • cost control and savings generated from back-office consolidation, reduction in personnel and other lean initiatives; and • increased sales volume in the industrial business, which resulted in increased leverage on operating expenses. Provision for income taxes The 29.5 percentage point increase in the effective tax rate in 2018 from 2017 was primarily due to: • the provisional tax benefit of $84.8 million recognized as a result of U.S. tax reform in 2017 that is not recurring in 2018. The 33.1 percentage point decrease in the effective tax rate in 2017 from 2016 was primarily due to: • a net provisional tax benefit of $84.8 million recognized in 2017 as a result of the enactment of U.S. tax reform; and • the mix of global earnings toward lower tax jurisdictions. On December 20, 2018, the U.S. Treasury issued proposed regulations that, when finalized, would limit the availability of tax benefits we currently claim related to the deductibility of interest (the “Proposed Regulations”). It is anticipated that the Proposed Regulations will be finalized during, or prior to, June 2019. As the Proposed Regulations are not yet finalized, the ultimate outcome is not specifically known at this time. Such changes could materially adversely affect our effective tax rate and/or require us to take further action to seek to preserve our effective tax rate. SEGMENT RESULTS OF OPERATIONS The summary that follows provides a discussion of the results of operations of our three reportable segments (Enclosures, Thermal Management and Electrical & Fastening Solutions). Each of these segments comprises various product offerings that serve multiple end markets. We evaluate performance based on sales and segment income and use a variety of ratios to measure performance of our reporting segments. Segment income (loss) represents operating income exclusive of intangible amortization, separation costs, net interest expense, costs of restructuring activities, impairments and other unusual non-operating items. Enclosures The net sales and segment income for Enclosures were as follows: Net sales The components of the change in Enclosures net sales were as follows: The 9.1 percent increase in Enclosures sales in 2018 from 2017 was primarily the result of: • organic sales growth of approximately 5.0% from our industrial business and approximately 2.5% from our infrastructure business, which includes selective increases in selling prices; and • favorable foreign currency effects. The 2.6 percent increase in Enclosures sales in 2017 from 2016 was primarily the result of: • increased sales volume of approximately 3.5% from the industrial business, primarily as a result of increased volumes in the U.S.; and • favorable foreign currency effects. These increases were partially offset by: • continued slowdown in capital spending, particularly in the infrastructure business, driving sales volume decline of approximately 2%. Segment income The components of the change in Enclosures segment income from the prior period were as follows: The 0.5 percentage point decrease in segment income for Enclosures as a percentage of net sales in 2018 from 2017 was primarily the result of: • inflationary increases related to certain raw materials, labor and freight costs. This decrease was partially offset by: • organic sales growth from our industrial and infrastructure businesses, including selective increases in selling prices, which resulted in increased leverage on production and operating expenses; and • higher contribution margin as a result of savings generated from our lean and supply management practices. The 2.6 percentage point decrease in segment income for Enclosures as a percentage of net sales in 2017 from 2016 was primarily the result of: • inflationary increases related to labor costs and certain raw materials; • higher cost of sales due to manufacturing footprint rationalization and a new U.S. distribution center. • lower sales volume in the infrastructure business, which resulted in decreased leverage on operating expenses. These decreases were partially offset by: • increased sales volume in the industrial business, which resulted in increased leverage on operating expenses. Thermal Management The net sales and segment income for Thermal Management were as follows: Net sales The components of the change in Thermal Management net sales were as follows: The 0.2 percent increase in Thermal Management sales in 2018 from 2017 was primarily the result of: • organic sales growth of approximately 4.0% from our commercial & residential business, which includes selective increases in selling prices; and • favorable foreign currency effects. These increases were partially offset by: • lower project sales volume in the energy business driving lower organic sales of approximately 4.0%. The 10.1 percent decrease in Thermal Management sales in 2017 from 2016 was primarily the result of: • lower project sales volume as a result of the impact of three large Canadian Oil Sands projects in 2016 that did not recur in 2017. This decrease was partially offset by: • increased sales volume of approximately 1.5% from the industrial business, primarily as a result of increased volumes in Western Europe and certain developing regions; and • favorable foreign currency effects. Segment income The components of the change in Thermal Management segment income from the prior period were as follows: The 1.0 percentage point increase in segment income for Thermal Management as a percentage of net sales in 2018 from 2017 was primarily the result of: • favorable mix as a result of the decline in lower margin long-cycle energy sales and growth in higher margin product sales; • organic sales growth in our commercial & residential business, which resulted in increased leverage on operating expenses; and • higher contribution margin as a result of savings generated from our lean and supply management practices. These increases were partially offset by: • inflationary increases related to certain raw materials, labor and freight costs; and • organic sales decline in our energy business, which resulted in decreased leverage on operating expenses. The 5.9 percentage point increase in segment income for Thermal Management as a percentage of sales in 2017 from 2016 was primarily the result of: • favorable mix as a result of the decline in lower margin long-cycle energy sales and growth in higher margin product sales; • increased sales volume in the industrial business, which resulted in increased leverage on operating expenses; and • higher contribution margin as a result of savings generated from our lean and supply management practices. These increases were partially offset by: • inflationary increases related to labor costs and certain raw materials. Electrical & Fastening Solutions The net sales and segment income for Electrical & Fastening Solutions were as follows: Net sales The components of the change in Electrical & Fastening Solutions net sales were as follows: The 5.5 percent increase in Electrical & Fastening Solutions sales in 2018 from 2017 was primarily the result of: • organic sales growth of approximately 3.0% from our commercial & residential business and approximately 1.5% from our industrial business, which includes selective increases in selling prices; and • favorable foreign currency effects. The 5.5 percent increase in Electrical & Fastening Solutions sales in 2017 from 2016 was primarily the result of: • increased sales related to a business acquisition that occurred in the first quarter of 2017; • selective increases in selling prices to mitigate inflationary cost increases; • increased sales volume of approximately 1.0% in the energy and industrial businesses, primarily as a result of increased volumes in the U.S.; and • favorable foreign currency effects. Segment income The components of the change in Electrical & Fastening Solutions segment income from the prior period were as follows: The 0.7 percentage point decrease in segment income for Electrical & Fastening Solutions as a percentage of net sales in 2018 from 2017 was primarily the result of: • inflationary increases related to certain raw materials, labor and freight costs; and • impact of unfavorable product mix. These decreases were partially offset by: • organic sales growth from our commercial & residential and industrial businesses, which resulted in increased leverage on operating expenses; • selective increases in selling prices to offset inflationary cost increases; and • higher contribution margin as a result of savings generated from our lean and supply management practices. The 2.3 percentage point decrease in segment income for Electrical & Fastening Solutions as a percentage of sales in 2017 from 2016 was primarily the result of: • inflationary increases related to labor costs and certain raw materials. This decrease was partially offset by: • higher contribution margin as a result of savings generated from our lean and supply management practices; and • increased sales volume in the energy and industrial businesses, which resulted in increased leverage on operating expenses. LIQUIDITY AND CAPITAL RESOURCES The primary source of liquidity for our business is cash flows provided by operations. For periods prior to the separation, transfers of cash to and from the former Parent's cash management system have been reflected in the Net Parent investment in the historical Consolidated and Combined Balance Sheets, Consolidated and Combined Statements of Cash Flows and Consolidated and Combined Statements of Changes in Equity. In connection with the separation, our capital structure and sources of liquidity changed significantly from our historical capital structure. Our businesses no longer participate in cash management and funding arrangements with the former Parent. We expect to continue to have cash requirements to support working capital needs and capital expenditures, to pay interest and service debt and to pay dividends to shareholders quarterly. We believe we have the ability and sufficient capacity to meet these cash requirements by using available cash and internally generated funds and borrowing under committed credit facilities. We are focused on increasing our cash flow and repaying debt, while continuing to fund our research and development, sales and marketing and capital investment initiatives. Our intent is to maintain investment grade metrics and a solid liquidity position. We experience seasonal cash flows primarily due to increased demand for Thermal Management products and services during the fall and winter months in the Northern Hemisphere and increased demand for Electrical & Fastening Solutions products during the spring and summer months in the Northern Hemisphere. Operating activities Cash provided by operating activities of continuing operations was $343.5 million in 2018. Cash provided by Operating Activities in 2018 primarily reflects Net income, net of non-cash depreciation and amortization, further increased by a positive impact of $41.7 million as a result of changes in net working capital. Cash provided by operating activities of continuing operations was $409.7 million in 2017, compared to $364.0 million in 2016. Cash provided by operating activities in 2017 primarily reflects Net income, net of non-cash depreciation and amortization, remeasurement of deferred income taxes as a result of the enactment of U.S. tax reform and trade name impairment, further increased by a positive impact of $28.4 million as a result of changes in net working capital. Investing activities Net cash used for investing activities of continuing operations was $39.1 million in 2018, compared to net cash used for investing activities of $41.2 million and $68.6 million in 2017 and 2016, respectively. The following investing activity impacted our cash flow: Capital expenditures Capital expenditures in 2018, 2017 and 2016 were $39.5 million, $31.8 million and $74.5 million, respectively. We anticipate capital expenditures for fiscal 2019 to be approximately $55 million, primarily for capacity expansions of manufacturing facilities, investments to expand our digital infrastructure and capabilities and developing new products and general maintenance. Financing activities Prior to the separation, transfers of cash, both to and from the former Parent’s centralized cash management system are reflected as a financing activity on the Consolidated and Combined Statements of Cash Flows. Net cash used for financing activities was $166.6 million in 2018, which primarily relates to $1.0 billion of proceeds from long-term debt described further below, offset by $993.6 million of cash provided at the separation to Pentair as consideration for the contribution of the net assets of the Electrical business to nVent by Pentair. Additionally, we repaid $52.5 million of outstanding principal on the Term Loan Facility, had cash outflows of $56.0 million for shares repurchased and paid $62.9 million of dividends during 2018. Net cash used for financing activities was $359.5 million and $308.9 million in 2017 and 2016. Cash used for financing activities in 2017 and 2016 reflect net transactions with the former Parent during the pre-separation period resulting from operating and investing activities discussed above. Senior notes In March 2018, nVent Finance S.à r.l. (“nVent Finance” or “Subsidiary Issuer”), a 100-percent owned subsidiary of nVent, issued $300.0 million aggregate principal amount of 3.950% senior notes due 2023 (the "2023 Notes") and $500.0 million aggregate principal amount of 4.550% senior notes due 2028 (the "2028 Notes" and, collectively with the 2023 Notes, the "Notes"). Interest on the Notes is payable semi-annually in arrears on April 15 and October 15 of each year, beginning October 15, 2018. In August 2018, nVent and nVent Finance filed a Registration Statement on Form S-4 with the Securities and Exchange Commission to exchange the Notes for new, registered Notes. The exchange offer was completed on October 22, 2018, pursuant to which substantially all of the Notes were exchanged for the new, registered Notes. The exchange offer did not impact the aggregate principal amount of the Notes outstanding or any material terms. The Notes are fully and unconditionally guaranteed as to payment by nVent ("the Parent Company Guarantor"). There are no subsidiaries that guarantee the Notes. The Parent Company Guarantor has no independent assets or operations unrelated to its investments in its consolidated subsidiaries. The Parent Company Guarantor’s only direct subsidiary is the Subsidiary Issuer. The Subsidiary Issuer has no independent assets or operations unrelated to its investments in its consolidated subsidiaries and the issuance of the Notes and other external debt. The Notes constitute general unsecured senior obligations of the Subsidiary Issuer and rank equally in right of payment with all existing and future unsubordinated and unsecured indebtedness and liabilities of the Subsidiary Issuer. The guarantees of the Notes by the Parent Company Guarantor constitute general unsecured obligations of the Parent Company Guarantor and rank equally in right of payment with all existing and future unsubordinated and unsecured indebtedness and liabilities of the Subsidiary Issuer. Subject to certain qualifications and exceptions, the indenture pursuant to which the Notes were issued contains covenants that, among other things, restrict nVent’s, nVent Finance’s and certain subsidiaries’ ability to merge or consolidate with another person, create liens or engage in sale and lease-back transactions. There are no significant restrictions on the ability of nVent to obtain funds from its subsidiaries by dividend or loan. None of the assets of nVent or its subsidiaries represents restricted net assets pursuant to the guidelines established by the SEC. Senior credit facilities In March 2018, nVent Finance entered into a credit agreement with a syndicate of banks providing for a five-year $200.0 million senior unsecured term loan facility (the "Term Loan Facility") and a five-year $600.0 million senior unsecured revolving credit facility (the "Revolving Credit Facility" and, together with the Term Loan Facility, the "Senior Credit Facilities"). We have the option to request to increase the Revolving Credit Facility in an aggregate amount of up to $300.0 million, subject to customary conditions, including the commitment of the participating lenders. There were no outstanding borrowings under the Revolving Credit Facility as of December 31, 2018. Our debt agreements contain certain financial covenants, the most restrictive of which are in the Senior Credit Facilities, including that we may not permit (i) the ratio of our consolidated debt (net of our consolidated unrestricted cash in excess of $5.0 million but not to exceed $250.0 million) to our consolidated net income (excluding, among other things, non-cash gains and losses) before interest, taxes, depreciation, amortization and non-cash share-based compensation expense ("EBITDA") on the last day of any period of four consecutive fiscal quarters to exceed 3.75 to 1.00 and (ii) the ratio of our EBITDA to our consolidated interest expense for the same period to be less than 3.00 to 1.00. In addition, subject to certain qualifications and exceptions, the Senior Credit Facilities also contain covenants that, among other things, restrict our ability to create liens, merge or consolidate with another person, make acquisitions and incur subsidiary debt. As of December 31, 2018, we were in compliance with all financial covenants in our debt agreements. As discussed above, we repaid $52.5 million of outstanding principal on the Term Loan Facility during 2018. As of December 31, 2018, we have $10.4 million of cash held in certain countries in which the ability to repatriate is limited due to local regulations or significant potential tax consequences. We expect to continue to have cash requirements to support working capital needs and capital expenditures, to pay interest and service debt and to pay dividends to shareholders quarterly. We believe we have the ability and sufficient capacity to meet these cash requirements by using available cash and internally generated funds and to borrow under our credit facilities. Dividends We paid dividends in 2018 of $62.9 million, or $0.35 per ordinary share. On December 11, 2018, the Board of Directors declared a quarterly cash dividend of $0.175 that was paid on February 8, 2019 to shareholders of record at the close of business on January 25, 2019. On February 19, 2019, the Board of Directors declared a quarterly cash dividend of $0.175 per ordinary share payable on May 3, 2019 to shareholders of record at the close of business on April 18, 2019. Under Irish law, the payment of future cash dividends and repurchases of shares may be paid only out of nVent Electric plc's "distributable reserves" on its statutory balance sheet. nVent Electric plc is not permitted to pay dividends out of share capital, which includes share premiums. Distributable reserves may be created through the earnings of the Irish parent company and through a reduction in share capital approved by the Irish High Court. Distributable reserves are not linked to a U.S. generally accepted accounting principles ("GAAP") reported amount (e.g., retained earnings). In June 2018, the Irish High Court approved nVent Electric plc's conversion of approximately $3.8 billion of share premium to distributable reserves. On July 9, 2018, following the approval of the Irish High Court, we made the required filing of nVent Electric plc's initial accounts with the Irish Companies Registration Office, which completed the process to allow us to pay future cash dividends and redeem and repurchase shares out of nVent Electric plc's "distributable reserves." Authorized shares Our authorized share capital consists of 400.0 million ordinary shares with a par value of $0.01 per share. Share repurchases On July 23, 2018, the Board of Directors authorized the repurchase of our ordinary shares up to a maximum dollar limit of $500.0 million. The authorization expires on July 23, 2021. During the year ended December 31, 2018, we repurchased 2.4 million of our ordinary shares for $59.0 million under the 2018 authorization. As of December 31, 2018, we had $441.0 million remaining availability for repurchases under the 2018 authorization. On February 19, 2019, the Board of Directors authorized the repurchase of our ordinary shares up to a maximum dollar limit of $380.0 million. This authorization is in addition to the authorization approved in July 2018 to repurchase up to $500.0 million of our ordinary shares. The authorization expires on July 23, 2021. Contractual obligations The following summarizes our significant contractual obligations that impact our liquidity: The majority of the purchase obligations represent commitments for raw materials to be utilized in the normal course of business. For purposes of the above table, arrangements are considered purchase obligations if a contract specifies all significant terms, including fixed or minimum quantities to be purchased, a pricing structure and approximate timing of the transaction. In addition to the summary of significant contractual obligations, we will incur annual interest expense on outstanding variable rate debt. As of December 31, 2018, variable interest rate debt was $147.5 million at a weighted average interest rate of 3.795%. The total gross liability for uncertain tax positions at December 31, 2018 was estimated to be $16.8 million. We record penalties and interest related to unrecognized tax benefits in Provision (benefit) for income taxes and Net interest expense, respectively, which is consistent with our past practices. As of December 31, 2018, we had recorded $1.7 million for the possible payment of penalties and $2.7 million related to the possible payment of interest. Other financial measures In addition to measuring our cash flow generation or usage based upon operating, investing and financing classifications included in the Consolidated and Combined Statements of Cash Flows, we also measure our free cash flow. Free cash flow is a non-GAAP financial measure that we use to assess our cash flow performance. We believe free cash flow is an important measure of liquidity because it provides us and our investors a measurement of cash generated from operations that is available to pay dividends, make acquisitions, repay debt and repurchase shares. In addition, free cash flow is used as a criterion to measure and pay compensation-based incentives. Our measure of free cash flow may not be comparable to similarly titled measures reported by other companies. The following table is a reconciliation of free cash flow: Off-balance sheet arrangements At December 31, 2018, we had no off-balance sheet financing arrangements. COMMITMENTS AND CONTINGENCIES We have been made parties to a number of actions filed or have been given notice of potential claims relating to the conduct of our business, including those pertaining to commercial disputes, product liability, environmental, safety and health, patent infringement and employment matters. While we believe that a material impact on our consolidated financial position, results of operations or cash flows from any such future claims or potential claims is unlikely, given the inherent uncertainty of litigation, a remote possibility exists that a future adverse ruling or unfavorable development could result in future charges that could have a material impact. We do and will continue to periodically reexamine our estimates of probable liabilities and any associated expenses and receivables and make appropriate adjustments to such estimates based on experience and developments in litigation. As a result, the current estimates of the potential impact on our consolidated financial position, results of operations and cash flows for the proceedings and claims described in ITEM 8, Note 15 of the Notes to the Consolidated and Combined Financial Statements could change in the future. Stand-by Letters of Credit, Bank Guarantees and Bonds In disposing of assets or businesses, we often provide representations, warranties and indemnities to cover various risks including unknown damage to assets, environmental risks involved in the sale of real estate, liability to investigate and remediate environmental contamination at waste disposal sites and manufacturing facilities and unidentified tax liabilities and legal fees related to periods prior to disposition. We do not have the ability to reasonably estimate the potential liability due to the inchoate and unknown nature of these potential liabilities. However, we have no reason to believe that these uncertainties would have a material adverse effect on our financial position, results of operations or cash flows. In the ordinary course of business, we are required to commit to bonds, letters of credit and bank guarantees that require payments to our customers for any non-performance. The outstanding face value of these instruments fluctuates with the value of our projects in process and in our backlog. In addition, we issue financial stand-by letters of credit primarily to secure our performance to third parties under self-insurance programs. As of December 31, 2018 and 2017, the outstanding value of bonds, letters of credit and bank guarantees totaled $75.8 million and $72.3 million, respectively. NEW ACCOUNTING STANDARDS See ITEM 8, Note 1 of the Notes to Consolidated and Combined Financial Statements, included in this Form 10-K, for information pertaining to recently adopted accounting standards or accounting standards to be adopted in the future. CRITICAL ACCOUNTING POLICIES We have adopted various accounting policies to prepare the consolidated financial statements in accordance with GAAP. Our significant accounting policies are more fully described in ITEM 8, Note 1 of the Notes to Consolidated and Combined Financial Statements. Certain of our accounting policies require the application of significant judgment by management in selecting the appropriate assumptions for calculating financial estimates. By their nature, these judgments are subject to an inherent degree of uncertainty. These judgments are based on our historical experience, terms of existing contracts, our observance of trends in the industry and information available from other outside sources, as appropriate. We consider an accounting estimate to be critical if: • it requires us to make assumptions about matters that were uncertain at the time we were making the estimate; and • changes in the estimate or different estimates that we could have selected would have had a material impact on our financial condition or results of operations. Our critical accounting estimates include the following: Cost allocations For periods prior to the separation, the consolidated and combined financial statements of nVent include general corporate expenses of Pentair for certain support functions that were provided on a centralized basis, such as expenses related to executive management, finance, audit, legal, information technology, human resources, communications, facilities and employee benefits and compensation. These general corporate expenses are included in the Consolidated and Combined Statements of Income and Comprehensive Income within Selling, general and administrative expense and Other expense. The amounts allocated were $42.5 million, $65.7 million and $75.7 million for the years ended December 31, 2018, 2017 and 2016, respectively, of which $10.3 million, $31.0 million and $31.0 million, respectively, were historically recorded to the Electrical segment in Pentair’s consolidated financial statements. These expenses were allocated to nVent on the basis of direct usage when identifiable, with the remainder allocated based on a proportional basis of net sales, headcount or other measures. The Company considers the allocation methodology regarding Pentair’s general corporate expenses to be reasonable for all periods presented. Nevertheless, the consolidated and combined financial statements of nVent for periods prior to the separation may not reflect the actual expenses that would have been incurred and may not reflect nVent’s consolidated and combined results of operations, financial position and cash flows had it been a stand-alone company during the periods presented. Actual costs for periods prior to the separation that would have been incurred if nVent had been a standalone company would depend on multiple factors including organization structure, capital structure and strategic decisions made in various areas, including information technology and infrastructure. Transactions between nVent and Pentair have been included in related party transactions in these consolidated and combined financial statements and were considered to be effectively settled at the time the transaction was recorded. The total net effect of the settlement of these transactions is reflected in the Consolidated and Combined Statements of Cash Flows as a financing activity and in the Consolidated and Combined Balance Sheets as Net Parent investment. The Net Parent investment represents Pentair’s historical investment in nVent, the net effect of cost allocations from transactions with Pentair, net transfers of cash and assets to Pentair and nVent’s accumulated earnings. See ITEM 8, Note 7 of the Notes to Consolidated and Combined Financial Statements for a further description of related party transactions and Net Parent investment. Impairment of goodwill and indefinite-lived intangibles Goodwill Goodwill represents the excess of the cost of acquired businesses over the net of the fair value of identifiable tangible net assets and identifiable intangible assets purchased and liabilities assumed. Goodwill is tested annually for impairment as of the first day of the fourth quarter, and is tested for impairment more frequently if events or changes in circumstances indicate that the asset might be impaired. The impairment test is performed using a two-step process. In the first step, the fair value of each reporting unit is compared with the carrying amount of the reporting unit, including goodwill. If the estimated fair value is less than the carrying amount of the reporting unit there is an indication that goodwill impairment exists and a second step must be completed in order to determine the amount of the goodwill impairment, if any, which should be recorded. In the second step, an impairment loss is recognized for any excess of the carrying amount of the reporting unit’s goodwill over the implied fair value of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit in a manner similar to a purchase price allocation. The fair value of each reporting unit is determined using a discounted cash flow analysis and market approach. Projecting discounted future cash flows requires us to make significant estimates regarding future revenues and expenses, projected capital expenditures, changes in working capital and the appropriate discount rate. Use of the market approach consists of comparisons to comparable publicly-traded companies that are similar in size and industry. Actual results may differ from those used in our valuations. In developing our discounted cash flow analysis, assumptions about future revenues and expenses, capital expenditures and changes in working capital are based on our annual operating plan and long-term business plan for each of our reporting units. These plans take into consideration numerous factors including historical experience, anticipated future economic conditions, changes in raw material prices and growth expectations for the industries and end markets we participate in. These assumptions are determined over a six year long-term planning period. The six year growth rates for revenues and operating profits vary for each reporting unit being evaluated. Revenues and operating profit beyond 2024 are projected to grow at a perpetual growth rate of 3.0%. Discount rate assumptions for each reporting unit take into consideration our assessment of risks inherent in the future cash flows of the respective reporting unit and our weighted-average cost of capital. We utilized a discount rate of 10.0% for each reporting unit in determining the discounted cash flows in our fair value analysis. In estimating fair value using the market approach, we identify a group of comparable publicly-traded companies for each reporting unit that are similar in terms of size and product offering. These groups of comparable companies are used to develop multiples based on total market-based invested capital as a multiple of EBITDA. We determine our estimated values by applying these comparable EBITDA multiples to the operating results of our reporting units. The ultimate fair value of each reporting unit is determined considering the results of both valuation methods. We did not recognize any goodwill impairment losses in 2018, 2017 or 2016. Identifiable intangible assets Our primary identifiable intangible assets include: customer relationships, trade names, proprietary technology and patents. Identifiable intangibles with definite lives are amortized and those identifiable intangibles with indefinite lives are not amortized. Identifiable intangible assets that are subject to amortization are evaluated for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. Identifiable intangible assets not subject to amortization are tested for impairment annually or more frequently if events warrant. We complete our annual impairment test during the fourth quarter each year for those identifiable assets not subject to amortization. The impairment test for trade names consists of a comparison of the fair value of the trade name with its carrying value. Fair value is measured using the relief-from-royalty method. This method assumes the trade name has value to the extent that the owner is relieved of the obligation to pay royalties for the benefits received from them. This method requires us to estimate the future revenue for the related brands, the appropriate royalty rate and the weighted average cost of capital. During the fourth quarter of 2017, we recorded an impairment charge of $13.0 million related to a trade name in Electrical & Fastening Solutions as a result of lower forecasted sales volume in our annual impairment evaluation. We also recorded an impairment charge of $3.4 million related to certain trade names in Thermal Management as a result of rebranding strategies implemented in the fourth quarter of 2017. An impairment charge of $13.3 million was recorded in 2016 related to a trade name in Thermal Management as a result of a rebranding strategy implemented in the fourth quarter of 2016. The trade name impairment charges were recorded in Selling, general and administrative in our Consolidated and Combined Statements of Income and Comprehensive Income. There were no impairment charges recorded in 2018 for identifiable intangible assets. Pension and other post-retirement plans We sponsor defined-benefit pension plans and a post-retirement health plan ("Direct Plans"). The defined benefit plans cover certain non-U.S. employees and retirees and the pension benefits are based principally on an employee's years of service and/or compensation levels near retirement. For periods prior to the separation, certain nVent employees participated in defined benefit pension plans and post-retirement health plans sponsored by the former Parent, which also include the Parent participants. For purposes of these consolidated and combined financial statements, nVent accounts for these plans as multi-employer benefit plans. Accordingly, nVent does not record an asset or liability to recognize the funded status of these plans. However, nVent does record its share of the allocated expense, including net actuarial gains or losses described below. The amounts recognized in our consolidated and combined financial statements related to our defined-benefit pension and other post-retirement plans are determined from actuarial valuations. Inherent in these valuations are assumptions, including: expected return on plan assets, discount rates and rate of increase in future compensation levels. These assumptions are updated annually and are disclosed for our Direct Plans in ITEM 8, Note 12 to the Notes to Consolidated and Combined Financial Statements. Differences in actual experience or changes in assumptions may affect our pension and other post-retirement obligations and future expense. We recognize changes in the fair value of plan assets and net actuarial gains or losses for pension and other post-retirement benefits annually in the fourth quarter each year (“mark-to-market adjustment”) and, if applicable, in any quarter in which an interim remeasurement is triggered. Net actuarial gains and losses occur when the actual experience differs from any of the various assumptions used to value our pension and other post-retirement plans or when assumptions change, as they may each year. The primary factors contributing to actuarial gains and losses each year are (1) changes in the discount rate used to value pension and other post-retirement benefit obligations as of the measurement date and (2) differences between the expected and the actual return on plan assets. This accounting method also results in the potential for volatile and difficult to forecast mark-to-market adjustments. Mark-to-market adjustments resulted in a pre-tax charge of $7.0 million in 2018, pre-tax gain of $3.0 million in 2017 and pre-tax charge of $10.8 million in 2016. The remaining components of pension expense, including service and interest costs and estimated return on plan assets, are recorded on a quarterly basis as ongoing pension expense. Discount rates The discount rate reflects the current rate at which the pension liabilities could be effectively settled at the end of the year based on our December 31 measurement date. The discount rates on our pension plans ranged from 0.50% to 4.25%, 0.50% to 3.50% and 0.50% to 4.00% in 2018, 2017 and 2016, respectively. There are no known or anticipated changes in our discount rate assumptions that will impact our pension expense in 2019. Expected rates of return The expected rates of return on our pension plan assets ranged from 1.00% to 5.50%, 1.00% to 5.50% and 1.00% to 5.50% in 2018, 2017 and 2016, respectively. The expected rate of return is designed to be a long-term assumption that may be subject to considerable year-to-year variance from actual returns. In developing the expected long-term rate of return, we considered our historical returns, with consideration given to forecasted economic conditions, our asset allocations, input from external consultants and broader longer-term market indices. Any difference in the expected rate and actual returns will be included with the actuarial gain or loss recorded in the fourth quarter when our plans are remeasured. Sensitivity to changes in key assumptions A 0.25 percentage point change in the discount rates used to measure our pension and other post-retirement benefit plans is estimated to have an impact on our total projected benefit obligation of approximately $10 million. A 0.25 percentage point change in the assumed rate of return on pension assets or discount rates for our pension and other post-retirement benefit plans is estimated to have no material impact on our ongoing 2019 pension expense. These estimates exclude any potential mark-to-market adjustments. Income taxes For periods prior to the separation, certain nVent operations were included in Pentair’s U.S. federal and state income tax returns and substantially all income taxes on those operations have been paid by Pentair. Income tax expense and other income tax related information contained in these consolidated and combined financial statements for periods prior to the separation are presented on a separate return approach as if nVent filed its own tax returns. Under this approach, the provision for income taxes represented income tax paid or payable (or received or receivable) for the current year plus the change in deferred taxes during the year calculated as if nVent was a stand-alone taxpayer filing hypothetical income tax returns where applicable. Current income tax liabilities were assumed to be immediately settled with Pentair and relieved through the Net Parent investment account and the Net transfers to Parent in the Consolidated and Combined Statements of Cash Flows. In determining taxable income for financial statement purposes, we must make certain estimates and judgments. These estimates and judgments affect the calculation of certain tax liabilities and the determination of the recoverability of certain of the deferred tax assets, which arise from temporary differences between the tax and financial statement recognition of revenue and expense. In evaluating our ability to recover our deferred tax assets we consider all available positive and negative evidence including our past operating results, the existence of cumulative losses in the most recent years and our forecast of future taxable income. In estimating future taxable income, we develop assumptions including the amount of future pre-tax operating income, the reversal of temporary differences and the implementation of feasible and prudent tax planning strategies. These assumptions require significant judgment about the forecasts of future taxable income and are consistent with the plans and estimates we are using to manage the underlying businesses. We maintain valuation allowances with respect to our deferred tax assets unless it is more likely than not that all or a portion of such deferred tax assets will be realized. Our income tax expense recorded in the future may be reduced to the extent of decreases in our valuation allowances. The realization of our remaining deferred tax assets is primarily dependent on future taxable income in the appropriate jurisdiction. Any reduction in future taxable income including but not limited to any future restructuring activities may require that we record an additional valuation allowance against our deferred tax assets. An increase in the valuation allowance could result in additional income tax expense in such period and could have a significant impact on our future earnings. Changes in tax laws and rates could also affect recorded deferred tax assets and liabilities in the future. Management records the effect of a tax rate or law change on nVent’s deferred tax assets and liabilities in the period of enactment. Future tax rate or law changes could have a material effect on nVent’s financial condition, results of operations or cash flows. In addition, the calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax regulations in a multitude of jurisdictions across our global operations. We perform reviews of our income tax positions on a quarterly basis and accrue for uncertain tax positions. We recognize potential liabilities and record tax liabilities for anticipated tax audit issues in the tax jurisdictions in which we operate based on our estimate of whether, and the extent to which, additional taxes will be due. These tax liabilities are reflected net of related tax loss carryforwards. As events change or resolution occurs, these liabilities are adjusted, such as in the case of audit settlements with taxing authorities. The ultimate resolution may result in a payment that is materially different from our current estimate of the tax liabilities. If our estimate of tax liabilities proves to be less than the ultimate assessment, an additional charge to expense would result. If payment of these amounts ultimately proves to be less than the recorded amounts, the reversal of the liabilities would result in tax benefits being recognized in the period when we determine the liabilities are no longer necessary. We recognize the effect of income tax positions only if those positions are more likely than not to be sustained. Recognized income tax positions are measured at the largest amount that is more likely than not to be realized. Changes in recognition or measurement are reflected in the period in which the change in judgment occurs.
0.013326
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<s>[INST] Forwardlooking statements This report contains statements that we believe to be "forwardlooking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. All statements, other than statements of historical fact are forwardlooking statements. Without limitation, any statements preceded or followed by or that include the words "targets," "plans," "believes," "expects," "intends," "will," "likely," "may," "anticipates," "estimates," "projects," "should," "would," "positioned," "strategy," "future," "forecast" or words, phrases or terms of similar substance or the negative thereof, are forwardlooking statements. These forwardlooking statements are not guarantees of future performance and are subject to risks, uncertainties, assumptions and other factors, some of which are beyond our control, which could cause actual results to differ materially from those expressed or implied by such forwardlooking statements. These factors include; adverse effects on our business operations or financial results as a result of the consummation of the separation (as defined below); the ability of our business to operate independently following the separation; overall global economic and business conditions impacting our business; the ability to achieve the benefits of our restructuring plans; the ability to successfully identify, finance, complete and integrate acquisitions; competition and pricing pressures in the markets we serve, including the impacts of tariffs; the strength of housing and related markets; volatility in currency exchange rates and commodity prices; inability to generate savings from excellence in operations initiatives consisting of lean enterprise, supply management and cash flow practices; increased risks associated with operating foreign businesses; the ability to deliver backlog and win future project work; failure of markets to accept new product introductions and enhancements; the impact of changes in laws and regulations, including those that limit U.S. tax benefits; the outcome of litigation and governmental proceedings; and the ability to achieve our longterm strategic operating goals. Additional information concerning these and other factors is contained in our filings with the U.S. Securities and Exchange Commission (the "SEC"), including this Annual Report on Form 10K. All forwardlooking statements speak only as of the date of this report. nVent Electric plc assumes no obligation, and disclaims any obligation, to update the information contained in this report. Overview nVent is a leading global provider of electrical connection and protection solutions. We believe our inventive electrical solutions enable safer systems and ensure a more secure world. We design, manufacture, market, install, and service high performance products and solutions that connect and protect some of the world’s most sensitive equipment, buildings, and critical processes. We offer a comprehensive range of enclosures, electrical connections and fastening, and thermal management solutions across industryleading brands that are recognized globally for quality, reliability, and innovation. We classify our operations into business segments based primarily on types of products offered and markets served. We operate across three segments: Enclosures, Thermal Management, and Electrical & Fastening Solutions, which contributed 46%, 28% and 26% of total revenues during 2018, respectively. We classify our operations into business segments based primarily on types of products offered and markets served: Enclosures The Enclosures segment provides inventive solutions that protect, connect and manage heat in critical electronics, communication, control, and power equipment. From metallic and nonmetallic enclosures to cabinets, subracks and backplanes, it offers the physical infrastructure to host, connect and protect server and network equipment, as well as indoor and outdoor protection for broadband voice, data and video surveillance applications in industrial, infrastructure, commercial, and energy verticals. Thermal Management The Thermal Management segment provides electric thermal solutions that connect and protect critical buildings, infrastructure, industrial processes and people. Its thermal management systems include heat tracing, floor heating, firerated and specialty wiring, sensing and snow melting and deicing solutions for use in industrial, energy, commercial & residential and infrastructure verticals. Its highly reliable and easy to install solutions lower total cost of ownership to building owners, facility managers, operators and end users. Electrical & Fastening Solutions The Electrical & Fastening Solutions segment provides fastening solutions that connect and protect electrical and mechanical systems and civil structures. Its engineered electrical and fastening products are used across [/INST] Positive. </s>
2,019
8,780
1,720,635
nVent Electric plc
2020-02-25
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 refers to and should be read in conjunction with the audited consolidated and combined financial statements and the corresponding notes included in ITEM 8. Forward-looking statements This report contains statements that we believe to be "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. All statements, other than statements of historical fact are forward-looking statements. Without limitation, any statements preceded or followed by or that include the words "targets," "plans," "believes," "expects," "intends," "will," "likely," "may," "anticipates," "estimates," "projects," "should," "would," "positioned," "strategy," "future," "forecast" or words, phrases or terms of similar substance or the negative thereof, are forward-looking statements. These forward-looking statements are not guarantees of future performance and are subject to risks, uncertainties, assumptions and other factors, some of which are beyond our control, which could cause actual results to differ materially from those expressed or implied by such forward-looking statements. These factors include; adverse effects on our business operations or financial results as a result of the consummation of the separation (as defined below); overall global economic and business conditions impacting our business; the ability to achieve the benefits of our restructuring plans; the ability to successfully identify, finance, complete and integrate acquisitions, including the acquisition of Eldon Holding AB ("Eldon"); competition and pricing pressures in the markets we serve, including the impacts of tariffs; volatility in currency exchange rates and commodity prices; inability to generate savings from excellence in operations initiatives consisting of lean enterprise, supply management and cash flow practices; increased risks associated with operating foreign businesses; the ability to deliver backlog and win future project work; failure of markets to accept new product introductions and enhancements; the impact of changes in laws and regulations, including those that limit U.S. tax benefits; the outcome of litigation and governmental proceedings; and the ability to achieve our long-term strategic operating goals. Additional information concerning these and other factors is contained in our filings with the U.S. Securities and Exchange Commission (the "SEC"), including this Annual Report on Form 10-K. All forward-looking statements speak only as of the date of this report. nVent Electric plc assumes no obligation, and disclaims any obligation, to update the information contained in this report. The following is the discussion and analysis of changes in the financial condition and results of operations for fiscal year 2019 compared to fiscal year 2018. The discussion and analysis of fiscal year 2017 and changes in the financial condition and results of operations for fiscal year 2018 compared to fiscal year 2017 that are not included in this Form 10-K may be found in Part II, ITEM 7 of our Annual Report on Form 10-K/A for the fiscal year ended December 31, 2018, filed with the SEC on March 1, 2019. Overview nVent is a leading global provider of electrical connection and protection solutions. We believe our inventive electrical solutions enable safer systems and ensure a more secure world. We design, manufacture, market, install, and service high performance products and solutions that connect and protect some of the world’s most sensitive equipment, buildings, and critical processes. We offer a comprehensive range of enclosures, electrical connections and fastening, and thermal management solutions across industry-leading brands that are recognized globally for quality, reliability, and innovation. We classify our operations into business segments based primarily on types of products offered and markets served. We operate across three segments: Enclosures, Thermal Management, and Electrical & Fastening Solutions, which represented approximately 47%, 27% and 26% of total revenues during 2019, respectively. • Enclosures - The Enclosures segment provides inventive solutions that protect, connect and manage heat in critical electronics, communication, control, and power equipment. From metallic and non-metallic enclosures to cabinets, subracks and backplanes, it offers the physical infrastructure to host, connect and protect server and network equipment, as well as indoor and outdoor protection for test and measurement, aerospace and defense applications in industrial, infrastructure, energy and commercial verticals. • Thermal Management - The Thermal Management segment provides electric thermal solutions that connect and protect critical buildings, infrastructure, industrial processes and people. Its thermal management systems include heat tracing, floor heating, fire-rated and specialty wiring, sensing and snow melting and de-icing solutions for use in industrial, commercial & residential, energy and infrastructure verticals. It's highly reliable and easy to install solutions lower total cost of ownership to building owners, facility managers, operators and end users. • Electrical & Fastening Solutions - The Electrical & Fastening Solutions segment provides fastening solutions that connect and protect electrical and mechanical systems and civil structures. Its engineered electrical and fastening products are innovative cost efficient and labor saving connections that are used across a wide range of verticals, including commercial, industrial, infrastructure and energy. On April 30, 2018, Pentair plc ("Pentair" or "former Parent") completed the separation of its Water business and its Electrical business into two independent, publicly-traded companies (the "separation"). To effect the separation, Pentair distributed to its shareholders one ordinary share of nVent for every ordinary share of Pentair held as of the record date of April 17, 2018. As a result of the distribution, nVent is now an independent publicly-traded company and began regular way trading under the symbol "NVT" on the New York Stock Exchange on May 1, 2018. The Company was incorporated in Ireland on May 30, 2017. Although our jurisdiction of organization is Ireland, we manage our affairs so that we are centrally managed and controlled in the United Kingdom (the "U.K.") and have tax residency in the U.K. On August 30, 2019, as part of our Enclosures segment, we completed the acquisition of Eldon for $127.8 million, net of cash acquired. Eldon is an innovative European-based manufacturer of enclosures that protect sensitive electrical, electronic and data and telecommunications components. Key trends and uncertainties regarding our existing business The following trends and uncertainties affected our financial performance in 2019 and 2018, and will likely impact our results in the future: • We have identified specific product, vertical and geographic market opportunities that we find attractive and continue to pursue, both within and outside the U.S. We are positioning our businesses to more effectively address these opportunities through research and development and additional sales and marketing resources. Unless we successfully penetrate these markets, our organic sales growth will likely be limited or may decline. • We have experienced material and other cost inflation. We strive for productivity improvements and we implement increases in selling prices to help mitigate this inflation. We expect the current economic environment, including the impacts of tariffs, will result in continuing price volatility for many of our raw materials and purchased components and we are uncertain as to the timing and impact of these market changes. • During 2019 and 2018, we continued execution of certain business restructuring initiatives aimed at reducing our fixed cost structure and realigning our business. In 2020, our operating objectives include the following: • Achieving differentiated revenue growth through new products and solutions and vertical market expansion in key developing regions; • Driving operating excellence through lean enterprise initiatives, with specific focus on sourcing and supply management, cash flow management and lean operations; • Optimizing our technological capabilities to increasingly generate innovative new and connected products and advance digital transformation; and • Focusing on developing global talent in light of our global presence. The financial statements for periods prior to April 30, 2018 were prepared on a stand-alone basis derived from the consolidated financial statements and records of the former Parent as if nVent had operated on a stand-alone basis. For periods prior to the separation, the consolidated and combined financial statements of nVent include general corporate expenses of the former Parent for certain support functions that were provided on a centralized basis, such as expenses related to executive management, finance, audit, legal, information technology, human resources, communications, facilities and employee benefits and compensation. These general corporate expenses are included in the Consolidated and Combined Statements of Operations and Comprehensive Income within Selling, general and administrative expense and Other expense. These expenses were allocated to nVent on the basis of direct usage when identifiable, with the remainder allocated based on a proportional basis of net sales, headcount or other measures. nVent considers the allocation methodology regarding the former Parent’s general corporate expenses to be reasonable for periods presented prior to the separation. Nevertheless, the consolidated and combined financial statements of nVent for periods prior to the separation may not reflect the actual expenses that would have been incurred and may not reflect nVent’s consolidated and combined results of operations, financial position and cash flows had it been a stand-alone company during the periods presented. CONSOLIDATED AND COMBINED RESULTS OF OPERATIONS The consolidated and combined results of operations were as follows: N.M. Not Meaningful Net sales The components of the consolidated net sales change were as follows: The 0.4 percent decrease in net sales in 2019 from 2018 was primarily the result of: • unfavorable foreign currency effects; and • slowdown in capital spending resulting in organic sales decline of approximately 1.5% contributed from our industrial business in 2019 from 2018. This decrease was partially offset by: • sales of $30.6 million in 2019 as a result of the Eldon acquisition; and • organic sales growth contribution of approximately 1.0% from our commercial & residential business, which includes selective increases in selling prices. Gross profit The 0.3 percentage point decrease in gross profit as a percentage of sales in 2019 from 2018 was primarily the result of: • inflationary increases related to certain raw materials, labor and freight costs; and • sales volume decline resulting in decreased leverage on fixed expenses and cost of goods sold. This decrease was partially offset by: • selective increases in selling prices to mitigate cost increases; and • savings generated from our lean and supply management practices. Selling, general and administrative ("SG&A") The 1.5 percentage point decrease in SG&A expense as a percentage of sales in 2019 from 2018 was driven by: • non-recurring separation costs of $45.0 million incurred in 2018 to prepare nVent to operate as an independent stand-alone public company; and • savings generated from restructuring and other lean initiatives. This decrease was partially offset by: • restructuring and other costs of $24.2 million in 2019, compared to $7.7 million in 2018; • investment in sales and marketing to drive growth; and • inflationary increases impacting our labor costs. Provision for income taxes The 0.6 percentage point decrease in the effective tax rate in 2019 from 2018 was primarily due to: • the mix of global earnings towards lower tax rate jurisdictions. SEGMENT RESULTS OF OPERATIONS The summary that follows provides a discussion of the results of operations of our three reportable segments (Enclosures, Thermal Management and Electrical & Fastening Solutions). Each of these segments comprises various product offerings that serve multiple end markets. We evaluate performance based on sales and segment income and use a variety of ratios to measure performance of our reporting segments. Segment income (loss) represents operating income exclusive of intangible amortization, separation costs, costs of restructuring activities, impairments and other unusual non-operating items. Enclosures The net sales and segment income for Enclosures were as follows: Net sales The components of the change in Enclosures net sales were as follows: The 1.4 percent increase in Enclosures net sales in 2019 from 2018 was primarily the result of: • net sales of $30.6 million in 2019 as a result of the Eldon acquisition; and • organic sales growth contribution of approximately 1.0% from our commercial & residential business, which includes selective increases in selling prices. This increase was partially offset by: • unfavorable foreign currency effects; and • slowdown in capital spending resulting in organic sales decline of approximately 1.0% contributed from our industrial business. Segment income The components of the change in Enclosures segment income as a percentage of net sales from the prior period were as follows: The 0.4 percentage point increase in segment income for Enclosures as a percentage of net sales in 2019 from 2018 was primarily the result of: • selective increases in selling prices to mitigate inflationary cost increases; and • savings generated from restructuring and lean initiatives. This increase was partially offset by: • inflationary increases related to certain raw materials, labor and freight costs; and • lower sales volume resulting in decreased leverage on fixed expenses. Thermal Management The net sales and segment income for Thermal Management were as follows: Net sales The components of the change in Thermal Management net sales were as follows: The 5.2 percent decrease in Thermal Management net sales in 2019 from 2018 was primarily the result of: • slowdown in capital spending resulting in organic sales decline of approximately 5.0% contributed from our industrial business; and • unfavorable foreign currency effects. This decrease was partially offset by: • organic sales growth in the after-market repair and maintenance component of our industrial business. Segment income The components of the change in Thermal Management segment income as a percentage of net sales from the prior period were as follows: The 0.1 percentage point decrease in segment income for Thermal Management as a percentage of net sales in 2019 from 2018 was primarily the result of: • lower sales volume resulting in decreased leverage on fixed expenses; • inflationary increases related to certain raw materials, labor and freight costs; and • the impact of unfavorable product mix. This decrease was partially offset by: • savings generated from restructuring and lean initiatives; and • selective increases in selling prices to mitigate inflationary cost increases. Electrical & Fastening Solutions The net sales and segment income for Electrical & Fastening Solutions were as follows: Net sales The components of the change in Electrical & Fastening Solutions net sales were as follows: The 1.6 percent increase in Electrical & Fastening Solutions net sales in 2019 from 2018 was primarily the result of: • organic sales growth contribution of approximately 2.0% from our commercial & residential business, which includes selective increases in selling prices. This increase was partially offset by • unfavorable foreign currency effects. Segment income The components of the change in Electrical & Fastening Solutions segment income as a percentage of net sales from the prior period were as follows: The 0.5 percentage point increase in segment income for Electrical & Fastening Solutions as a percentage of net sales in 2019 from 2018 was primarily the result of: • selective increases in selling prices to offset inflationary cost increases; and • savings generated from our lean and supply management practices. This increase was partially offset by: • inflationary increases related to certain raw materials, labor and freight costs. LIQUIDITY AND CAPITAL RESOURCES The primary source of liquidity for our business is cash flows provided by operations. For periods prior to the separation, transfers of cash to and from the former Parent's cash management system have been reflected in the Net Parent investment in the historical Consolidated and Combined Statements of Cash Flows and Consolidated and Combined Statements of Changes in Equity. In connection with the separation, our capital structure and sources of liquidity changed significantly from our historical capital structure. Our businesses no longer participate in cash management and funding arrangements with the former Parent. We expect to continue to have cash requirements to support working capital needs and capital expenditures, to pay interest and service debt and to pay dividends to shareholders quarterly. We believe we have the ability and sufficient capacity to meet these cash requirements by using available cash and internally generated funds and borrowing under committed credit facilities. We are focused on increasing our cash flow, while continuing to fund our research and development, sales and marketing and capital investment initiatives. Our intent is to maintain investment grade metrics and a solid liquidity position. We experience seasonal cash flows primarily due to increased demand for Thermal Management products and services during the fall and winter months in the Northern Hemisphere and increased demand for Electrical & Fastening Solutions products during the spring and summer months in the Northern Hemisphere. Operating activities Net cash provided by operating activities was $336.3 million in 2019, compared to $343.5 million in 2018. Cash provided by operating activities in 2019 primarily reflects net income, net of non-cash depreciation and amortization, of $319.5 million, and the positive impact of $6.3 million as a result of changes in net working capital. Cash provided by operating activities in 2018 primarily reflects net income, net of non-cash depreciation and amortization, of $327.9 million, and the positive impact of $41.7 million as a result of changes in net working capital. Investing activities Net cash used for investing activities of continuing operations was $160.3 million in 2019, compared to net cash used for investing activities of $39.1 million in 2018. Net cash used for investing activities in 2019 primarily related to cash paid for the acquisition of Eldon of $127.8 million, net of cash acquired, and capital expenditures of $38.8 million. Net cash used for investing activities in 2018 primarily related to capital expenditures of $39.5 million. Capital expenditures are primarily used for capacity expansions of manufacturing facilities, developing new products and general maintenance. Financing activities For periods prior to the separation, transfers of cash, both to and from the former Parent’s centralized cash management system are reflected as a financing activity on the Consolidated and Combined Statements of Cash Flows. Net cash used for financing activities was $226.4 million in 2019, which primarily related to share repurchases of $235.7 million and dividends paid of $120.7 million, partially offset by net receipts of revolving long-term debt of $134.6 million. Net cash used for financing activities was $166.6 million in 2018, which primarily related to $1.0 billion of proceeds from long-term debt, offset by $993.6 million of cash provided to the former Parent in connection with the separation. In addition, we repaid $52.5 million of outstanding principal on the Term Loan Facility, executed share repurchases of $56.0 million and paid dividends of $62.9 million. Senior notes In March 2018, nVent Finance S.à r.l. (“nVent Finance” or “Subsidiary Issuer”), a 100-percent owned subsidiary of nVent, issued $300.0 million aggregate principal amount of 3.950% senior notes due 2023 (the "2023 Notes") and $500.0 million aggregate principal amount of 4.550% senior notes due 2028 (the "2028 Notes" and, collectively with the 2023 Notes, the "Notes"). Interest on the Notes is payable semi-annually in arrears on April 15 and October 15 of each year. The Notes are fully and unconditionally guaranteed as to payment by nVent ("the Parent Company Guarantor"). There are no subsidiaries that guarantee the Notes. The Parent Company Guarantor has no independent assets or operations unrelated to its investments in its consolidated subsidiaries. The Subsidiary Issuer has no independent assets or operations unrelated to its investments in its consolidated subsidiaries and the issuance of the Notes and other external debt. The Notes constitute general unsecured senior obligations of the Subsidiary Issuer and rank equally in right of payment with all existing and future unsubordinated and unsecured indebtedness and liabilities of the Subsidiary Issuer. The guarantees of the Notes by the Parent Company Guarantor constitute general unsecured obligations of the Parent Company Guarantor and rank equally in right of payment with all existing and future unsubordinated and unsecured indebtedness and liabilities of the Subsidiary Issuer. Subject to certain qualifications and exceptions, the indenture pursuant to which the Notes were issued contains covenants that, among other things, restrict nVent’s, nVent Finance’s and certain subsidiaries’ ability to merge or consolidate with another person, create liens or engage in sale and lease-back transactions. There are no significant restrictions on the ability of nVent to obtain funds from its subsidiaries by dividend or loan. None of the assets of nVent or its subsidiaries represents restricted net assets pursuant to the guidelines established by the SEC. Senior credit facilities In March 2018, nVent Finance entered into a credit agreement with a syndicate of banks providing for a five-year $200.0 million senior unsecured term loan facility (the "Term Loan Facility") and a five-year $600.0 million senior unsecured revolving credit facility (the "Revolving Credit Facility" and, together with the Term Loan Facility, the "Senior Credit Facilities"). We have the option to request to increase the Revolving Credit Facility in an aggregate amount of up to $300.0 million, subject to customary conditions, including the commitment of the participating lenders. As of December 31, 2019, there were outstanding borrowings of $134.6 million, and total availability of $465.4 million under the Revolving Credit Facility. Our debt agreements contain certain financial covenants, the most restrictive of which are in the Senior Credit Facilities, including that we may not permit (i) the ratio of our consolidated debt (net of our consolidated unrestricted cash in excess of $5.0 million but not to exceed $250.0 million) to our consolidated net income (excluding, among other things, non-cash gains and losses) before interest, taxes, depreciation, amortization and non-cash share-based compensation expense ("EBITDA") on the last day of any period of four consecutive fiscal quarters to exceed 3.75 to 1.00 and (ii) the ratio of our EBITDA to our consolidated interest expense for the same period to be less than 3.00 to 1.00. In addition, subject to certain qualifications and exceptions, the Senior Credit Facilities also contain covenants that, among other things, restrict our ability to create liens, merge or consolidate with another person, make acquisitions and incur subsidiary debt. As of December 31, 2019, we were in compliance with all financial covenants in our debt agreements. As of December 31, 2019, we have $14.9 million of cash held in certain countries in which the ability to repatriate is limited due to local regulations or significant potential tax consequences. Dividends Dividends paid per ordinary share were $0.70 and $0.35 for the years ended December 31, 2019 and 2018, respectively. On December 10, 2019, the Board of Directors declared a quarterly cash dividend of $0.175 that was paid on February 7, 2020 to shareholders of record at the close of business on January 24, 2020. The balance of dividends payable included in Other current liabilities on our Consolidated Balance Sheets was $29.7 million and $31.0 million at December 31, 2019 and 2018, respectively. On February 25, 2020, the Board of Directors declared a quarterly cash dividend of $0.175 per ordinary share payable on May 8, 2020 to shareholders of record at the close of business on April 24, 2020. Under Irish law, the payment of future cash dividends and repurchases of shares may be paid only out of nVent Electric plc's "distributable reserves" on its statutory balance sheet. nVent Electric plc is not permitted to pay dividends out of share capital, which includes share premiums. Distributable reserves may be created through the earnings of the Irish parent company and through a reduction in share capital approved by the Irish High Court. Distributable reserves are not linked to a generally accepted accounting principles in the United States of America ("GAAP") reported amount (e.g., retained earnings). In June 2018, the Irish High Court approved nVent Electric plc's conversion of approximately $3.8 billion of share premium to distributable reserves, and in July 2018, we made the required filing of nVent Electric plc's initial accounts with the Irish Companies Registration Office to complete the process. Authorized shares Our authorized share capital consists of 400.0 million ordinary shares with a par value of $0.01 per share. Share repurchases On July 23, 2018, the Board of Directors authorized the repurchase of our ordinary shares up to a maximum dollar limit of $500.0 million (the "2018 Authorization'"). On February 19, 2019, the Board of Directors authorized the repurchase of our ordinary shares up to a maximum dollar limit of $380.0 million (the "2019 Authorization"). The 2018 and 2019 Authorizations expire on July 23, 2021. During the year ended December 31, 2019, we repurchased 9.0 million of our ordinary shares for $232.7 million under the 2018 Authorization. As of December 31, 2019, we had $588.3 million available for repurchases under the 2018 and 2019 Authorizations, which total $880.0 million. Contractual obligations The following summarizes our significant contractual obligations that impact our liquidity: The majority of the purchase obligations represent commitments for raw materials to be utilized in the normal course of business. For purposes of the above table, arrangements are considered purchase obligations if a contract specifies all significant terms, including fixed or minimum quantities to be purchased, a pricing structure and approximate timing of the transaction. In addition to the summary of significant contractual obligations, we will incur annual interest expense on outstanding variable rate debt. As of December 31, 2019, variable interest rate debt was $269.6 million at a weighted average interest rate of 3.167%. The total gross liability for uncertain tax positions at December 31, 2019 was estimated to be $17.0 million. We record penalties and interest related to unrecognized tax benefits in Provision (benefit) for income taxes and Net interest expense, respectively, which is consistent with our past practices. As of December 31, 2019, we had recorded $1.7 million for the possible payment of penalties and $3.0 million related to the possible payment of interest. Other financial measures In addition to measuring our cash flow generation or usage based upon operating, investing and financing classifications included in the Consolidated and Combined Statements of Cash Flows, we also measure our free cash flow. Free cash flow is a non-GAAP financial measure that we use to assess our cash flow performance. We believe free cash flow is an important measure of liquidity because it provides us and our investors a measurement of cash generated from operations that is available to pay dividends, make acquisitions, repay debt and repurchase shares. In addition, free cash flow is used as a criterion to measure and pay compensation-based incentives. Our measure of free cash flow may not be comparable to similarly titled measures reported by other companies. The following table is a reconciliation of free cash flow: Off-balance sheet arrangements At December 31, 2019, we had no off-balance sheet financing arrangements. COMMITMENTS AND CONTINGENCIES We have been, and in the future may be, made parties to a number of actions filed or have been, and in the future may be, given notice of potential claims relating to the conduct of our business, including those pertaining to commercial or contractual disputes, product liability, environmental, safety and health, patent infringement and employment matters. While we believe that a material impact on our consolidated financial position, results of operations or cash flows from any such future claims or potential claims is unlikely, given the inherent uncertainty of litigation, a remote possibility exists that a future adverse ruling or unfavorable development could result in future charges that could have a material impact. We do and will continue to periodically re-examine our estimates of probable liabilities and any associated expenses and receivables and make appropriate adjustments to such estimates based on experience and developments in litigation. As a result, the current estimates of the potential impact on our consolidated financial position, results of operations and cash flows for the proceedings and claims described in ITEM 8, Note 16 of the Notes to the Consolidated and Combined Financial Statements could change in the future. Stand-by Letters of Credit, Bank Guarantees and Bonds In disposing of assets or businesses, we often provide representations, warranties and indemnities to cover various risks including unknown damage to assets, environmental risks involved in the sale of real estate, liability to investigate and remediate environmental contamination at waste disposal sites and manufacturing facilities and unidentified tax liabilities and legal fees related to periods prior to disposition. We do not have the ability to reasonably estimate the potential liability due to the inchoate and unknown nature of these potential liabilities. However, we have no reason to believe that these uncertainties would have a material adverse effect on our financial position, results of operations or cash flows. In the ordinary course of business, we are required to commit to bonds, letters of credit and bank guarantees that require payments to our customers for any non-performance. The outstanding face value of these instruments fluctuates with the value of our projects in process and in our backlog. In addition, we issue financial stand-by letters of credit primarily to secure our performance to third parties under self-insurance programs. As of December 31, 2019 and 2018, the outstanding value of bonds, letters of credit and bank guarantees totaled $70.0 million and $75.8 million, respectively. NEW ACCOUNTING STANDARDS See ITEM 8, Note 1 of the Notes to Consolidated and Combined Financial Statements, included in this Form 10-K, for information pertaining to recently adopted accounting standards or accounting standards to be adopted in the future. CRITICAL ACCOUNTING POLICIES We have adopted various accounting policies to prepare the consolidated and combined financial statements in accordance with GAAP. Our significant accounting policies are more fully described in ITEM 8, Note 1 of the Notes to Consolidated and Combined Financial Statements. Certain of our accounting policies require the application of significant judgment by management in selecting the appropriate assumptions for calculating financial estimates. By their nature, these judgments are subject to an inherent degree of uncertainty. These judgments are based on our historical experience, terms of existing contracts, our observance of trends in the industry and information available from other outside sources, as appropriate. We consider an accounting estimate to be critical if: • it requires us to make assumptions about matters that were uncertain at the time we were making the estimate; and • changes in the estimate or different estimates that we could have selected would have had a material impact on our financial condition or results of operations. Our critical accounting estimates include the following: Cost allocations For periods prior to the separation, the consolidated and combined financial statements of nVent include general corporate expenses of the former Parent for certain support functions that were provided on a centralized basis, such as expenses related to executive management, finance, audit, legal, information technology, human resources, communications, facilities and employee benefits and compensation. These general corporate expenses are included in the Consolidated and Combined Statements of Operations and Comprehensive Income within Selling, general and administrative expense and Other expense. The amount allocated was $42.5 million for the year ended December 31, 2018, of which $10.3 million was historically recorded to the Electrical segment in the former Parent’s consolidated financial statements. These expenses were allocated to nVent on the basis of direct usage when identifiable, with the remainder allocated based on a proportional basis of net sales, headcount or other measures. The Company considers the allocation methodology regarding the former Parent’s general corporate expenses to be reasonable for all periods presented. Nevertheless, the consolidated and combined financial statements of nVent for periods prior to the separation may not reflect the actual expenses that would have been incurred and may not reflect nVent’s consolidated and combined results of operations, financial position and cash flows had it been a stand-alone company during the periods presented. Actual costs for periods prior to the separation that would have been incurred if nVent had been a stand-alone company would depend on multiple factors including organization structure, capital structure and strategic decisions made in various areas, including information technology and infrastructure. Transactions between nVent and the former Parent have been included in related party transactions in these consolidated and combined financial statements and were considered to be effectively settled at the time the transaction was recorded. The total net effect of the settlement of these transactions is reflected in the Consolidated and Combined Statements of Cash Flows as a financing activity. Impairment of goodwill and indefinite-lived intangibles Goodwill Goodwill represents the excess of the cost of acquired businesses over the net of the fair value of identifiable tangible net assets and identifiable intangible assets purchased and liabilities assumed. Goodwill is tested annually for impairment as of the first day of the fourth quarter, and is tested for impairment more frequently if events or changes in circumstances indicate that the asset might be impaired. The impairment test is performed using a two-step process. In the first step, the fair value of each reporting unit is compared with the carrying amount of the reporting unit, including goodwill. If the estimated fair value is less than the carrying amount of the reporting unit there is an indication that goodwill impairment exists and a second step must be completed in order to determine the amount of the goodwill impairment, if any, which should be recorded. In the second step, an impairment loss is recognized for any excess of the carrying amount of the reporting unit’s goodwill over the implied fair value of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit in a manner similar to a purchase price allocation. The fair value of each reporting unit is determined using a discounted cash flow analysis and market approach. Projecting discounted future cash flows requires us to make significant estimates regarding future revenues and expenses, projected capital expenditures, changes in working capital and the appropriate discount rate. Use of the market approach consists of comparisons to comparable publicly-traded companies that are similar in size and industry. Actual results may differ from those used in our valuations. In developing our discounted cash flow analysis, assumptions about future revenues and expenses, capital expenditures and changes in working capital are based on our annual operating plan and long-term business plan for each of our reporting units. These plans take into consideration numerous factors including historical experience, anticipated future economic conditions, changes in raw material prices and growth expectations for the industries and end markets we participate in. These assumptions are determined over a six year long-term planning period. The six year growth rates for revenues and operating profits vary for each reporting unit being evaluated. Revenues and operating profit beyond 2025 are projected to grow at a perpetual growth rate of 3.0%. Discount rate assumptions for each reporting unit take into consideration our assessment of risks inherent in the future cash flows of the respective reporting unit and our weighted-average cost of capital. We utilized a discount rate ranging from 10.0% to 10.5% for each reporting unit in determining the discounted cash flows in our fair value analysis. In estimating fair value using the market approach, we identify a group of comparable publicly-traded companies for each reporting unit that are similar in terms of size and product offering. These groups of comparable companies are used to develop multiples based on total market-based invested capital as a multiple of earnings before interest, taxes, depreciation and amortization (“EBITDA”). We determine our estimated values by applying these comparable EBITDA multiples to the operating results of our reporting units. The ultimate fair value of each reporting unit is determined considering the results of both valuation methods. We did not recognize any goodwill impairment losses in 2019 and 2018. Identifiable intangible assets Our primary identifiable intangible assets include: customer relationships, trade names, proprietary technologies and patents. Identifiable intangibles with definite lives are amortized and those identifiable intangibles with indefinite lives are not amortized. Identifiable intangible assets that are subject to amortization are evaluated for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. Identifiable intangible assets not subject to amortization are tested for impairment annually or more frequently if events warrant. We complete our annual impairment test during the fourth quarter each year for those identifiable assets not subject to amortization. The impairment test for trade names consists of a comparison of the fair value of the trade name with its carrying value. Fair value is measured using the relief-from-royalty method. This method assumes the trade name has value to the extent that the owner is relieved of the obligation to pay royalties for the benefits received from them. This method requires us to estimate the future revenue for the related brands, the appropriate royalty rate and the weighted average cost of capital. There were no impairment charges recorded in 2019 or 2018 for identifiable intangible assets. Pension and other post-retirement plans We sponsor defined-benefit pension plans and a post-retirement health plan ("Direct Plans"). The defined benefit plans cover certain non-U.S. employees and retirees and the pension benefits are based principally on an employee's years of service and/or compensation levels near retirement. For periods prior to the separation, certain nVent employees participated in defined benefit pension plans and post-retirement health plans sponsored by the former Parent. For purposes of these consolidated and combined financial statements, nVent accounts for these plans as multi-employer benefit plans. Accordingly, nVent does not record an asset or liability to recognize the funded status of these plans. However, nVent does record its share of the allocated expense, including net actuarial gains or losses described below. The amounts recognized in our consolidated and combined financial statements related to our defined-benefit pension and other post-retirement plans are determined from actuarial valuations. Inherent in these valuations are assumptions, including: expected return on plan assets, discount rates and rate of increase in future compensation levels. These assumptions are updated annually and are disclosed for our Direct Plans in ITEM 8, Note 12 to the Notes to Consolidated and Combined Financial Statements. Differences in actual experience or changes in assumptions may affect our pension and other post-retirement obligations and future expense. We recognize changes in the fair value of plan assets and net actuarial gains or losses for pension and other post-retirement benefits annually in the fourth quarter each year (“mark-to-market adjustment”) and, if applicable, in any quarter in which an interim remeasurement is triggered. Net actuarial gains and losses occur when the actual experience differs from any of the various assumptions used to value our pension and other post-retirement plans or when assumptions change, as they may each year. The primary factors contributing to actuarial gains and losses each year are (1) changes in the discount rate used to value pension and other post-retirement benefit obligations as of the measurement date and (2) differences between the expected and the actual return on plan assets. This accounting method also results in the potential for volatile and difficult to forecast mark-to-market adjustments. Mark-to-market adjustments resulted in a pre-tax charge of $27.3 million in 2019 and $7.0 million in 2018. The remaining components of pension expense, including service and interest costs and estimated return on plan assets, are recorded on a quarterly basis as ongoing pension expense. Discount rates The discount rate reflects the current rate at which the pension liabilities could be effectively settled at the end of the year based on our December 31 measurement date. The discount rates on our pension plans ranged from 0.25% to 3.25% and 0.50% to 4.25% in 2019 and 2018, respectively. The discount rates are determined by matching high-quality, fixed-income debt instruments with maturities corresponding to the expected timing of benefit payments as of the annual measurement date for each of the various plans. There are no known or anticipated changes in our discount rate assumptions that will materially impact our pension expense in 2020. Expected rates of return The expected rates of return on our pension plan assets ranged from 1.00% to 5.25% and 1.00% to 5.50% in 2019 and 2018, respectively. The expected rate of return is designed to be a long-term assumption that may be subject to considerable year-to-year variance from actual returns. In developing the expected long-term rate of return, we considered our historical returns, with consideration given to forecasted economic conditions, our asset allocations, input from external consultants and broader long-term market indices. Any difference in the expected rate and actual returns will be included with the actuarial gain or loss recorded in the fourth quarter when our plans are remeasured. Sensitivity to changes in key assumptions A 0.25 percentage point change in the discount rates used to measure our pension and other post-retirement benefit plans is estimated to have an impact on our total projected benefit obligation of approximately $11 million. A 0.25 percentage point change in the assumed rate of return on pension assets or discount rates for our pension and other post-retirement benefit plans is estimated to have no material impact on our ongoing 2020 pension expense. These estimates exclude any potential mark-to-market adjustments. Income taxes For periods prior to the separation, certain nVent operations were included in the former Parent’s U.S. federal and state income tax returns and substantially all income taxes on those operations have been paid by the former Parent. Income tax expense and other income tax related information contained in these consolidated and combined financial statements for periods prior to the separation are presented on a separate return approach as if nVent filed its own tax returns. Under this approach, the provision for income taxes represented income tax paid or payable (or received or receivable) for the current year plus the change in deferred taxes during the year calculated as if nVent was a stand-alone taxpayer filing hypothetical income tax returns where applicable. Current income tax liabilities were assumed to be immediately settled with the former Parent and relieved through the Net Parent investment account and the Net transfers to Parent in the Consolidated and Combined Statements of Cash Flows. In determining taxable income for financial statement purposes, we must make certain estimates and judgments. These estimates and judgments affect the calculation of certain tax liabilities and the determination of the recoverability of certain of the deferred tax assets, which arise from temporary differences between the tax and financial statement recognition of revenue and expense. In evaluating our ability to recover our deferred tax assets we consider all available positive and negative evidence including our past operating results, the existence of cumulative losses in the most recent years and our forecast of future taxable income. In estimating future taxable income, we develop assumptions including the amount of future pre-tax operating income, the reversal of temporary differences and the implementation of feasible and prudent tax planning strategies. These assumptions require significant judgment about the forecasts of future taxable income and are consistent with the plans and estimates we are using to manage the underlying businesses. We maintain valuation allowances with respect to our deferred tax assets unless it is more likely than not that all or a portion of such deferred tax assets will be realized. Our income tax expense recorded in the future may be reduced to the extent of decreases in our valuation allowances. The realization of our remaining deferred tax assets is primarily dependent on future taxable income in the appropriate jurisdiction. Any reduction in future taxable income including but not limited to any future restructuring activities may require that we record an additional valuation allowance against our deferred tax assets. An increase in the valuation allowance could result in additional income tax expense in such period and could have a significant impact on our future earnings. Changes in tax laws and rates could also affect recorded deferred tax assets and liabilities in the future. Management records the effect of a tax rate or law change on nVent’s deferred tax assets and liabilities in the period of enactment. Future tax rate or law changes could have a material effect on nVent’s financial condition, results of operations or cash flows. In addition, the calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax regulations in a multitude of jurisdictions across our global operations. We perform reviews of our income tax positions on a quarterly basis and accrue for uncertain tax positions. We recognize potential liabilities and record tax liabilities for anticipated tax audit issues in the tax jurisdictions in which we operate based on our estimate of whether, and the extent to which, additional taxes will be due. These tax liabilities are reflected net of related tax loss carryforwards. As events change or resolution occurs, these liabilities are adjusted, such as in the case of audit settlements with taxing authorities. The ultimate resolution may result in a payment that is materially different from our current estimate of the tax liabilities. If our estimate of tax liabilities proves to be less than the ultimate assessment, an additional charge to expense would result. If payment of these amounts ultimately proves to be less than the recorded amounts, the reversal of the liabilities would result in tax benefits being recognized in the period when we determine the liabilities are no longer necessary. We recognize the effect of income tax positions only if those positions are more likely than not to be sustained. Recognized income tax positions are measured at the largest amount that is more likely than not to be realized. Changes in recognition or measurement are reflected in the period in which the change in judgment occurs.
-0.028406
-0.02837
0
<s>[INST] Forwardlooking statements This report contains statements that we believe to be "forwardlooking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. All statements, other than statements of historical fact are forwardlooking statements. Without limitation, any statements preceded or followed by or that include the words "targets," "plans," "believes," "expects," "intends," "will," "likely," "may," "anticipates," "estimates," "projects," "should," "would," "positioned," "strategy," "future," "forecast" or words, phrases or terms of similar substance or the negative thereof, are forwardlooking statements. These forwardlooking statements are not guarantees of future performance and are subject to risks, uncertainties, assumptions and other factors, some of which are beyond our control, which could cause actual results to differ materially from those expressed or implied by such forwardlooking statements. These factors include; adverse effects on our business operations or financial results as a result of the consummation of the separation (as defined below); overall global economic and business conditions impacting our business; the ability to achieve the benefits of our restructuring plans; the ability to successfully identify, finance, complete and integrate acquisitions, including the acquisition of Eldon Holding AB ("Eldon"); competition and pricing pressures in the markets we serve, including the impacts of tariffs; volatility in currency exchange rates and commodity prices; inability to generate savings from excellence in operations initiatives consisting of lean enterprise, supply management and cash flow practices; increased risks associated with operating foreign businesses; the ability to deliver backlog and win future project work; failure of markets to accept new product introductions and enhancements; the impact of changes in laws and regulations, including those that limit U.S. tax benefits; the outcome of litigation and governmental proceedings; and the ability to achieve our longterm strategic operating goals. Additional information concerning these and other factors is contained in our filings with the U.S. Securities and Exchange Commission (the "SEC"), including this Annual Report on Form 10K. All forwardlooking statements speak only as of the date of this report. nVent Electric plc assumes no obligation, and disclaims any obligation, to update the information contained in this report. The following is the discussion and analysis of changes in the financial condition and results of operations for fiscal year 2019 compared to fiscal year 2018. The discussion and analysis of fiscal year 2017 and changes in the financial condition and results of operations for fiscal year 2018 compared to fiscal year 2017 that are not included in this Form 10K may be found in Part II, ITEM 7 of our Annual Report on Form 10K/A for the fiscal year ended December 31, 2018, filed with the SEC on March 1, 2019. Overview nVent is a leading global provider of electrical connection and protection solutions. We believe our inventive electrical solutions enable safer systems and ensure a more secure world. We design, manufacture, market, install, and service high performance products and solutions that connect and protect some of the world’s most sensitive equipment, buildings, and critical processes. We offer a comprehensive range of enclosures, electrical connections and fastening, and thermal management solutions across industryleading brands that are recognized globally for quality, reliability, and innovation. We classify our operations into business segments based primarily on types of products offered and markets served. We operate across three segments: Enclosures, Thermal Management, and Electrical & Fastening Solutions, which represented approximately 47%, 27% and 26% of total revenues during 2019, respectively. Enclosures The Enclosures segment provides inventive solutions that protect, connect and manage heat in critical electronics, communication, control, and power equipment. From metallic and nonmetallic enclosures to cabinets, subracks and backplanes, it offers the physical infrastructure to host, connect and protect server and network equipment, as well as indoor and outdoor protection for test and measurement, aerospace and defense applications in industrial, infrastructure, energy and commercial verticals. Thermal Management The Thermal Management segment provides electric thermal solutions that connect and protect critical buildings, infrastructure, industrial processes and people. [/INST] Negative. </s>
2,020
7,494
1,341,317
Bridgewater Bancshares Inc
2019-03-14
2018-12-31
Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General The following discussion and analysis of our results of operations and financial condition should be read in conjunction with the ‘‘Selected Financial Data’’ and our consolidated financial statements and related notes included elsewhere in this report. In addition to historical information, 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 report, 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. Readers of our Annual Report on Form 10-K should consider these risks and uncertainties in evaluating forward-looking statements and should not place undue reliance on forward-looking statements. Overview The Company is a financial holding company headquartered in Bloomington, Minnesota, which is currently celebrating thirteen years of successful operations. The principal sources of funds for loans and investments are transaction, savings, time, and other deposits, and short-term and long-term borrowings. The Company’s principal sources of income are interest and fees collected on loans, interest and dividends earned on investment securities and service charges. The Company’s principal expenses are interest paid on deposit accounts and borrowings, employee compensation and other overhead expenses. The Company’s simple, efficient business model of providing responsive support and unconventional experiences to clients continues to be the underlying principle that drives the Company’s profitable growth. Critical Accounting Policies and Estimates The consolidated financial statements of the Company are prepared based on the application of certain accounting policies, the most significant of which are described in Note 1 of the notes to the consolidated financial statements included as a part of this report. Certain of these policies require numerous estimates and strategic or economic assumptions that may prove inaccurate or subject to variation and may significantly affect the reported results and financial position for the current period or in future periods. The use of estimates, assumptions, and judgments are necessary when financial assets and liabilities are required to be recorded or adjusted to reflect fair value. Assets carried at fair value inherently result in more financial statement volatility. Fair values and information used to record valuation adjustments for certain assets and liabilities are based on either quoted market prices or are provided by other independent third-party sources, when available. When such information is not available, management estimates valuation adjustments. Changes in underlying factors, assumptions or estimates in any of these areas could have a material impact on the future financial condition and results of operations. The JOBS Act permits the Company an extended transition period for complying with new or revised accounting standards affecting public companies. The Company has elected to take advantage of this extended transition period, which means that the financial statements included in this report, as well as any financial statements filed 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 the Company remains an emerging growth company or until the Company affirmatively and irrevocably opts out of the extended transition period under the JOBS Act. The following is a discussion of the critical accounting policies and significant estimates that require us to make complex and subjective judgements. Allowance for Loan Losses The allowance for loan losses, sometimes referred to as the “allowance,” is established through a provision for loan losses which is charged to expense. Loan losses are charged against the allowance when management determines all or a portion of the loan balance to be uncollectible. Subsequent recoveries, if any, are credited to the allowance for cash received on previously charged-off amounts. If the allowance is considered inadequate to absorb future loan losses on existing loans for any reason, including but not limited to, increases in the size of the loan portfolio, increases in charge-offs or changes in the risk characteristics of the loan portfolio, then the provision for loan losses is increased. A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the original contractual terms of the loan agreement. The collection of all amounts due according to original contractual terms means that both the contractual interest and principal payments of a loan will be collected as scheduled in the loan agreement. An impaired loan is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, or, as a practical expedient, at the loan’s observable market price, or the fair value of the underlying collateral, reduced by costs to sell on a discounted basis, is used if a loan is collateral dependent. Investment Securities Impairment Periodically, the Company may need to assess whether there have been any events or economic circumstances to indicate that a security on which there is an unrealized loss is impaired on an other than temporary basis. In any such instance, the Company would consider many factors, including the length of time and the extent to which the fair value has been less than the amortized cost basis, the market liquidity for the security, the financial condition and the near-term prospects of the issuer, expected cash flows, and the intent and ability to hold the investment for a period of time sufficient to recover the temporary loss. Securities on which there is an unrealized loss that is deemed to be other than temporary are written down to fair value, with the write-down recorded as a realized loss in securities gains (losses). The fair values of investment securities are generally determined by various pricing models. The Company evaluates the methodologies used to develop the resulting fair values. The Company performs a semi-annual analysis on the pricing of investment securities to ensure that the prices represent reasonable estimates of fair value. The procedures include initial and ongoing reviews of pricing methodologies and trends. The Company seeks to ensure prices represent reasonable estimates of fair value through the use of broker quotes, current sales transactions from the portfolio and pricing techniques, which are based on the net present value of future expected cash flows discounted at a rate of return market participants would require. As a result of this analysis, if the Company determines there is a more appropriate fair value, the price is adjusted accordingly. Deferred Tax Asset The Company uses the asset and liability method of accounting for income taxes as prescribed by GAAP. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. If currently available information indicates it is “more likely than not” that the deferred tax asset will not be realized, a valuation allowance is established. 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. Accounting for deferred income taxes is a critical accounting estimate because the Company exercises significant judgment in evaluating the amount and timing of recognition of the resulting tax liabilities and assets. Management’s determination of the realization of deferred tax assets is based upon management’s judgment of various future events and uncertainties, including the timing and amount of future income, reversing temporary differences which may offset, and the implementation of various tax plans to maximize realization of the deferred tax asset. These judgments and estimates are inherently subjective and reviewed on a continual basis as regulatory and business factors change. Any reduction in estimated future taxable income may require us to record a valuation allowance against the deferred tax assets. A valuation allowance would result in additional income tax expense in such period, which would negatively affect earnings. Results of Operations Net Income 2018 compared to 2017 Net income was $26.9 million for the year ended December 31, 2018, a 59.4% increase over net income of $16.9 million for the year ended December 31, 2017. Net income per diluted common share for the year ended December 31, 2018 was $0.91, a 35.5% increase, compared to $0.68 per diluted common share for the year ended December 31, 2017. ROA was 1.51% and 1.16% for the years ended December 31, 2018 and 2017, respectively. ROE was 13.87% and 13.18% for the years ended December 31, 2018 and 2017, respectively. The year ended 2017 included a one-time additional expense of $2.0 million related to the enactment of the Tax Cuts and Jobs Act. Excluding the one-time impact of the Tax Cuts and Jobs Act, ROA and ROE for the year ended December 31, 2017 would have been 1.30% and 14.75%, respectively. 2017 compared to 2016 Net income was $16.9 million for the year ended December 31, 2017, a 27.8% increase over net income of $13.2 million for the year ended December 31, 2016. Net income per diluted common share for the year ended December 31, 2017 was $0.68, a 15.6% increase, compared to $0.58 per diluted common share for the year ended December 31, 2016. ROA was 1.16% and 1.20% for the years ended December 31, 2017 and 2016, respectively. ROE was 13.18% and 12.88% for the years ended December 31, 2017 and 2016, respectively. Net Interest Income The Company’s primary source of revenue is net interest income, which is impacted by the level of interest earning assets and related funding sources, as well as changes in the levels of interest rates. The difference between the average yield on earning assets and the average rate paid for interest bearing liabilities is the net interest spread. Noninterest bearing sources of funds, such as demand deposits and shareholders’ equity, also support earning assets. The impact of the noninterest bearing sources of funds is captured in the net interest margin, which is calculated as net interest income divided by average earning assets. Both the net interest margin and net interest spread are presented on a tax-equivalent basis, which means that tax-free interest income has been adjusted to pretax-equivalent income, assuming a 21% federal tax rate beginning in 2018. A 35% federal tax rate has been applied to periods prior to 2018. Management’s ability to respond to changes in interest rates by effective asset-liability management techniques is critical to maintaining net interest margin and the momentum of the Company’s primary source of earnings. Average Balances and Yields The following table shows, for the years ended December 31, 2018, 2017, and 2016, the average balances of each principal category of assets, liabilities and shareholders’ equity, and an analysis of net interest income. The average balances are principally daily averages and, for loans, include both performing and nonperforming balances. Interest income on loans includes the effects of net deferred loan origination fees and costs accounted for as yield adjustments. These tables are presented on a tax-equivalent basis, if applicable. (1) Interest income and average rates for tax-exempt securities are presented on a tax-equivalent basis, assuming a federal income tax rate of 21% in 2018 and 35% in 2017 and 2016. (2) Average loan balances include nonaccrual loans. Interest income on loans includes amortization of deferred loan fees, net of deferred loan costs. (3) Net interest margin includes the tax equivalent adjustment and represents the annualized results of: (i) the difference between interest income on interest earning assets and the interest expense on interest bearing liabilities, divided by (ii) average interest earning assets for the period. Interest Rates and Operating Interest Differential Increases and decreases in interest income and interest expense result from changes in average balances (volume) of interest earning assets and interest bearing liabilities, as well as changes in average interest rates. The following tables show the effect that these factors had on the interest earned on interest earning assets and the interest incurred on interest bearing liabilities. The effect of changes in volume is determined by multiplying the change in volume by the previous period’s average rate. Similarly, the effect of rate changes is calculated by multiplying the change in average rate by the previous period’s volume. Changes which are not due solely to volume or rate have been allocated to these categories based on the respective percentage changes in average volume and average rate as they compare to each other. The following table presents the changes in the volume and rate of interest bearing assets and liabilities for the year ended December 31, 2018, compared to the year ended December 31, 2017, and for the year ended December 31, 2017, compared to the year ended December 31, 2016. Interest Income, Interest Expense, and Net Interest Margin 2018 Compared to 2017 Net interest income was $64.7 million for the year ended December 31, 2018, an increase of $10.6 million, or 19.5%, compared to $54.2 million for the year ended December 31, 2017. The increase in net interest income was largely attributable to growth in average interest earning assets, particularly strong organic growth in the loan portfolio. Net interest margin (on a fully tax-equivalent basis) for the year ended December 31, 2018 was 3.72%, compared to 3.92% for the year ended December 31, 2017, a decrease of 20 basis points. While net interest margin has benefitted from the repricing of variable rate loans and the origination of new loans at higher rates, this was outpaced by increased balances and rates on deposits and borrowings. Furthermore, the lower statutory federal tax rate reduced the net interest income tax equivalent adjustment by six basis points. Average interest earning assets for the year ended December 31, 2018 increased $327.0 million, or 22.7%, to $1.77 billion from $1.44 billion for the year ended December 31, 2017. This increase in average interest earning assets was due to continued organic growth in the loan portfolio as a result of increased loan production. Average interest bearing liabilities increased $223.5 million, or 21.9%, to $1.24 billion for the year ended December 31, 2018, from $1.02 billion for the year ended December 31, 2017. The increase in average interest bearing liabilities was due to an increase in interest bearing deposits, federal funds purchased, FHLB advances, and the issuance of $25.0 million of subordinated debentures in July of 2017. Average interest earning assets produced a tax-equivalent yield of 4.88% for year ended December 31, 2018, compared to 4.76% for the year ended December 31, 2017. The average rate paid on interest bearing liabilities was 1.65% for the year ended December 31, 2018, compared to 1.19% for the year ended December 31, 2017. Interest Income. Total interest income on a tax-equivalent basis was $86.2 million for the year ended December 31, 2018, compared to $68.5 million for the year ended December 31, 2017. The $17.7 million, or 25.8%, increase in total interest income on a tax-equivalent basis was primarily due to organic growth in the loan portfolio. Interest income on loans for the year ended December 31, 2018 was $78.0 million, compared to $60.0 million for the year ended December 31, 2017. The $18.0 million, or 30.0%, increase was due to a 26.6% increase in the average balance of loans outstanding and a 13 basis point increase in the average yield on loans. The increase in the average balance of loans outstanding was due to organic loan growth. The increase in yield on the loan portfolio resulted primarily from repricing of variable rate loans and new loan production at yields accretive to the existing portfolio yield. Interest income on the investment securities portfolio on a fully-tax equivalent basis decreased $473,000, or 5.8%, during the year ended December 31, 2018 compared to the year ended December 31, 2017, despite a $13.6 million increase in average balances between the periods. Interest Expense. Interest expense on interest bearing liabilities increased $8.3 million, or 68.3%, to $20.5 million for the year ended December 31, 2018, compared to $12.2 million for the year ended December 31, 2017, due to increases in interest rates and average balances of both deposits and borrowings. Interest expense on deposits increased to $16.0 million for the year ended December 31, 2018, compared to $9.7 million for the year ended December 31, 2017. The $6.3 million, or 64.3%, increase in interest expense on deposits was primarily due to the average balance of deposits increasing 18.8% combined with a 41 basis point increase in the average rate paid. The increase in the average balance of deposits resulted primarily from increases in savings and money market deposits, time deposits, and brokered deposits. The increase in the average rate paid was primarily due to the impact of higher market interest rates demanded on deposits in the local and wholesale markets. Interest expense on borrowings increased $2.1 million to $4.5 million for the year ended December 31, 2018, compared to $2.5 million for the year ended December 31, 2017. This increase was primarily due to increased rates and average balances of federal funds purchased and FHLB advances, offset in part by a reduction in interest expense on notes payable as a result of a decreased principal balance. 2017 Compared to 2016 Net interest income was $54.2 million for year ended December 31, 2017, an increase of $12.1 million, or 28.6%, compared to $42.1 million for year ended December 31, 2016. The increase in net interest income was largely attributable to growth in average interest earning assets, particularly strong organic growth in the loan portfolio. Net interest margin (on a fully tax-equivalent basis) for the year ended December 31, 2017 was 3.92%, compared to 4.00% for the year ended December 31, 2016, a decrease of 8 basis points. While net interest margin benefitted from the repricing of variable rate loans and the origination of new loans at higher rates, this was offset by increased balances and rates on non-core deposits and borrowings. Average interest earning assets for the year ended December 31, 2017 increased $350.9 million, or 32.2%, to $1.44 billion from $1.09 billion for the year ended December 31, 2016. This increase in average interest earning assets was due to continued organic growth in the loan portfolio as a result of increased loan production. Average interest bearing liabilities increased $242.1 million, or 31.1%, to $1.0 billion for the year ended December 31, 2017, from $777.7 million for the year ended December 31, 2016. The increase in average interest bearing liabilities was primarily due to an increase in interest bearing deposits, federal funds purchased, and the issuance of $25.0 million of subordinated debentures in July of 2017. Average interest earning assets produced a tax-equivalent yield of 4.76% for the year ended December 31, 2017, compared to 4.78% for the year ended December 31, 2016. The average rate paid on interest bearing liabilities was 1.19% for the year ended December 31, 2017, compared to 1.09% for the year ended December 31, 2016. Interest Income. Total interest income on a tax-equivalent basis was $68.5 million for the year ended December 31, 2017, compared to $52.0 million for the year ended December 31, 2016. The $16.5 million, or 31.7%, increase in total interest income on a tax-equivalent basis was primarily due to growth in our loan and investment securities portfolios. Interest income on loans for the year ended December 31, 2017 was $60.0 million, compared to $46.6 million for the year ended December 31, 2016. The $13.4 million, or 28.7%, increase was primarily due to a 31.3% increase in the average balance of loans outstanding, offset in part by a 10 basis point decrease in the average yield on loans. The increase in the average balance of loans outstanding was primarily due to loan growth in commercial real estate loans. The decrease in yield on the loan portfolio resulted primarily from the lagging of repricing from the historic low interest rate environment and competitive pricing pressure in the market. Interest income on our investment securities portfolio on a fully-tax equivalent basis increased $3.1 million, or 61.9% to $8.2 million in the year ended December 31, 2017, compared to the year ended December 31, 2016. Such growth in investment securities was intended to address our rising loan-to-deposit ratio and further diversify our earning asset composition. Furthermore, meaningful growth in the investment securities portfolio added necessary on-balance sheet liquidity, as investment securities were more actively utilized for pledging to public entities. Interest Expense. Interest expense on interest bearing liabilities increased $3.7 million, or 43.0%, to $12.2 million for the year ended December 31, 2017, compared to $8.5 million for the year ended December 31, 2016, primarily due to increases in average balances of both deposits and borrowings. Interest expense on deposits increased to $9.7 million for the year ended December 31, 2017, compared to $7.0 million for the year ended December 31, 2016. The $2.8 million, or 39.7%, increase in interest expense on deposits was primarily due to the average balance of deposits increasing 32.2% combined with a 4 basis point increase in the average rate paid. Interest expense on borrowings increased $895,000 to $2.5 million for the year ended December 31, 2017, compared to $1.6 million for the year ended December 31, 2016. This increase was primarily due to the issuance of $25.0 million in subordinated debentures in July 2017, as well as an increased average balance of federal funds purchased, offset in part by a reduction in interest expense on notes payable as a result of decreased principal balance. Provision for Loan Losses 2018 Compared to 2017 The allowance for loan losses increased $3.5 million as of December 31, 2018, compared to December 31, 2017, reflecting a provision for loan losses of $3.6 million and net charge-offs of $46,000 during 2018. The provision for loan losses was $3.6 million for the year ended December 31, 2018, a decrease of $600,000, compared to the provision for loan losses of $4.2 million for the year ended December 31, 2017, due primarily to continued strength in credit quality. The allowance for loan losses at December 31, 2018 represented 1.20% of loans outstanding, compared to 1.22% at December 31, 2017. 2017 Compared to 2016 The allowance for loan losses increased $4.2 million as of December 31, 2017, compared to December 31, 2016, reflecting a provision for loan losses of $4.2 million and net charge-offs of $6,000 during 2017. The provision for loan losses was $4.2 million for the year ended December 31, 2017, an increase of $925,000, compared to the provision for loan losses of $3.3 million for the year ended December 31, 2016, due primarily to growth in the loan portfolio. The allowance for loan losses at December 31, 2017 represented 1.22% of loans outstanding, compared to 1.23% at December 31, 2016. The following table presents a summary of the activity in the allowance for loan losses for the years ended December 31, 2018, 2017, and 2016: Noninterest Income 2018 Compared to 2017 Noninterest income was $2.5 million for the years ended December 31, 2018 and 2017, an increase of $7,000. The marginal increase was largely due to increased fees related to customer deposit accounts as a result of the overall increase in the number of our deposit clients, increased fees earned for letters of credit due to increased volume, and a decrease in losses on sales of securities. This activity was offset by an increased loss on sales of foreclosed assets. 2017 Compared to 2016 Noninterest income was $2.5 million and $2.6 million for the years ended December 31, 2017 and 2016, a decrease of $31,000. The marginal decrease was due to the company realizing a net loss of $250,000 on sales of investment securities in 2017 compared to a net gain of $830,000 in 2016. This was offset in part by increased gains on the sale of foreclosed assets of $386,000 and increased letter of credit fees of $230,000. Increased fees related to customer deposit accounts were due to an overall increase in the number of our deposit clients. The following table presents the major components of noninterest income for the year ended December, 2018, compared to the year ended December 31, 2017, and for the year ended December 31, 2017, compared to the year ended December 31, 2016: Noninterest Expense 2018 Compared to 2017 Noninterest expense totaled $31.6 million for the year ended December 31, 2018, a $6.1 million, or 23.8% increase from $25.5 million for the year ended December 31, 2017. The increase was primarily driven by a $4.6 million increase in salaries and employee benefits as the result of increased staff to meet the needs of the Company’s growth and merit increases, a $1.4 million increase in amortization of tax credit investments, a $261,000 increase in information technology and telecommunication expenses to support the Company’s growing infrastructure, and a $359,000 increase in marketing expenses to increase brand recognition in its market area. The increases were partially offset by a decrease of $1.1 million in professional and consulting fees due to higher expenses incurred during 2017 for preparation of the Company’s initial public offering, in comparison to 2018. Full-time equivalent employees increased from 114 as of December 31, 2017, to 140 as of December 31, 2018. The increase includes key strategic hires, particularly in deposit gathering roles, as the Company continues to capitalize on M&A disruption in its market area. Efficiency Ratio. The efficiency ratio, a non-GAAP financial measure, reports total noninterest expense, less amortization of intangible assets, as a percentage of net interest income plus total noninterest income less gains (losses) on sales of securities. Management believes this non-GAAP financial measure provides a meaningful comparison of operational performance and facilitates investors’ assessments of business performance and trends in comparison to peers in the banking industry. The Company’s efficiency ratio, and its comparability to some peers, is negatively impacted by the amortization of tax credit investments within noninterest expense. The efficiency ratio was 46.5% for the year ended December 31, 2018, a marginal increase over 44.4% for the year ended December 31, 2017. The amortization of tax credit investments elevated the level of operating expenses in both years, and while the recognition of the tax credits increases operating expenses, and concurrently the efficiency ratio, it directly reduces income tax expense and the effective tax rate. The adjusted efficiency ratio, which excludes the impact of the amortization of tax credit investments, remained generally consistent at 41.7% for the year ended December 31, 2018, compared to 41.1% for the year ended December 31, 2017. 2017 Compared to 2016 Noninterest expense totaled $25.5 million for the year ended December 31, 2017, a $5.3 million, or 26.4%, increase from $20.2 million for the year ended December 31, 2016. The increase was primarily driven by a $2.0 million increase in salaries and employee benefits as the result of merit increases and increased staff to meet the needs of the Company’s growth, a $1.3 million increase in professional and consulting expenses incurred in preparation of the Company’s IPO, and a $1.9 million expense related to the amortization of tax credit investments. Full-time equivalent employees increased from 97 as of December 31, 2016, to 114 as of December 31, 2017. The increase in staffing was due to the Company’s growing infrastructure, particularly in areas to support preparing to become and operate as a publicly traded company. Efficiency Ratio. The efficiency ratio was 44.4% for the year ended December 31, 2017, a marginal decrease over 45.8% for the year ended December 31, 2016, despite the amortization of tax credit investments elevating the level of operating expenses in 2017. The adjusted efficiency ratio, which excludes the impact of the amortization of tax credit investments, decreased more meaningfully to 41.1% for the year ended December 31, 2017, compared to 45.8% for the year ended December 31, 2016, due primarily to favorable operating leverage. The following table presents the major components of noninterest expense for the year ended December 31, 2018, compared to the year ended December 31, 2017, and the year ended December 31, 2017, compared to the year ended December 31, 2016: The Company expects future increases in noninterest expense as the Company continues investing in infrastructure to support balance sheet growth. Management remains focused on supporting growth primarily by adding to staff, investing in technology, and by enhancing risk controls. At the same time, management seeks to contain costs whenever prudent, which is evident in the stable nature of the efficiency ratio. Income Tax Expense The provision for income taxes includes both federal and state taxes. Fluctuations in effective tax rates reflect the differences in the inclusion or deductibility of certain income and expenses for income tax purposes. Our future effective income tax rate will fluctuate based on the mix of taxable and tax-free investments and loans, the recognition and availability of tax credit investments, and overall taxable income. In both periods, comparability is impacted by the enactment of the Tax Cuts and Jobs Act on December 22, 2017. The legislation reduced the federal corporate tax rate from 35% in 2017 and periods prior to 21% starting in 2018 and required the Company to charge a one-time revaluation of the deferred tax asset of $2.0 million to the provision for income taxes. 2018 Compared to 2017 Income tax expense was $5.2 million for the year ended December 31, 2018, compared to $10.1 million for the year ended December 31, 2017. The effective combined federal and state income tax rate for the year ended December 31, 2018 was 16.3%, compared to 37.5% for the year ended December 31, 2017. The lower effective combined rate was primarily due to the recognition of $3.8 million of tax credit investments and reduction in the federal corporate tax rate. The recognition of tax credit investments significantly impacts the Company’s effective tax rate. Excluding the impact of tax credit investments, the effective combined federal and state income tax rate for the year ended December 31, 2018 was 25.5%. 2017 Compared to 2016 Income tax expense was $10.1 million for the year ended December 31, 2017, compared to $8.1 million for the year ended December 31, 2016. The increase in tax expenses was due to the increase of taxable earnings and a $2.0 million expense related to the revaluation of the deferred tax asset in 2017, offset in part by a historic tax credit benefit of $1.6 million. The effective tax rate for the years ended December 31, 2017 and 2016 was 37.5% and 37.9%, respectively. Financial Condition Overview Total assets at December 31, 2018 were $1.97 billion, an increase of $357.1 million, or 22.1%, from December 31, 2017. Total gross loans increased $317.8 million, or 23.6%, from December 31, 2017. Securities available for sale were $253.4 million at December 31, 2018, an increase of $23.4 million, or 10.4%, from December 31, 2017. Total liabilities at December 31, 2018 were $1.75 billion, an increase of $273.3 million, or 18.5%, from December 31, 2017. Total deposits increased $221.6 million, or 16.5%, from December 31, 2017. Total borrowings were $181.6 million, an increase of $49.1 million, or 37.1%, from December 31, 2017. Investment Securities Portfolio The investment securities portfolio is used to make various term investments and is intended to provide the Company with adequate liquidity, a source of stable income, and at times, serve as collateral for certain types of deposits. Investment balances in the investment securities portfolio are subject to change over time based on funding needs and interest rate risk management objectives. The liquidity levels take into account anticipated future cash flows and are maintained at levels management believes are appropriate to assure future flexibility in meeting anticipated funding needs. The investment securities portfolio consists primarily of municipal securities, U.S. government agency mortgage-backed securities, and Small Business Administration, or SBA, securities, although the Company also holds U.S. treasury securities, corporate securities and other debt securities, all with varying contractual maturities. These maturities do not necessarily represent the expected life of the securities as the securities may be called or paid down without penalty prior to their stated maturities. All investment securities are held as available for sale. Securities available for sale were $253.4 million at December 31, 2018, compared to $229.5 million at December 31, 2017, an increase of $23.9 million or 10.4%. At December 31, 2018, municipal securities represented 46.6% of the investment securities portfolio, government agency mortgage-backed securities represented 18.0% of the portfolio, SBA securities represented 19.4% of the portfolio, corporate securities represented 8.3% of the portfolio, U.S. treasury securities represented 7.1% of the portfolio, and other mortgage-backed securities represented 0.6% of the portfolio. The following table presents the amortized cost and fair value of securities available for sale, by type, at December 31, 2018 and 2017. The following tables present the fair value of securities as of December 31, 2018 and December 31, 2017 by their stated maturities, as well as the fully tax-equivalent yields for each maturity range. Loan Portfolio The Company focuses on lending to borrowers located or investing in the Twin Cities MSA across a diverse range of industries and property types. The Company lends primarily to commercial customers, consisting of loans secured by nonfarm, nonresidential properties, loans secured by multifamily residential properties, construction loans, land development loans, and commercial and industrial loans. Responsive service, local decision making, and an efficient turnaround time from application to closing have been significant factors in growing the loan portfolio. The Company manages concentrations of credit exposure through a comprehensive program which implements formalized processes and procedures specifically for managing and mitigating risk within the loan portfolio. The processes and procedures include board and management oversight, CRE exposure limits, portfolio monitoring tools, management information systems, market reports, underwriting standards, a credit risk review function, and periodic stress testing to evaluate potential credit risk and the subsequent impact on capital and earnings. Total gross loans increased $317.8 million, or 23.6%, to $1.66 billion at December 31, 2018, compared to $1.35 billion at December 31, 2017. The multifamily, construction and land development, and CRE nonowner occupied categories contributed most significantly to the $317.8 million growth. As of December 31, 2018, multifamily loans increased $90.1 million, or 28.3%, construction and land development loans increased $79.5 million, or 60.8%, and nonowner occupied CRE loans increased $75.6, or 18.2%, when compared to December 31, 2017. The following table details the dollar composition and percentage composition of the loan portfolio by category, at the dates indicated: The Company’s primary focus has been on real estate mortgage lending, which constituted 71.5% of the portfolio as of December 31, 2018. The composition of the portfolio remained consistent with prior periods and although the Company expects continued growth, it does not expect any significant changes in the foreseeable future in the composition of the loan portfolio or in the emphasis on real estate lending. As of December 31, 2018, CRE loans totaled $1.11 billion, consisting of $490.6 million of loans secured by nonowner occupied CRE, $407.9 million of loans secured by multifamily residential properties and $210.0 million of construction and land development loans. CRE loans represented 66.6% of the total gross loan portfolio and 480.2% of the Bank’s total risk-based capital at December 31, 2018. The following table details time to contractual maturity and sensitivity to interest rate changes for the loan portfolio at December 31, 2018: Asset Quality The Company emphasizes credit quality in the originating and monitoring of the loan portfolio, and success in underwriting is measured by the levels of classified and nonperforming assets and net charge-offs. Federal regulations and internal policies require the use of an asset classification system as a means of managing and reporting problem and potential problem assets. The Company has incorporated an internal asset classification system, substantially consistent with federal banking regulations, as a part of the credit monitoring system. Federal banking regulations set forth a classification scheme for problem and potential problem assets as “substandard,” “doubtful” or “loss” assets. An asset is considered “substandard” if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. “Substandard” assets include those characterized by the “distinct possibility” that the insured institution will sustain “some loss” if the deficiencies are not corrected. Assets classified as “doubtful” have all of the weaknesses inherent in those classified “substandard” with the added characteristic that the weaknesses present make “collection or liquidation in full,” on the basis of currently existing facts, conditions, and values, “highly questionable and improbable.” Assets classified as “loss” are those considered “uncollectible” and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted. Assets which do not currently expose the insured institution to sufficient risk to warrant classification in one of the aforementioned categories but possess weaknesses are required to be designated “watch.” The following table presents information on loan classifications at December 31, 2018. The Company had no assets classified as doubtful or loss. Nonperforming Assets Nonperforming loans include loans accounted for on a nonaccrual basis and loans 90 days past due and still accruing. Nonperforming assets consist of nonperforming loans plus foreclosed assets. Nonaccrual loans totaled $581,000 as of December 31, 2018 and $1.1 million as of December 31, 2017, a decrease of $558,000. There were no loans 90 days past due and still accruing as of December 31, 2018 and 2017. There were no foreclosed assets as of December 31, 2018 and $581,000 as of December 31, 2017, a decrease of $581,000. The following table summarizes nonperforming assets, by category, at the dates indicated: (1) Nonperforming assets are defined as nonaccrual loans and loans greater than 90 days past due still accruing plus foreclosed assets. There were no loans greater than 90 days past due still accruing for any period shown. The balance of nonperforming assets can fluctuate due to changes in economic conditions. The Company has established a policy to discontinue accruing interest on a loan (that is, place the loan on nonaccrual status) after it has become 90 days delinquent as to payment of principal or interest, unless the loan is considered to be well-collateralized and is actively in the process of collection. In addition, a loan will be placed on nonaccrual status before it becomes 90 days delinquent unless management believes that the collection of interest is expected. Interest previously accrued but uncollected on such loans is reversed and charged against current income when the receivable is determined to be uncollectible. If management believes that a loan will not be collected in full, an increase to the allowance for loan losses is recorded to reflect management’s estimate of any potential exposure or loss. Generally, payments received on nonaccrual loans are applied directly to principal. There are not any loans, outside of those included in the table above, that cause management to have serious doubts as to the ability of borrowers to comply with present repayment terms. Due to the low levels of nonaccrual loans, gross income that would have been recorded is immaterial. Allowance for Loan Losses The allowance for loan losses is a reserve established through charges to earnings in the form of a provision for loan losses. The Company maintains an allowance for loan losses at a level management considers adequate to provide for known and probable incurred losses in the portfolio. The level of the allowance is based on management’s evaluation of estimated losses in the portfolio, after consideration of risk characteristics of the loans and prevailing and anticipated economic conditions. Loan charge-offs (i.e., loans judged to be uncollectible) are charged against the reserve and any subsequent recovery is credited to the reserve. The Company analyzes risks within the loan portfolio on a continual basis. A risk system, consisting of multiple grading categories for each portfolio class, is utilized as an analytical tool to assess risk and appropriate reserves. In addition to the risk system, management further evaluates risk characteristics of the loan portfolio under current and anticipated economic conditions and considers such factors as the financial condition of the borrower, past and expected loss experience, and other factors which management feels deserve recognition in establishing an appropriate reserve. These estimates are reviewed at least quarterly, and, as adjustments become necessary, they are recognized in the periods in which they become known. Although management strives to maintain an allowance it deems adequate, future economic changes, deterioration of borrowers’ creditworthiness, and the impact of examinations by regulatory agencies all could cause changes to the allowance for loan losses. At December 31, 2018, the allowance for loan losses was $20.0 million, an increase of $3.5 million from $16.5 million at December 31, 2017. Net charge-offs totaled $46,000 during the year ended December 31, 2018 and $6,000 during the year ended December 31, 2017. The allowance for loan losses as a percentage of total loans was 1.20% at December 31, 2018 and 1.22% at December 31, 2017. The following is a summary of the activity in the allowance for loan loss reserve for the periods indicated: The following table presents a summary of the allocation of the allowance for loan losses by loan portfolio segment for the periods indicated: Goodwill and Other Intangible Assets Goodwill was $2.6 million at December 31, 2018 and December 31, 2017. Goodwill represents the excess of the consideration paid over the fair value of the net assets acquired, which originated from the acquisition of First National Bank of the Lakes in May of 2016. Goodwill is not amortized but is subject to, at a minimum, an annual test for impairment. Other intangible assets consist of core deposit relationships and favorable lease term intangibles. Total other intangible assets at December 31, 2018 and December 31, 2017 were $1.0 million and $1.2 million, respectively. Other intangible assets are amortized over their estimated useful life. Deposits The principal sources of funds for the Company are core deposits, consisting of demand deposits, money market accounts, savings accounts, and certificates of deposit. The following table details the dollar and percentage composition of the deposit portfolio, by category, at the dates indicated: Total deposits at December 31, 2018 were $1.56 billion, an increase of $221.6 million, or 16.5%, compared to total deposits of $1.34 billion at December 31, 2017. Noninterest bearing deposits were $369.2 million at December 31, 2018, compared to $292.5 million at December 31, 2017. Noninterest bearing deposits comprised 23.6% of total deposits at December 31, 2018, compared to 21.9% at December 31, 2017. The Company relies on increasing the deposit base to fund loan and other asset growth. The Company is in a highly competitive market and competes for local deposits by offering attractive products with competitive rates. The Company expects to have a higher average cost of funds for local deposits compared to competitor banks due to the lack of an extensive branch network. The Company’s strategy is to offset the higher cost of funding with a lower level of operating expense and firm pricing discipline for loan products. When appropriate, the Company utilizes alternative funding sources such as brokered deposits. At December 31, 2018, total brokered deposits were $291.2 million or 18.7% of total deposits. The following table presents the average balance and average rate paid on each of the following deposit categories for the years ended December 31, 2018, 2017, and 2016: The following table shows time deposits, including brokered time deposits, of $100,000 or more, by time remaining until maturity. Borrowed Funds Federal Funds Purchased In addition to deposits, the Company utilizes overnight borrowings to meet the daily liquidity needs of clients and fund loan growth. The following table summarizes overnight borrowings, which consist of federal funds purchased from correspondent banks on an overnight basis at the prevailing overnight market rates and the weighted average interest rates paid for the periods presented: Other Borrowings At December 31, 2018, other borrowings outstanding consisted of FHLB advances of $124.0 million and notes payable of $15.0 million. The Company’s borrowing capacity at the FHLB is determined based on collateral pledged, generally consisting of loans. The Company had additional borrowing capacity under this credit facility of $122.1 million and $180.9 million at December 31, 2018 and December 31, 2017, respectively. Additionally, the Company has borrowing capacity from other sources. As of December 31, 2018, the Bank was eligible to use the Federal Reserve discount window for borrowings. Based on assets available for collateral as of the applicable date, the Bank’s borrowing availability was approximately $114.1 million and $37.5 million at December 31, 2018 and December 31, 2017, respectively. As of December 31, 2018 and December 31, 2017, the Company had no outstanding advances. The Company has entered into a swap agreement with an unaffiliated third party in order to hedge interest rate risk associated with the notes payable. This agreement provides for the Company to make payments at a fixed rate in exchange for receiving payments at a variable rate determined by one-month LIBOR. Subordinated Debentures On July 12, 2017, the Company issued $25.0 million of subordinated debentures at an initial fixed interest rate of 5.875% which is payable semi-annually. Beginning July 15, 2022, the interest rate converts to a variable interest rate equal to the three-month LIBOR plus 3.88%. The subordinated debentures mature on July 15, 2027. The subordinated debentures, net of issuance costs, were $24.6 million at December 31, 2018, compared to $24.5 million at December 31, 2017. The subordinated debentures qualify as Tier 2 regulatory capital treatment for the first five years, under applicable regulatory guidelines. Contractual Obligations The following table contains supplemental information regarding total contractual obligations at December 31, 2018: On August 27, 2018, the Bank and Reuter Walton Commercial, LLC (the “Contractor”) entered into a Standard Form of Agreement Between Owner and Contractor and the corresponding General Conditions of the Contract for Construction (collectively, the “Construction Contract”). Under the Construction Contract, the Contractor will construct the core and shell of a new headquarters building for the Bank in St. Louis Park, Minnesota, and the Bank will pay the Contractor a contract price consisting of the cost of work plus a fee equal to 3.75% of the cost of work, subject to a guaranteed maximum price of $23.0 million, with anticipated construction to be completed in 2020. As of December 31, 2018, $2.0 million has been paid under this Construction Contract. Operating lease obligations are in place for facilities and land on which banking branches are located. See Note 6 of the Company’s Consolidated Financial Statements included as part of this report for additional information. The Company believes that it will be able to meet all contractual obligations as they come due through the maintenance of adequate cash levels. The Company expects to maintain adequate cash levels through earnings, loan and securities repayments and maturity activity and continued deposit gathering activities. As described above, the Company has in place various borrowing mechanisms for both short-term and long-term liquidity needs. Shareholders’ Equity Shareholders’ equity at December 31, 2018 was $221.0 million, an increase of $83.8 million, or 61.1%, over shareholders’ equity of $137.2 million at December 31, 2017, primarily due to $58.9 million of net proceeds from the issuance of common stock in the Company’s initial public offering and $26.9 million of net income, offset by a $2.7 million decrease in accumulated other comprehensive income. The decrease in accumulated other comprehensive income primarily resulted from interest rate fluctuations between periods. The Company and the Bank are subject to various regulatory capital requirements administered by federal banking regulators. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by federal banking regulators that, if undertaken, could have a direct material effect on the Company’s and Bank’s business. Under applicable regulatory capital rules, the Company and Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank must also meet certain specific capital guidelines under the prompt corrective action framework. The capital amounts and classification are subject to qualitative judgments by the federal banking regulators about components, risk weightings and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios of common equity Tier 1 capital, Tier 1 capital and total capital to risk-weighted assets and of Tier 1 capital to average consolidated assets (referred to as the “leverage ratio”), as defined under the applicable regulatory capital rules. Management believes the Company and the Bank met all capital adequacy requirements to which they were subject as of December 31, 2018. The regulatory capital ratios for the Company and the Bank to meet the minimum capital adequacy standards and for the Bank to be considered well capitalized under the prompt corrective action framework are set forth in the following tables. The Company’s and the Bank’s actual capital amounts and ratios are as of the dates indicated. The Company and the Bank are subject to the rules of the Basel III regulatory capital framework and related Dodd-Frank Wall Street Reform and Consumer Protection Act. The rules include the implementation of a capital conservation buffer that is added to the minimum requirements for capital adequacy purposes. The capital conservation buffer is subject to a four year phase-in period that began on January 1, 2016, and will be fully phased-in on January 1, 2019, at 2.5%. The required phase-in capital conservation buffer during 2018 was 1.875%. A banking organization with a conservation buffer of less than the required amount will be subject to limitations on capital distributions, including dividend payments, and certain discretionary bonus payments to executive officers. At December 31, 2018, the ratios for the Company and the Bank were sufficient to meet the fully phased-in conservation buffer. Off-Balance Sheet Arrangements In the normal course of business, the Company enters into various transactions to meet the financing needs of clients, which, in accordance with GAAP, are not included in the consolidated balance sheets. These transactions include commitments to extend credit, standby letters of credit, and commercial letters of credit, which involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amounts recognized in the consolidated balance sheets. Most of these commitments mature within two years and the standby letters of credit are expected to expire without being drawn upon. All off-balance sheet commitments are included in the determination of the amount of risk-based capital that the Company and the Bank are required to hold. The Company’s exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit, standby letters of credit, and commercial letters of credit is represented by the contractual or notional amount of those instruments. The Company decreases its exposure to losses under these commitments by subjecting them to credit approval and monitoring procedures. The Company assesses the credit risk associated with certain commitments to extend credit and establishes a liability for probable credit losses. The following table sets forth credit arrangements and financial instruments whose contract amounts represent credit risk as of December 31, 2018 and December 31, 2017: Commitments to extend credit beyond current fundings are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Such commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments may expire without being drawn upon, the total commitment amounts 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 deemed necessary by us upon extension of credit, is based on our management’s credit evaluation. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties. Standby letters of credit are conditional commitments issued by us to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. Commercial letters of credit are issued specifically to facilitate trade or commerce and are paid directly when the underlying transaction is consummated. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Liquidity Liquidity Management Liquidity is the Company’s capacity to meet cash and collateral obligations at a reasonable cost. Maintaining an adequate level of liquidity depends on the Company’s ability to efficiently meet both expected and unexpected cash flows and collateral needs without adversely affecting either daily operations or financial condition. The Bank’s ALM Committee, which is comprised of members of senior management, is responsible for managing commitments to meet the needs of customers while achieving the Company’s financial objectives. The ALM Committee meets regularly to review balance sheet composition, funding capacities, and current and forecasted loan demand. The Company manages liquidity by maintaining adequate levels of cash and other assets from on and off-balance sheet arrangements. Specifically, on-balance sheet liquidity consists of cash and due from banks and unpledged investment securities available for sale, which are referred to as primary liquidity. In regard to off-balance sheet capacity, the Company maintains available borrowing capacity under secured borrowing lines with the FHLB and the Federal Reserve Bank of Minneapolis, as well as unsecured lines of credit for the purpose of overnight funds with various correspondent banks, which the Company refers to as secondary liquidity. In addition, the Bank is a member of the American Financial Exchange (“AFX”), through which it may either borrow or lend funds on an overnight or short-term basis with a group of approved commercial banks. The availability of funds changes daily. As of December 31, 2018, the Company had no borrowings outstanding through the AFX. The following tables provide a summary of primary and secondary liquidity levels as of the dates indicated: During the year ended December 31, 2018, primary liquidity increased $110.3 million due to a $23.9 million increase in securities available for sale, a $4.7 million increase in cash and cash equivalents, and a $81.6 million decrease in pledged securities, when compared to December 31, 2017. Secondary liquidity increased $47.7 million as of December 31, 2018 when compared to December 31, 2017, due to a $76.5 million increase in the borrowing capacity on the secured credit line with the Federal Reserve Bank and a $30.0 million increase in unsecured borrowing capacity with correspondent lenders, offset by a $58.8 million decrease in the borrowing capacity on the secured borrowing line with the FHLB. In addition to primary liquidity, the Company generates liquidity from cash flows from the loan and securities portfolios and from the large base of core customer deposits, defined as noninterest bearing transaction, interest bearing transaction, savings, non-brokered money market accounts and non-brokered time deposits less than $250,000. At December 31, 2018, core deposits totaled approximately $1.16 billion and represented 74.2% of total deposits. These core deposits are normally less volatile, often with customer relationships tied to other products offered by the Company, which promote long-standing relationships and stable funding sources. The Company uses brokered deposits, the availability of which is uncertain and subject to competitive market forces and regulation, for liquidity management purposes. At December 31, 2018, brokered deposits totaled $291.2 million, consisting of $264.2 million of brokered time deposits and $27.0 million of non-maturity brokered money market and transaction accounts. At December 31, 2017, brokered deposits totaled $207.5 million, consisting of $183.4 million of brokered time deposits and $24.1 million of non-maturity brokered money market accounts. The Company has increased the amount of brokered deposits in recent quarters because of the efficiency in obtaining such deposits relative to comparable core deposit offerings, and the callable nature embedded in the structures, should rates decline. The Company’s liquidity policy includes guidelines for On-Balance Sheet Liquidity (a measurement of primary liquidity to total deposits plus borrowings), Total On-Balance Sheet Liquidity with Borrowing Capacity (a measurement of primary and secondary liquidity to total deposits plus borrowings), Wholesale Funding Ratio (a measurement of total wholesale funding to total deposits plus borrowings), and other guidelines developed for measuring and maintaining liquidity. As of December 31, 2018 and 2017, the Company was in compliance with all established liquidity guidelines. GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures Some of the financial data included in this report are not measures of financial performance recognized by GAAP. Management uses these non-GAAP financial measures in the analysis of performance: · ‘‘Efficiency ratio’’ is defined as noninterest expense less the amortization of intangibles divided by our operating revenue, which is equal to net interest income plus noninterest income excluding gains and losses on sales of securities. In our judgment, the adjustments made to operating revenue allow investors and analysts to better assess our operating expenses in relation to our core operating revenue by removing the volatility that is associated with certain one-time items and other discrete items that are unrelated to our core business. · ‘‘Adjusted Efficiency ratio’’ is defined as the efficiency ratio adjusted to exclude the amortization of tax credit investments from noninterest expense. · “Tangible common equity’’ is defined as shareholders’ equity reduced by goodwill and other intangible assets. We believe that this measure is important to many investors in the marketplace who are interested in changes from period to period in shareholders’ equity exclusive of changes in intangible assets. Goodwill and other intangibles that were recorded in a purchase business combination have the effect of increasing both equity and assets while not increasing our tangible equity or tangible assets. · ‘‘Tangible common equity to tangible assets’’ is defined as the ratio of tangible common equity, as defined above, divided by total assets reduced by goodwill and other intangible assets. We believe that this measure is important to many investors in the market place who are interested in relative changes from period to period in shareholders’ equity to total assets, each exclusive of changes in intangible assets. Goodwill and other intangibles that were recorded in a purchase business combination have the effect of increasing both equity and assets while not increasing our tangible equity or tangible assets. · ‘‘Tangible book value per share’’ is defined as tangible shareholders’ equity divided by total common voting and non-voting shares outstanding. We believe that this measure is important to many investors in the marketplace who are interested in changes from period to period in book value per share exclusive of changes in intangible assets. Goodwill and other intangibles that were recorded in a purchase business combination have the effect of increasing book value while not increasing our tangible book value. The Company believes these non-GAAP financial measures provide useful information to management and investors that is supplementary to our financial condition, results of operations and cash flows computed in accordance with GAAP; however, we acknowledge that our non-GAAP financial measures have a number of limitations. As such, you should not view these disclosures as a substitute for results determined in accordance with GAAP, and they are not necessarily comparable to non-GAAP financial measures that other companies use. The following reconciliation table provides a more detailed analysis of these non-GAAP financial measures:
0.021872
0.022306
0
<s>[INST] The following discussion and analysis of our results of operations and financial condition should be read in conjunction with the ‘‘Selected Financial Data’’ and our consolidated financial statements and related notes included elsewhere in this report. In addition to historical information, 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 report, may cause actual results to differ materially from those projected in the forward looking statements. We assume no obligation to update any of these forwardlooking statements. Readers of our Annual Report on Form 10K should consider these risks and uncertainties in evaluating forwardlooking statements and should not place undue reliance on forwardlooking statements. Overview The Company is a financial holding company headquartered in Bloomington, Minnesota, which is currently celebrating thirteen years of successful operations. The principal sources of funds for loans and investments are transaction, savings, time, and other deposits, and shortterm and longterm borrowings. The Company’s principal sources of income are interest and fees collected on loans, interest and dividends earned on investment securities and service charges. The Company’s principal expenses are interest paid on deposit accounts and borrowings, employee compensation and other overhead expenses. The Company’s simple, efficient business model of providing responsive support and unconventional experiences to clients continues to be the underlying principle that drives the Company’s profitable growth. Critical Accounting Policies and Estimates The consolidated financial statements of the Company are prepared based on the application of certain accounting policies, the most significant of which are described in Note 1 of the notes to the consolidated financial statements included as a part of this report. Certain of these policies require numerous estimates and strategic or economic assumptions that may prove inaccurate or subject to variation and may significantly affect the reported results and financial position for the current period or in future periods. The use of estimates, assumptions, and judgments are necessary when financial assets and liabilities are required to be recorded or adjusted to reflect fair value. Assets carried at fair value inherently result in more financial statement volatility. Fair values and information used to record valuation adjustments for certain assets and liabilities are based on either quoted market prices or are provided by other independent thirdparty sources, when available. When such information is not available, management estimates valuation adjustments. Changes in underlying factors, assumptions or estimates in any of these areas could have a material impact on the future financial condition and results of operations. The JOBS Act permits the Company an extended transition period for complying with new or revised accounting standards affecting public companies. The Company has elected to take advantage of this extended transition period, which means that the financial statements included in this report, as well as any financial statements filed 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 the Company remains an emerging growth company or until the Company affirmatively and irrevocably opts out of the extended transition period under the JOBS Act. The following is a discussion of the critical accounting policies and significant estimates that require us to make complex and subjective judgements. Allowance for Loan Losses The allowance for loan losses, sometimes referred to as the “allowance,” is established through a provision for loan losses which is charged to expense. Loan losses are charged against the allowance when management determines all or a portion of the loan balance to be uncollectible. Subsequent recoveries, if any, are credited to the allowance for cash received on previously chargedoff amounts. If the allowance is considered inadequate to absorb future loan losses on existing loans for any reason, including but not limited to, increases in the size of the loan portfolio, increases in chargeoffs or changes in the risk characteristics of the loan portfolio, then the provision for loan losses is increased. A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the original contractual terms of the loan agreement. The collection of all amounts due according to original contractual terms means that both the contractual interest and principal payments of a loan will be collected as scheduled in the loan agreement. An impaired loan is measured based on the present value of expected future cash flows discounted at [/INST] Positive. </s>
2,019
9,872
1,341,317
Bridgewater Bancshares Inc
2020-03-12
2019-12-31
Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General The following discussion and analysis of our results of operations and financial condition should be read in conjunction with the “Selected Financial Data” and our consolidated financial statements and related notes included elsewhere in this report. In addition to historical information, 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 report, 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. Readers of our Annual Report on Form 10-K should consider these risks and uncertainties in evaluating forward-looking statements and should not place undue reliance on forward-looking statements. Overview The Company is a financial holding company headquartered in Bloomington, Minnesota, which is currently celebrating fourteen years of successful operations. The principal sources of funds for loans and investments are transaction, savings, time, and other deposits, and short-term and long-term borrowings. The Company’s principal sources of income are interest and fees collected on loans, interest and dividends earned on investment securities and service charges. The Company’s principal expenses are interest paid on deposit accounts and borrowings, employee compensation and other overhead expenses. The Company’s simple, efficient business model of providing responsive support and unconventional experiences to clients continues to be the underlying principle that drives the Company’s profitable growth. Critical Accounting Policies and Estimates The consolidated financial statements of the Company are prepared based on the application of certain accounting policies, the most significant of which are described in Note 1 of the notes to the consolidated financial statements included as a part of this report. Certain policies require numerous estimates and strategic or economic assumptions that may prove inaccurate or subject to variation and may significantly affect the reported results and financial position for the current period or in future periods. The use of estimates, assumptions, and judgments are necessary when financial assets and liabilities are required to be recorded or adjusted to reflect fair value. Assets carried at fair value inherently result in more financial statement volatility. Fair values and information used to record valuation adjustments for certain assets and liabilities are based on either quoted market prices or are provided by other independent third-party sources, when available. When such information is not available, management estimates valuation adjustments. Changes in underlying factors, assumptions or estimates in any of these areas could have a material impact on the future financial condition and results of operations. Management has discussed each critical accounting policy and the methodology for the identification and determination of critical accounting policies with the Company’s Audit Committee. The JOBS Act permits the Company an extended transition period for complying with new or revised accounting standards affecting public companies. The Company has elected to take advantage of this extended transition period, which means that the financial statements included in this report, as well as any financial statements filed 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 the Company remains an emerging growth company or until the Company affirmatively and irrevocably opts out of the extended transition period under the JOBS Act. The following is a discussion of the critical accounting policies and significant estimates that require the Company to make complex and subjective judgements. Allowance for Loan Losses The allowance for loan losses, sometimes referred to as the “allowance,” is established through a provision for loan losses which is charged to expense. Loan losses are charged against the allowance when management determines all or a portion of the loan balance to be uncollectible. Subsequent recoveries, if any, are credited to the allowance for cash received on previously charged-off amounts. If the allowance is considered inadequate to absorb future loan losses on existing loans for any reason, including but not limited to, increases in the size of the loan portfolio, increases in charge-offs or changes in the risk characteristics of the loan portfolio, then the provision for loan losses is increased. A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the original contractual terms of the loan agreement. The collection of all amounts due according to original contractual terms means that both the contractual interest and principal payments of a loan will be collected as scheduled in the loan agreement. An impaired loan is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, or, as a practical expedient, at the loan’s observable market price, or the fair value of the underlying collateral, reduced by costs to sell on a discounted basis, is used if a loan is collateral dependent. Investment Securities Impairment Periodically, the Company may need to assess whether there have been any events or economic circumstances to indicate that a security on which there is an unrealized loss is impaired on an other than temporary basis. In any such instance, the Company would consider many factors, including the length of time and the extent to which the fair value has been less than the amortized cost basis, the market liquidity for the security, the financial condition and the near-term prospects of the issuer, expected cash flows, and the intent and ability to hold the investment for a period of time sufficient to recover the temporary loss. Securities on which there is an unrealized loss that is deemed to be other than temporary are written down to fair value, with the write-down recorded as a realized loss in securities gains (losses). The fair values of investment securities are generally determined by various pricing models. The Company evaluates the methodologies used to develop the resulting fair values. The Company performs a semi-annual analysis on the pricing of investment securities to ensure that the prices represent reasonable estimates of fair value. The procedures include initial and ongoing reviews of pricing methodologies and trends. The Company seeks to ensure prices represent reasonable estimates of fair value through the use of broker quotes, current sales transactions from the portfolio and pricing techniques, which are based on the net present value of future expected cash flows discounted at a rate of return market participants would require. As a result of this analysis, if the Company determines there is a more appropriate fair value, the price is adjusted accordingly. Deferred Tax Asset The Company uses the asset and liability method of accounting for income taxes as prescribed by GAAP. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. If currently available information indicates it is “more likely than not” that the deferred tax asset will not be realized, a valuation allowance is established. 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. Accounting for deferred income taxes is a critical accounting estimate because the Company exercises significant judgment in evaluating the amount and timing of recognition of the resulting tax liabilities and assets. Management’s determination of the realization of deferred tax assets is based upon management’s judgment of various future events and uncertainties, including the timing and amount of future income, reversing temporary differences which may offset, and the implementation of various tax plans to maximize realization of the deferred tax asset. These judgments and estimates are inherently subjective and reviewed on a continual basis as regulatory and business factors change. Any reduction in estimated future taxable income may require the Company to record a valuation allowance against the deferred tax assets. A valuation allowance would result in additional income tax expense in such period, which would negatively affect earnings. Results of Operations Net Income 2019 compared to 2018 Net income was $31.4 million for the year ended December 31, 2019, a 16.7% increase over net income of $26.9 million for the year ended December 31, 2018. Net income per diluted common share for the year ended December 31, 2019 was $1.05, a 14.5% increase, compared to $0.91 per diluted common share for the year ended December 31, 2018. ROA was 1.49% and 1.51% for the years ended December 31, 2019 and 2018, respectively. ROE was 13.50% and 13.87% for the years ended December 31, 2019 and 2018, respectively. 2018 compared to 2017 Net income was $26.9 million for the year ended December 31, 2018, a 59.4% increase over net income of $16.9 million for the year ended December 31, 2017. Net income per diluted common share for the year ended December 31, 2018 was $0.91, a 35.5% increase, compared to $0.68 per diluted common share for the year ended December 31, 2017. ROA was 1.51% and 1.16% for the years ended December 31, 2018 and 2017, respectively. ROE was 13.87% and 13.18% for the years ended December 31, 2018 and 2017, respectively. The year ended 2017 included a one-time additional expense of $2.0 million related to the enactment of the Tax Cuts and Jobs Act. Excluding the one-time impact of the Tax Cuts and Jobs Act, ROA and ROE for the year ended December 31, 2017 would have been 1.30% and 14.75%, respectively. Net Interest Income The Company’s primary source of revenue is net interest income, which is impacted by the level of interest earning assets and related funding sources, as well as changes in the levels of interest rates. The difference between the average yield on earning assets and the average rate paid for interest bearing liabilities is the net interest spread. Noninterest bearing sources of funds, such as demand deposits and shareholders’ equity, also support earning assets. The impact of the noninterest bearing sources of funds is captured in the net interest margin, which is calculated as net interest income divided by average earning assets. Both the net interest margin and net interest spread are presented on a tax-equivalent basis, which means that tax-free interest income has been adjusted to pretax-equivalent income, assuming a 21% federal tax rate beginning in 2018. A 35% federal tax rate has been applied to periods prior to 2018. Management’s ability to respond to changes in interest rates by effective asset-liability management techniques is critical to maintaining net interest margin. Average Balances and Yields The following table presents, for the years ended December 31, 2019, 2018, and 2017, the average balances of each principal category of assets, liabilities and shareholders’ equity, and an analysis of net interest income. The average balances are principally daily averages and, for loans, include both performing and nonperforming balances. Interest income on loans includes the effects of net deferred loan origination fees and costs accounted for as yield adjustments. These tables are presented on a tax-equivalent basis, if applicable. (1) Interest income and average rates for tax-exempt securities are presented on a tax-equivalent basis, assuming a federal income tax rate of 21% in 2019 and 2018 and 35% in 2017. (2) Average loan balances include nonaccrual loans. Interest income on loans includes amortization of deferred loan fees, net of deferred loan costs. (3) Net interest margin includes the tax equivalent adjustment and represents the annualized results of: (i) the difference between interest income on interest earning assets and the interest expense on interest bearing liabilities, divided by (ii) average interest earning assets for the period. Interest Rates and Operating Interest Differential Increases and decreases in interest income and interest expense result from changes in average balances (volume) of interest earning assets and interest bearing liabilities, as well as changes in average interest rates. The following table presents the effect that these factors had on the interest earned on interest earning assets and the interest incurred on interest bearing liabilities. The effect of changes in volume is determined by multiplying the change in volume by the previous period’s average rate. Similarly, the effect of rate changes is calculated by multiplying the change in average rate by the previous period’s volume. The changes not attributable specifically to either volume or rate have been allocated to the changes due to volume. The following table presents the changes in the volume and rate of interest bearing assets and liabilities for the year ended December 31, 2019, compared to the year ended December 31, 2018, and for the year ended December 31, 2018, compared to the year ended December 31, 2017. Interest Income, Interest Expense, and Net Interest Margin 2019 Compared to 2018 Net interest income was $74.1 million for the year ended December 31, 2019, an increase of $9.4 million, or 14.5%, compared to $64.7 million for the year ended December 31, 2018. The increase in net interest income was largely attributable to growth in average interest earning assets, particularly strong organic growth in the loan portfolio. Net interest margin (on a fully tax-equivalent basis) for the year ended December 31, 2019 was 3.59%, compared to 3.72% for the year ended December 31, 2018, a decrease of 13 basis points. While net interest margin has benefitted from the repricing of variable rate loans and the origination of new loans at higher rates, this was outpaced by increased balances and rates on deposits and borrowings. Average interest earning assets for the year ended December 31, 2019 increased $324.7 million, or 18.4%, to $2.09 billion from $1.77 billion for the year ended December 31, 2018. This increase in average interest earning assets was due to continued organic growth in the loan portfolio as a result of increased loan production. Average interest bearing liabilities increased $217.2 million, or 17.5%, to $1.46 billion for the year ended December 31, 2019, from $1.24 billion for the year ended December 31, 2018. The increase in average interest bearing liabilities was due to an increase in interest bearing deposits and FHLB advances, partially offset by a decrease in federal funds purchased and notes payable. Average interest earning assets produced a tax-equivalent yield of 5.01% for year ended December 31, 2019, compared to 4.88% for the year ended December 31, 2018. The average rate paid on interest bearing liabilities was 2.03% for the year ended December 31, 2019, compared to 1.65% for the year ended December 31, 2018. Interest Income. Total interest income on a tax-equivalent basis was $104.7 million for the year ended December 31, 2019, compared to $86.2 million for the year ended December 31, 2018. The $18.4 million, or 21.4%, increase in total interest income on a tax-equivalent basis was primarily due to strong organic growth in the loan portfolio and an increase in the average yield on loans. Interest income on cash investments increased $505,000, or 202.0%, for the year ended December 31, 2019, compared to the year ended December 31, 2018, due to increased liquidity, which resulted from strong deposit growth. Interest income on the investment securities portfolio on a fully-tax equivalent basis increased $974,000, or 12.6%, for the year ended December 31, 2019, compared to the year ended December 31, 2018, primarily due to a 33 basis point increase in the aggregate portfolio yield. Interest income on loans for the year ended December 31, 2019 was $94.9 million, compared to $78.0 million for the year ended December 31, 2018. The $16.8 million, or 21.6%, increase was due to a $294.8 million, or 19.8%, increase in the average balance of loans outstanding and an 8 basis point increase in the average yield on loans. The increase in the average balance of loans outstanding was due to organic loan growth. The increase in yield on the loan portfolio resulted primarily from strong loan growth at yields accretive to the existing portfolio yield and has enabled the Company to offset the decreases in loan fee income. While deferred fees are regularly amortized into income, fluctuations in the level of loan fees recognized can vary based on prepayments and other factors. The following table presents a summary of interest and fees recognized on loans for the years ended December 31, 2019, 2018 and 2017: Interest Expense. Interest expense on interest bearing liabilities increased $9.2 million, or 44.7%, to $29.6 million for the year ended December 31, 2019, compared to $20.5 million for the year ended December 31, 2018, due to increases in market interest rates and growth in average balances of both deposits and borrowings, partially offset by a decrease in average balances of federal funds purchased. Interest expense on deposits increased to $24.0 million for the year ended December 31, 2019, compared to $16.0 million for the year ended December 31, 2018. The $8.0 million, or 50.2%, increase in interest expense on deposits was primarily due to the average balance of interest bearing deposits increasing $189.9, or 17.4%, combined with a 41 basis point increase in the average rate paid. The increase in the average balance of interest bearing deposits resulted primarily from increases in interest bearing transaction deposits, savings and money market deposits, time deposits and brokered deposits. The increase in the average rate paid was primarily due to the impact of higher market interest rates demanded on deposits in the local and wholesale markets. Interest expense on borrowings increased $1.1 million to $5.7 million for the year ended December 31, 2019, compared to $4.5 million for the year ended December 31, 2018. This increase was primarily due to increased rates and average balances of FHLB advances, offset in part by a reduction in interest expense on federal funds purchased and notes payable as a result of a decrease in the average balances of these types of borrowings. 2018 Compared to 2017 Net interest income was $64.7 million for the year ended December 31, 2018, an increase of $10.6 million, or 19.5%, compared to $54.2 million for the year ended December 31, 2017. The increase in net interest income was largely attributable to growth in average interest earning assets, particularly strong organic growth in the loan portfolio. Net interest margin (on a fully tax-equivalent basis) for the year ended December 31, 2018 was 3.72%, compared to 3.92% for the year ended December 31, 2017, a decrease of 20 basis points. While net interest margin benefitted from the repricing of variable rate loans and the origination of new loans at higher rates, this was outpaced by increased balances and rates on deposits and borrowings. Furthermore, the lower statutory federal tax rate reduced the net interest income tax equivalent adjustment by six basis points. Average interest earning assets for the year ended December 31, 2018 increased $327.0 million, or 22.7%, to $1.77 billion from $1.44 billion for the year ended December 31, 2017. This increase in average interest earning assets was due to continued organic growth in the loan portfolio as a result of increased loan production. Average interest bearing liabilities increased $223.5 million, or 21.9%, to $1.24 billion for the year ended December 31, 2018, from $1.02 billion for the year ended December 31, 2017. The increase in average interest bearing liabilities was due to an increase in interest bearing deposits, federal funds purchased, FHLB advances, and the issuance of $25.0 million of subordinated debentures in July of 2017. Average interest earning assets produced a tax-equivalent yield of 4.88% for year ended December 31, 2018, compared to 4.76% for the year ended December 31, 2017. The average rate paid on interest bearing liabilities was 1.65% for the year ended December 31, 2018, compared to 1.19% for the year ended December 31, 2017. Interest Income. Total interest income on a tax-equivalent basis was $86.2 million for the year ended December 31, 2018, compared to $68.5 million for the year ended December 31, 2017. The $17.7 million, or 25.8%, increase in total interest income on a tax-equivalent basis was primarily due to organic growth in the loan portfolio. Interest income on loans for the year ended December 31, 2018 was $78.0 million, compared to $60.0 million for the year ended December 31, 2017. The $18.0 million, or 30.0%, increase was due to a 26.6% increase in the average balance of loans outstanding and a 13 basis point increase in the average yield on loans. The increase in the average balance of loans outstanding was due to organic loan growth. The increase in yield on the loan portfolio resulted primarily from repricing of variable rate loans and new loan production at yields accretive to the existing portfolio yield. Interest income on the investment securities portfolio on a fully-tax equivalent basis decreased $473,000, or 5.8%, during the year ended December 31, 2018 compared to the year ended December 31, 2017, despite a $13.6 million increase in average balances between the periods. Interest Expense. Interest expense on interest bearing liabilities increased $8.3 million, or 68.3%, to $20.5 million for the year ended December 31, 2018, compared to $12.2 million for the year ended December 31, 2017, due to increases in interest rates and average balances of both deposits and borrowings. Interest expense on deposits increased to $16.0 million for the year ended December 31, 2018, compared to $9.7 million for the year ended December 31, 2017. The $6.3 million, or 64.3%, increase in interest expense on deposits was primarily due to the average balance of deposits increasing 18.8% combined with a 40 basis point increase in the average rate paid. The increase in the average balance of deposits resulted primarily from increases in savings and money market deposits, time deposits, and brokered deposits. The increase in the average rate paid was primarily due to the impact of higher market interest rates demanded on deposits in the local and wholesale markets. Interest expense on borrowings increased $2.1 million to $4.5 million for the year ended December 31, 2018, compared to $2.5 million for the year ended December 31, 2017. This increase was primarily due to increased rates and average balances of federal funds purchased and FHLB advances, offset in part by a reduction in interest expense on notes payable as a result of a decreased principal balance. Provision for Loan Losses 2019 Compared to 2018 The allowance for loan losses increased $2.5 million as of December 31, 2019, compared to December 31, 2018, reflecting a provision for loan losses of $2.7 million and net charge-offs of $205,000 during 2019. The provision for loan losses was $2.7 million for the year ended December 31, 2019, a decrease of $875,000, compared to the provision for loan losses of $3.6 million for the year ended December 31, 2018, due primarily to continued strength in credit quality and consistent performance of the loan portfolio. The allowance for loan losses at December 31, 2019 represented 1.18% of gross loans outstanding, compared to 1.20% at December 31, 2018. 2018 Compared to 2017 The allowance for loan losses increased $3.5 million as of December 31, 2018, compared to December 31, 2017, reflecting a provision for loan losses of $3.6 million and net charge-offs of $46,000 during 2018. The provision for loan losses was $3.6 million for the year ended December 31, 2018, a decrease of $600,000, compared to the provision for loan losses of $4.2 million for the year ended December 31, 2017, due primarily to continued strength in credit quality. The allowance for loan losses at December 31, 2018 represented 1.20% of gross loans outstanding, compared to 1.22% at December 31, 2017. The following table presents a summary of the activity in the allowance for loan losses for the years ended December 31, 2019, 2018, and 2017: Noninterest Income 2019 Compared to 2018 Noninterest income was $3.8 million for the year ended December 31, 2019, compared to $2.5 million for the year ended December 31, 2018, an increase of $1.3 million, or 50.5%. The increase was primarily due to an increase in gains on sales of securities and foreclosed assets and an increase in swap fees, partially offset by decreased letter of credit fees. 2018 Compared to 2017 Noninterest income was $2.5 million for the years ended December 31, 2018 and 2017, an increase of $7,000. The marginal increase was largely due to increased fees related to customer deposit accounts as a result of the overall increase in the number of our deposit clients, increased fees earned for letters of credit due to increased volume, and a decrease in losses on sales of securities. This activity was offset by an increased loss on sales of foreclosed assets. The following table presents the major components of noninterest income for the year ended December 31, 2019, compared to the year ended December 31, 2018, and for the year ended December 31, 2018, compared to the year ended December 31, 2017: Noninterest Expense 2019 Compared to 2018 Noninterest expense totaled $36.9 million for the year ended December 31, 2019, a $5.4 million, or 17.0% increase from $31.6 million for the year ended December 31, 2018. The increase was primarily driven by a $3.5 million increase in salaries and employee benefits as the result of merit increases and increased staff to meet the needs of the Company’s growth, a $734,000 increase in occupancy and equipment and a $565,000 increase in professional and consulting fees. The increases were partially offset by a decrease of $180,000 in FDIC Insurance Assessment due to a credit from the FDIC for a portion of premiums previously paid to the DIF that became refundable when the DIF exceeded 1.38% of insured deposits, which occurred during the year ended December 31, 2019. The Company has no remaining credits as of December 31, 2019. Full-time equivalent employees increased from 140 as of December 31, 2018, to 160 as of December 31, 2019. The increase includes key strategic hires in deposit gathering roles, lending, information technology and other supportive functions as the Company continues to attract talent and capitalize on the M&A disruption in its market area. Efficiency Ratio. The efficiency ratio, a non-GAAP financial measure, reports total noninterest expense, less amortization of intangible assets, as a percentage of net interest income plus total noninterest income less gains (losses) on sales of securities. Management believes this non-GAAP financial measure provides a meaningful comparison of operational performance and facilitates investors’ assessments of business performance and trends in comparison to peers in the banking industry. The Company’s efficiency ratio, and its comparability to some peers, is negatively impacted by the amortization of tax credit investments within noninterest expense. The efficiency ratio was 47.4% for the year ended December 31, 2019, a marginal increase over 46.5% for the year ended December 31, 2018. The amortization of tax credit investments elevated the level of operating expenses in both years, and while the recognition of the tax credits increases operating expenses, and concurrently the efficiency ratio, it directly reduces income tax expense and the effective tax rate. The adjusted efficiency ratio, a non-GAAP financial measure, which excludes the impact of the amortization of tax credit investments, increased slightly to 43.3% for the year ended December 31, 2019, compared to 41.7% for the year ended December 31, 2018. 2018 Compared to 2017 Noninterest expense totaled $31.6 million for the year ended December 31, 2018, a $6.1 million, or 23.8% increase from $25.5 million for the year ended December 31, 2017. The increase was primarily driven by a $4.6 million increase in salaries and employee benefits as the result of merit increases and increased staff to meet the needs of the Company’s growth, a $1.4 million increase in amortization of tax credit investments, a $261,000 increase in information technology and telecommunication expenses to support the Company’s growing infrastructure, and a $359,000 increase in marketing expenses to increase brand recognition in its market area. The increases were partially offset by a decrease of $1.1 million in professional and consulting fees due to higher expenses incurred during 2017 for preparation of the Company’s initial public offering, in comparison to 2018. Full-time equivalent employees increased from 114 as of December 31, 2017, to 140 as of December 31, 2018. Efficiency Ratio. The efficiency ratio was 46.5% for the year ended December 31, 2018, a marginal increase over 44.4% for the year ended December 31, 2017. The amortization of tax credit investments elevated the level of operating expenses in both years, and while the recognition of the tax credits increases operating expenses, and concurrently the efficiency ratio, it directly reduces income tax expense and the effective tax rate. The adjusted efficiency ratio, a non-GAAP financial measure, which excludes the impact of the amortization of tax credit investments, remained generally consistent at 41.7% for the year ended December 31, 2018, compared to 41.1% for the year ended December 31, 2017. The following table presents the major components of noninterest expense for the year ended December 31, 2019, compared to the year ended December 31, 2018, and the year ended December 31, 2018, compared to the year ended December 31, 2017: The Company expects future increases in noninterest expense as the Company continues investing in infrastructure to support balance sheet growth. Management remains focused on supporting growth primarily by adding to staff, investing in technology, and by enhancing risk controls. At the same time, management seeks to contain costs whenever prudent, which is evident in the stable nature of the efficiency ratio. Income Tax Expense The provision for income taxes includes both federal and state taxes. Fluctuations in effective tax rates reflect the differences in the inclusion or deductibility of certain income and expenses for income tax purposes. The Company’s future effective income tax rate will fluctuate based on the mix of taxable and tax-free investments and loans, the recognition and availability of tax credit investments, and overall taxable income. 2019 Compared to 2018 Income tax expense was $6.9 million for the year ended December 31, 2019, compared to $5.2 million for the year ended December 31, 2018. The effective combined federal and state income tax rate for the year ended December 31, 2019 was 18.1%, compared to 16.3% for the year ended December 31, 2018. The higher effective combined rate was primarily due to fewer tax credits being recognized during 2019. The recognition of tax credit investments significantly impacts the Company’s effective tax rate. Excluding the impact of tax credit investments, the effective combined federal and state income tax rate for the year ended December 31, 2019 was 24.8%. 2018 Compared to 2017 In the prior period, comparability is impacted by the enactment of the Tax Cuts and Jobs Act on December 22, 2017. The legislation reduced the federal corporate tax rate from 35% in 2017 and periods prior to 21% starting in 2018 and required the Company to charge a one-time revaluation of the deferred tax asset of $2.0 million to the provision for income taxes. Income tax expense was $5.2 million for the year ended December 31, 2018, compared to $10.1 million for the year ended December 31, 2017. The effective combined federal and state income tax rate for the year ended December 31, 2018 was 16.3%, compared to 37.5% for the year ended December 31, 2017. The lower effective combined rate was primarily due to the recognition of $3.8 million of tax credit investments and reduction in the federal corporate tax rate. Excluding the impact of tax credit investments, the effective combined federal and state income tax rate for the year ended December 31, 2018 was 25.5%. Financial Condition Overview Total assets at December 31, 2019 were $2.27 billion, an increase of $295.1 million, or 15.0%, from December 31, 2018. Total gross loans were $1.91 billion, an increase of $247.1 million, or 14.8%, from December 31, 2018. Securities available for sale were $289.9 million at December 31, 2019, an increase of $36.5 million, or 14.4%, from December 31, 2018. Total liabilities at December 31, 2019 were $2.02 billion, an increase of $271.3 million, or 15.5%, from December 31, 2018. Total deposits increased $262.4 million, or 16.8%, from December 31, 2018. Total borrowings were $174.2 million, a decrease of $7.4 million, or 4.1%, from December 31, 2018. Investment Securities Portfolio The investment securities portfolio is used to make various term investments and is intended to provide the Company with adequate liquidity, a source of stable income, and at times, serve as collateral for certain types of deposits. Investment balances in the investment securities portfolio are subject to change over time based on funding needs and interest rate risk management objectives. The liquidity levels take into account anticipated future cash flows and are maintained at levels management believes are appropriate to assure future flexibility in meeting anticipated funding needs. The investment securities portfolio consists primarily of municipal securities, U.S. government agency mortgage-backed securities, Small Business Administration, or SBA, securities, and corporate securities comprised of subordinated debentures of bank and financial holding companies. In addition, the Company also holds U.S. treasury securities, asset-backed securities and other debt securities, all with varying contractual maturities. These maturities do not necessarily represent the expected life of the securities as the securities may be called or paid down without penalty prior to their stated maturities. All investment securities are held as available for sale. Securities available for sale were $289.9 million at December 31, 2019, compared to $253.4 million at December 31, 2018, an increase of $36.5 million, or 14.4%. At December 31, 2019, municipal securities represented 36.5% of the investment securities portfolio, government agency mortgage-backed securities represented 22.0% of the portfolio, SBA securities represented 17.1% of the portfolio, corporate securities represented 17.3% of the portfolio, U.S. treasury securities represented 1.7% of the portfolio, asset-backed securities represented 5.0% of the portfolio, and other commercial mortgage-backed securities represented 0.4% of the portfolio. The following table presents the amortized cost and fair value of securities available for sale, by type, at December 31, 2019, 2018 and 2017. The following tables present the fair value of securities as of December 31, 2019 and 2018 by their stated maturities, as well as the fully tax-equivalent yields for each maturity range. Loan Portfolio The Company focuses on lending to borrowers located or investing in the Twin Cities MSA across a diverse range of industries and property types. The Company lends primarily to commercial customers, consisting of loans secured by nonfarm, nonresidential properties, loans secured by multifamily residential properties, construction loans, land development loans, and commercial and industrial loans. Responsive service, local decision making, and an efficient turnaround time from application to closing have been significant factors in growing the loan portfolio. The Company manages concentrations of credit exposure through a comprehensive program which implements formalized processes and procedures specifically for managing and mitigating risk within the loan portfolio. The processes and procedures include board and management oversight, CRE exposure limits, portfolio monitoring tools, management information systems, market reports, underwriting standards, a credit risk review function, and periodic stress testing to evaluate potential credit risk and the subsequent impact on capital and earnings. The Company originated net loan exposures of $954.7 million for the year ended December 31, 2019 and $1.1 billion for the year ended December 31, 2018. Net loan exposures include principal advances and unfunded commitments, net of loan participations sold. Total gross loans increased $247.1 million, or 14.8%, to $1.91 billion at December 31, 2019, compared to $1.66 billion at December 31, 2018. The multifamily, CRE nonowner occupied and 1-4 family mortgage categories contributed most significantly to the $247.1 million growth. As of December 31, 2019, multifamily loans increased $107.1 million, or 26.2%, nonowner occupied CRE loans increased $101.9 million, or 20.8%, and 1-4 family mortgage loans increased $33.8 million, or 14.9%, when compared to December 31, 2018. The following table presents the dollar and percentage composition of the loan portfolio by category, at the dates indicated: The Company’s primary focus has been on real estate mortgage lending, which constituted 75.0% of the portfolio as of December 31, 2019. The composition of the portfolio remained consistent with prior periods and although the Company expects continued growth, it does not expect any significant changes in the foreseeable future in the composition of the loan portfolio or in the emphasis on real estate lending. As of December 31, 2019, CRE loans totaled $1.30 billion, consisting of $592.5 million of loans secured by nonowner occupied CRE, $515.0 million of loans secured by multifamily residential properties and $196.8 million of construction and land development loans. CRE loans represented 68.2% of the total gross loan portfolio and 516.6% of the Bank’s total risk-based capital at December 31, 2019. The following table presents time to contractual maturity and sensitivity to interest rate changes for the loan portfolio at December 31, 2019 as of such date: Asset Quality The Company emphasizes credit quality in the originating and monitoring of the loan portfolio, and success in underwriting is measured by the levels of classified and nonperforming assets and net charge-offs. Federal regulations and internal policies require the use of an asset classification system as a means of managing and reporting problem and potential problem assets. The Company has incorporated an internal asset classification system, substantially consistent with federal banking regulations, as a part of the credit monitoring system. Federal banking regulations set forth a classification scheme for problem and potential problem assets as “substandard,” “doubtful” or “loss” assets. An asset is considered “substandard” if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. “Substandard” assets include those characterized by the “distinct possibility” that the insured institution will sustain “some loss” if the deficiencies are not corrected. Assets classified as “doubtful” have all of the weaknesses inherent in those classified “substandard” with the added characteristic that the weaknesses present make “collection or liquidation in full,” on the basis of currently existing facts, conditions, and values, “highly questionable and improbable.” Assets classified as “loss” are those considered “uncollectible” and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted. Assets which do not currently expose the insured institution to sufficient risk to warrant classification in one of the aforementioned categories but possess weaknesses are required to be designated “watch.” The following table presents information on loan classifications at December 31, 2019. The Company had no assets classified as doubtful or loss. Nonperforming Assets Nonperforming loans include loans accounted for on a nonaccrual basis and loans 90 days past due and still accruing. Nonperforming assets consist of nonperforming loans plus foreclosed assets. Nonaccrual loans totaled $461,000 at December 31, 2019 and $581,000 at December 31, 2018, a decrease of $120,000. There were no loans 90 days past due and still accruing as of December 31, 2019 and 2018. There were no foreclosed assets as of December 31, 2019 and 2018. The following table presents a summary of nonperforming assets, by category, at the dates indicated: (1) Nonperforming assets are defined as nonaccrual loans and loans greater than 90 days past due still accruing plus foreclosed assets. There were no loans greater than 90 days past due still accruing for any period shown. The balance of nonperforming assets can fluctuate due to changes in economic conditions. The Company has established a policy to discontinue accruing interest on a loan (that is, place the loan on nonaccrual status) after it has become 90 days delinquent as to payment of principal or interest, unless the loan is considered to be well-collateralized and is actively in the process of collection. In addition, a loan will be placed on nonaccrual status before it becomes 90 days delinquent unless management believes that the collection of interest is expected. Interest previously accrued but uncollected on such loans is reversed and charged against current income when the receivable is determined to be uncollectible. If management believes that a loan will not be collected in full, an increase to the allowance for loan losses is recorded to reflect management’s estimate of any potential exposure or loss. Generally, payments received on nonaccrual loans are applied directly to principal. There are not any loans, outside of those included in the table above, that cause management to have serious doubts as to the ability of borrowers to comply with present repayment terms. Due to the low levels of nonaccrual loans, gross income that would have been recorded on nonaccrual loans is $44,000. Allowance for Loan Losses The allowance for loan losses is a reserve established through charges to earnings in the form of a provision for loan losses. The Company maintains an allowance for loan losses at a level management considers adequate to provide for known and probable incurred losses in the portfolio. The level of the allowance is based on management’s evaluation of estimated losses in the portfolio, after consideration of risk characteristics of the loans and prevailing and anticipated economic conditions. Loan charge-offs (i.e., loans judged to be uncollectible) are charged against the reserve and any subsequent recovery is credited to the reserve. The Company analyzes risks within the loan portfolio on a continual basis. A risk system, consisting of multiple grading categories for each portfolio class, is utilized as an analytical tool to assess risk and appropriate reserves. In addition to the risk system, management further evaluates risk characteristics of the loan portfolio under current and anticipated economic conditions and considers such factors as the financial condition of the borrower, past and expected loss experience, and other factors which management feels deserve recognition in establishing an appropriate reserve. These estimates are reviewed at least quarterly, and, as adjustments become necessary, they are recognized in the periods in which they become known. Although management strives to maintain an allowance it deems adequate, future economic changes, deterioration of borrowers’ creditworthiness, and the impact of examinations by regulatory agencies all could cause changes to the allowance for loan losses. At December 31, 2019, the allowance for loan losses was $22.5 million, an increase of $2.5 million from $20.0 million at December 31, 2018. Net charge-offs totaled $205,000 during the year ended December 31, 2019 and $46,000 during the year ended December 31, 2018. The allowance for loan losses as a percentage of total loans was 1.18% at December 31, 2019 and 1.20% at December 31, 2018. The following presents a summary of the activity in the allowance for loan loss reserve for the periods indicated: The following table presents a summary of the allocation of the allowance for loan losses by loan portfolio segment for the periods indicated: Goodwill and Other Intangible Assets Goodwill was $2.6 million at December 31, 2019 and 2018. Goodwill represents the excess of the consideration paid over the fair value of the net assets acquired, which originated from the acquisition of First National Bank of the Lakes in May of 2016. Goodwill is not amortized but is subject to, at a minimum, an annual test for impairment. Other intangible assets consist of core deposit relationships and favorable lease term intangibles. Total other intangible assets at December 31, 2019 and 2018 were $861,000 and $1.0 million, respectively. Other intangible assets are amortized over their estimated useful life. Deposits The principal sources of funds for the Company are core deposits, consisting of demand deposits, money market accounts, savings accounts, and certificates of deposit. The following table presents the dollar and percentage composition of the deposit portfolio by category, at the dates indicated: Total deposits at December 31, 2019 were $1.82 billion, an increase of $262.4 million, or 16.8%, compared to total deposits of $1.56 billion at December 31, 2018. Noninterest bearing deposits were $447.5 million at December 31, 2019, an increase of $78.3 million, or 21.2%, compared to $369.2 million at December 31, 2018. Noninterest bearing deposits comprised 24.5% of total deposits at December 31, 2019, compared to 23.6% at December 31, 2018. The Company relies on increasing the deposit base to fund loan and other asset growth. The Company is in a highly competitive market and competes for local deposits by offering attractive products with competitive rates. The Company expects to have a higher average cost of funds for local deposits compared to competitor banks due to the lack of an extensive branch network. The Company’s strategy is to offset the higher cost of funding with a lower level of operating expense. When appropriate, the Company utilizes alternative funding sources such as brokered deposits. At December 31, 2019, total brokered deposits were $234.4 million or 12.9% of total deposits, compared to total brokered deposits of $291.2 million, or 18.7% of total deposits at December 31, 2018. The decrease in brokered deposits as a percentage of total deposits was primarily attributable to the Company’s success in growing core deposits. Furthermore, the core deposit growth supported a strategy whereby the Company was able to exercise embedded call features on higher rate, brokered time deposits during the year ended December 31, 2019. The Company exercised the embedded optionality to decrease brokered deposit exposure, reissue brokered time deposits at lower rates, and utilize other funding sources, such as FHLB advances. The following table presents the average balance and average rate paid on each of the following deposit categories for the years ended December 31, 2019, 2018, and 2017: The following table presents time deposits, including brokered time deposits, of $100,000 or more, by time remaining until maturity. Borrowed Funds Federal Funds Purchased In addition to deposits, the Company utilizes overnight borrowings to meet the daily liquidity needs of clients and fund loan growth. The following table presents a summary of overnight borrowings, which consist of federal funds purchased from correspondent banks on an overnight basis at the prevailing overnight market rates and the weighted average interest rates paid for the periods presented: Other Borrowings At December 31, 2019, other borrowings outstanding consisted of FHLB advances of $136.5 million and notes payable of $13.0 million. The Company’s borrowing capacity at the FHLB is determined based on collateral pledged, generally consisting of loans. The Company had additional borrowing capacity under this credit facility of $209.8 million and $122.1 million at December 31, 2019 and 2018, respectively. Additionally, the Company has borrowing capacity from other sources. As of December 31, 2019, the Bank was eligible to use the Federal Reserve discount window for borrowings. Based on assets pledged as collateral as of the applicable date, the Bank’s borrowing availability was approximately $113.2 million and $114.1 million at December 31, 2019 and 2018, respectively. As of December 31, 2019 and 2018, the Company had no outstanding advances. The Company has entered into a swap agreement with an unaffiliated third party in order to hedge interest rate risk associated with the notes payable. This agreement provides for the Company to make payments at a fixed rate in exchange for receiving payments at a variable rate determined by one-month LIBOR. Subordinated Debentures On July 12, 2017, the Company issued $25.0 million of subordinated debentures at an initial fixed interest rate of 5.875% which is payable semi-annually. Beginning July 15, 2022, the interest rate converts to a variable interest rate equal to the three-month LIBOR plus 3.88%. The subordinated debentures mature on July 15, 2027. The subordinated debentures, net of issuance costs, were $24.7 million at December 31, 2019, compared to $24.6 million at December 31, 2018. The subordinated debentures qualify for Tier 2 regulatory capital treatment for the first five years, under applicable regulatory guidelines. Contractual Obligations The following table presents supplemental information regarding total contractual obligations at December 31, 2019: On August 27, 2018, the Bank and Reuter Walton Commercial, LLC (the “Contractor”) entered into a Standard Form of Agreement Between Owner and Contractor and the corresponding General Conditions of the Contract for Construction (collectively, the “Construction Contract”). Under the Construction Contract, the Contractor will construct the core and shell of a new headquarters building for the Bank in St. Louis Park, Minnesota, and the Bank will pay the Contractor a contract price consisting of the cost of work plus a fee equal to 3.75% of the cost of work, subject to a guaranteed maximum price of $23.0 million, with anticipated construction to be completed in 2020. As of December 31, 2019, $15.2 million has been paid under this Construction Contract. On December 3, 2019, the Bank entered into a contract with a third party relating to the construction of the interior build-out of the new headquarters building for the Bank. The sum of the contract is $6.32 million, with anticipated construction to be completed in 2020. As of December 31, 2019, no payments had been made under this contract. Operating lease obligations are in place for facilities and land on which banking branches are located. See Note 6 of the Company’s Consolidated Financial Statements included as part of this report for additional information. The Company believes that it will be able to meet all contractual obligations as they come due through the maintenance of adequate cash levels. The Company expects to maintain adequate cash levels through earnings, loan and securities repayments and maturity activity and continued deposit gathering activities. As described above, the Company has in place various borrowing mechanisms for both short-term and long-term liquidity needs. Shareholders’ Equity Shareholders’ equity at December 31, 2019 was $244.8 million, an increase of $23.8 million, or 10.8%, over shareholders’ equity of $221.0 million at December 31, 2018, primarily due to $31.4 million of net income retained and a $6.3 increase in accumulated other comprehensive income, partially offset by $15.0 million of stock repurchases made under the Company’s stock repurchase program. The increase in accumulated other comprehensive income primarily resulted from interest rate fluctuations between periods. Stock Repurchase Program. On January 22, 2019, the Company adopted a stock repurchase program. Under the repurchase program, the Company was initially authorized to repurchase up to $15.0 million of its common stock in open market transactions or through privately negotiated transactions at the Company’s discretion. On July 23, 2019, the Company’s Board of Directors approved a $10.0 million increase to the Company’s stock repurchase program, increasing the authorization to repurchase common stock under the program from a total of $15.0 million to a total of $25.0 million. During the year ended December 31, 2019, the Company repurchased 1,331,512 shares of its common stock, representing approximately 5% of the Company’s outstanding shares. Shares were repurchased at a weighted average price of $11.23 for a total of $15.0 million. All shares repurchased under the stock repurchase program were converted to authorized but unissued shares. At December 31, 2019, the remaining amount that could be used to repurchase shares under the stock repurchase program was $10.0 million. Regulatory Capital. The Company and the Bank are subject to various regulatory capital requirements administered by federal banking regulators. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by federal banking regulators that, if undertaken, could have a direct material effect on the Company’s and Bank’s business. Under applicable regulatory capital rules, the Company and Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank must also meet certain specific capital guidelines under the prompt corrective action framework. The capital amounts and classification are subject to qualitative judgments by the federal banking regulators about components, risk weightings and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios of common equity Tier 1 capital, Tier 1 capital and total capital to risk-weighted assets and of Tier 1 capital to average consolidated assets (referred to as the “leverage ratio”), as defined under the applicable regulatory capital rules. Management believes the Company and the Bank met all capital adequacy requirements to which they were subject as of December 31, 2019. The regulatory capital ratios for the Company and the Bank to meet the minimum capital adequacy standards and for the Bank to be considered well capitalized under the prompt corrective action framework are presented in the following tables. The Company’s and the Bank’s actual capital amounts and ratios are as of the dates indicated. The Company and the Bank are subject to the rules of the Basel III regulatory capital framework and related Dodd-Frank Wall Street Reform and Consumer Protection Act. The rules include the implementation of a capital conservation buffer that is added to the minimum requirements for capital adequacy purposes. The capital conservation buffer was subject to a four year phase-in period that began on January 1, 2016, and was fully phased-in on January 1, 2019, at 2.5%. The required phase-in capital conservation buffer during 2018 was 1.875%. A banking organization with a conservation buffer of less than the required amount will be subject to limitations on capital distributions, including dividend payments, and certain discretionary bonus payments to executive officers. At December 31, 2019, the ratios for the Company and the Bank were sufficient to meet the fully phased-in conservation buffer. Off-Balance Sheet Arrangements In the normal course of business, the Company enters into various transactions to meet the financing needs of clients, which, in accordance with GAAP, are not included in the consolidated balance sheets. These transactions include commitments to extend credit, standby letters of credit, and commercial letters of credit, which involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amounts recognized in the consolidated balance sheets. Most of these commitments mature within two years and the standby letters of credit are expected to expire without being drawn upon. All off-balance sheet commitments are included in the determination of the amount of risk-based capital that the Company and the Bank are required to hold. The Company’s exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit, standby letters of credit, and commercial letters of credit is represented by the contractual or notional amount of those instruments. The Company decreases its exposure to losses under these commitments by subjecting them to credit approval and monitoring procedures. The Company assesses the credit risk associated with certain commitments to extend credit and establishes a liability for probable credit losses. The following table presents credit arrangements and financial instruments whose contract amounts represent credit risk as of December 31, 2019 and 2018: Commitments to extend credit beyond current funding are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Such commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments may expire without being drawn upon, the total commitment amounts 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 deemed necessary by us upon extension of credit, is based on our management’s credit evaluation. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties. Standby letters of credit are conditional commitments issued by us to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. Commercial letters of credit are issued specifically to facilitate trade or commerce and are paid directly when the underlying transaction is consummated. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Liquidity Liquidity is the Company’s capacity to meet cash and collateral obligations at a reasonable cost. Maintaining an adequate level of liquidity depends on the Company’s ability to efficiently meet both expected and unexpected cash flows and collateral needs without adversely affecting either daily operations or financial condition. The Bank’s ALM Committee, which is comprised of members of senior management, is responsible for managing commitments to meet the needs of customers while achieving the Company’s financial objectives. The ALM Committee meets regularly to review balance sheet composition, funding capacities, and current and forecasted loan demand. The Company manages liquidity by maintaining adequate levels of cash and other assets from on and off-balance sheet arrangements. Specifically, on-balance sheet liquidity consists of cash and due from banks and unpledged investment securities available for sale, which are referred to as primary liquidity. In regard to off-balance sheet capacity, the Company maintains available borrowing capacity under secured borrowing lines with the FHLB and the Federal Reserve Bank of Minneapolis, as well as unsecured lines of credit for the purpose of overnight funds with various correspondent banks, which the Company refers to as secondary liquidity. In addition, the Bank is a member of the American Financial Exchange, or AFX, through which it may either borrow or lend funds on an overnight or short-term basis with a group of approved commercial banks. The availability of funds changes daily. As of December 31, 2019, the Company had no borrowings outstanding through the AFX. The following tables present a summary of primary and secondary liquidity levels as of the dates indicated: During the year ended December 31, 2019, primary liquidity increased $40.0 million due to a $36.5 million increase in securities available for sale and a $3.5 million increase in cash and cash equivalents, when compared to December 31, 2018. Secondary liquidity increased $101.8 million as of December 31, 2019 when compared to December 31, 2018, due to a $87.7 million increase in the borrowing capacity on the secured borrowing line with the FHLB and a $15.0 million increase in unsecured borrowing capacity with correspondent lenders, offset partially by a $887,000 decrease in the borrowing capacity on the secured credit line with the Federal Reserve Bank. In addition to primary liquidity, the Company generates liquidity from cash flows from the loan and securities portfolios and from the large base of core customer deposits, defined as noninterest bearing transaction, interest bearing transaction, savings, non-brokered money market accounts and non-brokered time deposits less than $250,000. At December 31, 2019, core deposits totaled approximately $1.47 billion and represented 80.7% of total deposits. These core deposits are normally less volatile, often with customer relationships tied to other products offered by the Company, which promote long-standing relationships and stable funding sources. The Company uses brokered deposits, the availability of which is uncertain and subject to competitive market forces and regulation, for liquidity management purposes. At December 31, 2019, brokered deposits totaled $234.4 million, consisting of $231.9 million of brokered time deposits and $2.4 million of non-maturity brokered money market and transaction accounts. At December 31, 2018, brokered deposits totaled $291.2 million, consisting of $264.2 million of brokered time deposits and $27.0 million of non-maturity brokered money market accounts. The Company’s liquidity policy includes guidelines for On-Balance Sheet Liquidity (a measurement of primary liquidity to total deposits plus borrowings), Total On-Balance Sheet Liquidity with Borrowing Capacity (a measurement of primary and secondary liquidity to total deposits plus borrowings), Wholesale Funding Ratio (a measurement of total wholesale funding to total deposits plus borrowings), and other guidelines developed for measuring and maintaining liquidity. As of December 31, 2019, the Company was in compliance with all established liquidity guidelines. GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures Some of the financial data included in this report are not measures of financial performance recognized by GAAP. Management uses these non-GAAP financial measures in the analysis of performance: · “Efficiency ratio” is defined as noninterest expense less the amortization of intangibles divided by our operating revenue, which is equal to net interest income plus noninterest income excluding gains and losses on sales of securities. In our judgment, the adjustments made to operating revenue allow investors and analysts to better assess our operating expenses in relation to our core operating revenue by removing the volatility that is associated with certain one-time items and other discrete items that are unrelated to our core business. · “Adjusted Efficiency ratio” is defined as the efficiency ratio adjusted to exclude the amortization of tax credit investments from noninterest expense. · “Tangible common equity” is defined as shareholders’ equity reduced by goodwill and other intangible assets. We believe that this measure is important to many investors in the marketplace who are interested in changes from period to period in shareholders’ equity exclusive of changes in intangible assets. Goodwill and other intangibles that were recorded in a purchase business combination have the effect of increasing both equity and assets while not increasing our tangible equity or tangible assets. · “Tangible common equity to tangible assets” is defined as the ratio of tangible common equity, as defined above, divided by total assets reduced by goodwill and other intangible assets. We believe that this measure is important to many investors in the market place who are interested in relative changes from period to period in shareholders’ equity to total assets, each exclusive of changes in intangible assets. Goodwill and other intangibles that were recorded in a purchase business combination have the effect of increasing both equity and assets while not increasing our tangible equity or tangible assets. · “Tangible book value per share” is defined as tangible shareholders’ equity divided by total common voting and non-voting shares outstanding. We believe that this measure is important to many investors in the marketplace who are interested in changes from period to period in book value per share exclusive of changes in intangible assets. Goodwill and other intangibles that were recorded in a purchase business combination have the effect of increasing book value while not increasing our tangible book value. The Company believes these non-GAAP financial measures provide useful information to management and investors that is supplementary to our financial condition, results of operations and cash flows computed in accordance with GAAP; however, we acknowledge that our non-GAAP financial measures have a number of limitations. As such, you should not view these disclosures as a substitute for results determined in accordance with GAAP, and they are not necessarily comparable to non-GAAP financial measures that other companies use. The following reconciliation table provides a more detailed analysis of these non-GAAP financial measures:
0.015227
0.015706
0
<s>[INST] The following discussion and analysis of our results of operations and financial condition should be read in conjunction with the “Selected Financial Data” and our consolidated financial statements and related notes included elsewhere in this report. In addition to historical information, 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 report, may cause actual results to differ materially from those projected in the forward looking statements. We assume no obligation to update any of these forwardlooking statements. Readers of our Annual Report on Form 10K should consider these risks and uncertainties in evaluating forwardlooking statements and should not place undue reliance on forwardlooking statements. Overview The Company is a financial holding company headquartered in Bloomington, Minnesota, which is currently celebrating fourteen years of successful operations. The principal sources of funds for loans and investments are transaction, savings, time, and other deposits, and shortterm and longterm borrowings. The Company’s principal sources of income are interest and fees collected on loans, interest and dividends earned on investment securities and service charges. The Company’s principal expenses are interest paid on deposit accounts and borrowings, employee compensation and other overhead expenses. The Company’s simple, efficient business model of providing responsive support and unconventional experiences to clients continues to be the underlying principle that drives the Company’s profitable growth. Critical Accounting Policies and Estimates The consolidated financial statements of the Company are prepared based on the application of certain accounting policies, the most significant of which are described in Note 1 of the notes to the consolidated financial statements included as a part of this report. Certain policies require numerous estimates and strategic or economic assumptions that may prove inaccurate or subject to variation and may significantly affect the reported results and financial position for the current period or in future periods. The use of estimates, assumptions, and judgments are necessary when financial assets and liabilities are required to be recorded or adjusted to reflect fair value. Assets carried at fair value inherently result in more financial statement volatility. Fair values and information used to record valuation adjustments for certain assets and liabilities are based on either quoted market prices or are provided by other independent thirdparty sources, when available. When such information is not available, management estimates valuation adjustments. Changes in underlying factors, assumptions or estimates in any of these areas could have a material impact on the future financial condition and results of operations. Management has discussed each critical accounting policy and the methodology for the identification and determination of critical accounting policies with the Company’s Audit Committee. The JOBS Act permits the Company an extended transition period for complying with new or revised accounting standards affecting public companies. The Company has elected to take advantage of this extended transition period, which means that the financial statements included in this report, as well as any financial statements filed 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 the Company remains an emerging growth company or until the Company affirmatively and irrevocably opts out of the extended transition period under the JOBS Act. The following is a discussion of the critical accounting policies and significant estimates that require the Company to make complex and subjective judgements. Allowance for Loan Losses The allowance for loan losses, sometimes referred to as the “allowance,” is established through a provision for loan losses which is charged to expense. Loan losses are charged against the allowance when management determines all or a portion of the loan balance to be uncollectible. Subsequent recoveries, if any, are credited to the allowance for cash received on previously chargedoff amounts. If the allowance is considered inadequate to absorb future loan losses on existing loans for any reason, including but not limited to, increases in the size of the loan portfolio, increases in chargeoffs or changes in the risk characteristics of the loan portfolio, then the provision for loan losses is increased. A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the original contractual terms of the loan agreement. The collection of all amounts due according to original contractual terms means that both the contractual interest and principal payments of a loan will be collected as scheduled in the loan [/INST] Positive. </s>
2,020
10,367
1,725,057
Ceridian HCM Holding Inc.
2019-02-28
2018-12-31
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The following is a discussion and analysis of our financial condition and results of operations as of, and for, the periods presented. 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 thereto included elsewhere in this report. This discussion and analysis contains forward-looking statements, including statements regarding industry outlook, our expectations for the future of our business, and our liquidity and capital resources as well as other non-historical statements. These statements are based on current expectations and are subject to numerous risks and uncertainties, including but not limited to the risks and uncertainties described in “Risk Factors” and “Forward-Looking Statements.” Our actual results may differ materially from those contained in or implied by these forward-looking statements. Overview Ceridian is a global HCM software company. We categorize our solutions into two categories: Cloud and Bureau solutions. Cloud revenue is generated from HCM solutions that are delivered via two cloud offerings: Dayforce, our flagship cloud HCM platform, and Powerpay, a cloud HR and payroll solution for the Canadian small business market. We also continue to support customers using our Bureau solutions, which we generally stopped actively selling to new customers following the acquisition of Dayforce in 2012. We invest in maintenance and necessary updates to support our Bureau customers and continue to migrate them to Dayforce. Dayforce provides HR, payroll, benefits, workforce management, and talent management functionality. Our platform is used by organizations, regardless of industry or size, to optimize management of the entire employee lifecycle, including attracting, engaging, paying, deploying, and developing their people. Dayforce was built as a single application from the ground up that combines a modern, consumer-grade user experience with proprietary application architecture, including a single employee record and a rules engine spanning all areas of HCM. Dayforce provides continuous real-time calculations across all modules to enable, for example, payroll administrators access to data through the entire pay period, and managers access to real-time data to optimize work schedules. Our platform is designed to make work life better for our customers and their employees by improving HCM decision-making processes, streamlining workflows, exposing strategic organizational insights, and simplifying legislative compliance. The platform is designed to ease administrative work for both employees and managers, creating opportunities for companies to increase employee engagement. We are a founder-led organization, and our culture combines the agility and innovation of a start-up with a history of deep domain and operational expertise. We sell Dayforce through our direct sales force on a subscription per-employee, per-month (“PEPM”) basis. Our subscriptions are typically structured with an initial fixed term of between three and five years, with evergreen renewal thereafter. Dayforce can serve customers of all sizes, ranging from 100 to over 100,000 employees. We have rapidly grown the Dayforce platform to more than 3,700 live Dayforce customers, representing approximately 3.1 million active global users as of December 31, 2018. In 2018, we added over 715 net new live Dayforce customers. Our customers vary across industries, and no single customer constituted more than 1% of our revenues for the year ended December 31, 2018. We have experienced significant Cloud revenue growth at scale, particularly from Dayforce, which has grown at a compound annual growth rate (“CAGR”) of more than 55% since 2012. Our annual Cloud revenue retention rate continues to exceed 95% due to our intense focus on solving complex problems and our superior customer experience. The following table presents Dayforce revenue by quarter from 2012 to 2018. Our Business Model Our business model focuses on supporting the rapid growth of Dayforce and maximizing the lifetime value of our Dayforce customer relationships. Due to our subscription model, where we recognize subscription revenues ratably over the term of the subscription period, and high customer retention rates, we have a high level of visibility into our future revenues. The profitability of a customer to our business depends, in large part, on how long they have been a customer. Because in our current business model, PEPM subscription fees are not charged until the customer goes live, and because we incur costs in advance of receiving PEPM revenue that are not offset by our implementation fees, we estimate that it takes an average of 2.5 years before we are able to recover our implementation, customer acquisition, and other direct costs on a new Dayforce customer contract. As the proportion of Dayforce customers who have been live for two or more years increases, our related profitability increases. The following sets forth the number of live Dayforce customers at the end of each quarter presented: Over the lifetime of the customer relationship, we have the opportunity to realize additional PEPM revenue, both as the customer grows or rolls out the Dayforce solution to additional employees, and also by selling additional functionality to existing customers that do not currently utilize our full platform. We also incur costs to manage the account, to retain customers, and to sell additional functionality. These costs, however, are significantly less than the costs initially incurred to acquire and to implement the customer. How We Assess Our Performance In assessing our performance, we consider a variety of performance indicators in addition to revenue and net income. Set forth below is a description of our key performance measures. (a) Annual Cloud revenue retention rate and Cloud annualized recurring revenue are calculated on an annual basis, and the disclosure reflects data as of the most recent fiscal year end. Please see below for further explanation. (b) For a reconciliation of Adjusted EBITDA to operating profit, please see “Non-GAAP Measures.” Live Dayforce Customers We use the number of customers live on Dayforce as an indicator of future revenue and the overall performance of the business and to assess the performance of our implementation services. As shown in the following table, the number of customers live on Dayforce has increased from 482 as of December 31, 2012 to 3,718 as of December 31, 2018. In addition, we had over 450 net new Dayforce customers contracted, but not yet live on Dayforce as of December 31, 2018. We expect the majority of these Dayforce customers to be taken live in 2019. For 2018, our 3,718 live Dayforce customers represented over 3.1 million active users. We market Dayforce to customers of all sizes, including small (under 500 employees), mid-sized (501 to 2,500 employees), and enterprise (over 2,500 employees). For 2018, small businesses accounted for 14% of the total number of active customer employees, mid-sized businesses accounted for 32% of the total number of active customer employees, and enterprise businesses accounted for 54% of the total number of active customer employees. As our business and go-to-market strategy continues to evolve, in 2019, we will be modifying our customer segmentation for increased relevance. From 2017 to 2018, live Dayforce customers increased from 3,001 to 3,718, a net increase of 717. Of the customers taken live during 2018, 77% represented net new customers to Dayforce, and the remainder were migration customers from our Bureau solution. Of the net new customers to Dayforce, small businesses accounted for 9% of the total number of active customer employees, mid-sized businesses accounted for 33% of the total number of active customer employees, and enterprise businesses accounted for 58% of the total number of active customer employees. Of the migration customers, small businesses accounted for 23% of the total number of active customer employees, mid-sized businesses accounted for 41% of the total number of active customer employees, and enterprise businesses accounted for 36% of the total number of active customer employees. From 2016 to 2017, live Dayforce customers increased from 2,339 to 3,001, a net increase of 662. Of the customers taken live during 2017, 58% represented net new customers to Dayforce and the remainder were migration customers from our Bureau solutions. Of the net new customers to Dayforce, small businesses accounted for 13% of the total number of active customer employees, mid-sized businesses accounted for 33% of the total number of active customer employees, and enterprise businesses accounted for 54% of the total number of active customer employees. Of the migration customers, small businesses accounted for 20% of the total number of active customer employees, mid-sized businesses accounted for 48% of the total number of active customer employees, and enterprise businesses accounted for 32% of the total number of active customer employees. The following table sets forth the number of live Dayforce customers at the end of the years presented: Annual Cloud Revenue Retention Rate Our annual Cloud revenue retention rate measures the percentage of revenues that we retain from our existing Cloud customers. We use this retention rate as an indicator of customer satisfaction and future revenues. We calculate the annual Cloud revenue retention rate as a percentage, where the numerator is the Cloud annualized recurring revenue for the prior year, less the Cloud annualized recurring revenue from lost Cloud customers during that year; and the denominator is the Cloud annualized recurring revenue for the prior year. Our annual Cloud revenue retention rate has been 95% or above for the years ended December 31, 2018, 2017, and 2016. We set annual targets for Cloud revenue retention rate and monitor progress toward those targets on a quarterly basis by reviewing known and anticipated customer losses. Our Cloud revenue retention rate may fluctuate as a result of a number of factors, including the mix of Cloud solutions used by customers, the level of customer satisfaction, and changes in the number of users live on our Cloud solutions. Cloud Annualized Recurring Revenue (“ARR”) We derive the majority of our Cloud revenues from recurring fees, primarily PEPM subscription charges. We also derive recurring revenue from fees related to the rental and maintenance of clocks, charges for once-a-year services, such as year-end tax statements, and investment income on our customer funds held in trust before such funds are remitted to taxing authorities, customer employees, or other third parties. To calculate Cloud ARR, we start with recurring revenue at year end, subtract the once-a-year charges, annualize the revenue for customers live for less than a full year to reflect the revenue that would have been realized if the customer had been live for a full year, and add back the once-a-year charges. We set annual targets for Cloud ARR and monitor progress toward those targets on a quarterly basis. Adjusted EBITDA and Adjusted EBITDA margin We believe that Adjusted EBITDA and Adjusted EBITDA margin, non-GAAP financial measures, are useful to management and investors as supplemental measures to evaluate our overall operating performance. Adjusted EBITDA and Adjusted EBITDA margin are components of our management incentive plan and are used by management to assess performance and to compare our operating performance to our competitors. We define Adjusted EBITDA as net income or loss before interest, taxes, depreciation, and amortization, as adjusted to exclude net income or loss from discontinued operations, sponsor management fees, non-cash charges for asset impairments, gains or losses on assets and liabilities held in a foreign currency other than the functional currency of a company subsidiary, share-based compensation expense, severance charges, restructuring consulting fees, transaction costs, and environmental reserve charges. Adjusted EBITDA margin is determined by calculating the percentage Adjusted EBITDA is of Total Revenue. Management believes that Adjusted EBITDA and Adjusted EBITDA margin are helpful in highlighting management performance trends because Adjusted EBITDA and Adjusted EBITDA margin exclude the results of decisions that are outside the normal course of our business operations. For a reconciliation of Adjusted EBITDA to operating profit, please see “Non-GAAP Measures.” Our History Ceridian was acquired in 2007 by affiliates and co-investors of the Sponsors. In April 2012, Ceridian acquired Dayforce Corporation, which had built Dayforce, a cloud HCM solution. In the months following the acquisition, Dayforce founder, David D. Ossip, was named Chief Executive Officer of Ceridian HCM, and shortly thereafter, we generally stopped actively selling our Bureau solutions to new customers in the United States to focus our resources on expanding the Dayforce platform and growing Cloud solutions. For each quarter since September 30, 2016, our Cloud revenue has surpassed our Bureau revenue. Cloud revenue grew from 39% of total revenue during the quarter ended December 31, 2015 to 74% of total revenue during the quarter ended December 31, 2018. As part of our strategy to focus on the growth of our Cloud solutions business, we undertook the following initiatives to simplify our business model: (i) sold our consumer-directed benefit services business in 2013, (ii) merged Comdata, our payment systems business unit, with FleetCor Technologies in 2014, (iii) sold our benefits administration and post-employment compliance business in 2015, (iv) sold our United Kingdom and Ireland Bureau businesses and a portion of our operations that supported such businesses in Mauritius in 2016, and (v) contributed our LifeWorks employee assistance program business to a joint venture, LifeWorks, in 2016, then distributed our ownership in this joint venture to a holding company owned by our stockholders in April 2018 (the “LifeWorks Disposition”). As a result of these transactions, we only actively sell Dayforce and Powerpay, which we believe simplifies our business model and positions us well for continued growth. Our benefits administration and post-employee compliance business, our United Kingdom and Ireland businesses, our divested Mauritius operations, and our LifeWorks joint venture are presented as discontinued operations in our financial statements. Our consumer-directed benefits services business and our benefits administration and post-employment compliance business are collectively referred to as our “Divested Benefits Businesses.” After the LifeWorks Disposition, management has concluded that we have one operating and reportable segment. This conclusion aligns with how management monitors operating performance, allocates resources, and deploys capital. Please refer to Note 3, “Discontinued Operations,” to our consolidated financial statements for further information regarding these transactions. On April 30, 2018, we completed our IPO, in which we issued and sold 21,000,000 shares of common stock at a public offering price of $22.00 per share. We granted the underwriters a 30-day option to purchase an additional 3,150,000 shares of common stock at the offering price, which was exercised in full. A total of 24,150,000 shares of common stock were issued on April 30, 2018, with gross proceeds of $531.3 million from the IPO before deducting underwriting discounts, commissions, and other offering expenses. Immediately subsequent to the closing of our IPO on April 30, 2018, THL / Cannae Investors LLC, one of our existing stockholders controlled by our Sponsors, purchased from us in a private placement $100.0 million of our common stock at a price per share equal to the offering price. Based on the offering price of $22.00 per share, 4,545,455 shares were issued in this private placement. Please refer to Note 1, “Organization,” for further discussion of the IPO transaction. We applied a portion of the net proceeds from the IPO to satisfy and to discharge the indenture governing our outstanding $475.0 million principal amount Senior Notes, and they were redeemed on May 30, 2018. Concurrently, we also refinanced our remaining debt under our (i) $702.0 million (original principal amount) Senior Term Debt and (ii) $130.0 million Revolving Credit Facility, including accrued interest and related costs and expenses, with new senior credit facilities consisting of a $680.0 million term loan debt facility and a $300.0 million revolving credit facility. Please refer to Note 9, “Debt,” for further discussion of the debt transactions. The IPO, private placement, and debt refinancing had the following impacts to our results of operations and cash during 2018: On November 16, 2018, we completed a secondary offering, in which certain of our stockholders (the “Selling Stockholders”) sold 11,000,000 shares of common stock, in an underwritten public offering at $36.00 per share. The Selling Stockholders granted the underwriters a 30-day option to purchase an additional 1,650,000 shares of common stock at the offering price, which was exercised in full. A total of 12,650,000 shares of common stock were sold by the Selling Stockholders on November 16, 2018, with all proceeds going to the Selling Stockholders. We incurred expenses of $1.3 million during the year ended December 31, 2018, related to the secondary offering within selling, general, and administrative expense. Components of Our Results of Operations Revenues We generate recurring revenues primarily from recurring fees charged for the use of our Cloud solutions, Dayforce and Powerpay, as well as from our Bureau solutions. We also generate professional services and other revenue associated primarily with the work performed to assist customers with the planning, design, implementation, and staging of their cloud-based solution. Our solutions are typically provided through long-term customer relationships that result in a high level of recurring revenue. We also generate recurring services revenue from investment income on our Cloud and Bureau customer funds held in trust before such funds are remitted to taxing authorities, customer employees, or other third parties. We refer to this investment income as float revenue. For Dayforce, we primarily charge monthly recurring fees on a PEPM basis, generally one-month in advance of service, based on the number and type of solutions provided to the customer and the number of employees and other users at the customer. Our standard Dayforce contracts are generally for a three to five-year period. The average time it takes to implement Dayforce typically ranges from three months for smaller customers to nine months for larger customers. Once Dayforce is implemented, the customer goes live, and we begin to generate recurring revenue. We also provide outsourced human resource solutions to certain of our Dayforce customers, which are tailored to meet their individual needs, and entail performing the duties of a customer’s human resources department, including payroll processing, time and labor management, performance management, and recruiting, as needed. The Powerpay offering is our solution designed primarily for small market Canadian customers. The typical Powerpay customer has fewer than 20 employees, and the majority of the revenue is generated from recurring fees charged on a per-employee, per-process basis. Typical processes include the customer’s payroll runs, year-end tax packages, and delivery of customers’ remittance advices or checks. Powerpay can typically be implemented on a remote basis within one to three days, at which point we start receiving recurring fees. For our Bureau solutions, we typically charge recurring fees on a per-process basis. Typical processes include the customer’s payroll runs, year-end tax packages, and delivery of customers’ remittance advices or checks. In addition to customers who use our payroll services, certain customers use our tax filing services on a stand-alone basis. Our outsourced human resource solutions are tailored to meet the needs of individual customers, and entail our contracting to perform many of the duties of a customer’s human resources department, including payroll processing, time and labor management, performance management, and recruiting. We also perform individual services for customers, such as check printing, wage attachment and disbursement, and ACA management. Cost of Revenue Cost of revenue consists of costs to deliver our solutions. Most of these costs are recognized as incurred. Some costs of revenue are recognized in the period that a service is sold and delivered. Other costs of revenue are recognized over the period of use or in proportion to the related revenue. The costs recognized as incurred consist primarily of customer service staff costs, customer technical support costs, implementation personnel costs, costs of hosting applications, consulting and purchased services, delivery services, and royalties. The costs of revenue recognized over the period of use are depreciation and amortization, rentals of facilities and equipment, and direct and incremental costs associated with deferred implementation service revenue. Cost of recurring services revenues primarily consists of costs to provide maintenance and technical support to our customers and the costs of hosting our applications. The cost of recurring services revenues also includes compensation and other employee-related expenses for data center staff, payments to outside service providers, data center expenses, and networking expenses. Cost of professional services and other revenues primarily consists of costs to provide implementation consulting services and training to our customers, as well as the cost of time clocks. Costs to provide implementation consulting services include compensation and other employee-related expenses for professional services staff, costs of subcontractors, and travel. Implementation consulting services are expected to continue to be primarily associated with the implementation of our Cloud solutions. Product development and management expense, included in cost of revenue, consists of costs related to software development activities that do not qualify for capitalization, such as development, quality assurance, testing of new technologies, and enhancements to our existing solutions that do not result in additional functionality. Product development and management expense also includes costs related to the management of our solutions. Depreciation and amortization related to cost of revenue primarily consists of amortization of capitalized software. Selling, General, and Administrative Expense Selling expense includes costs related to maintaining a direct marketing infrastructure and sales force and other direct marketing efforts, such as marketing events, advertising, telemarketing, direct mail, and trade shows. Advertising costs are expensed as incurred. Our sales and marketing expenses are expected to continue to be primarily associated with selling and marketing our Cloud solutions. General and administrative expense includes costs that are not directly related to delivery of services, selling efforts, or product development and management, primarily consisting of corporate-level costs, such as administration, finance, legal, and human resources, as well as management fees payable to affiliates of our Sponsors, FNF and THLM, until termination of the management agreements upon IPO in April 2018. Also included in this category are depreciation, and amortization of other intangible assets not reflected in cost of revenue, the provision for doubtful accounts receivable, and net periodic pension costs. Other Expense, net Other expense, net includes the results of transactions that are not appropriately classified in another category. These items include certain foreign currency translation gains and losses resulting mainly from intercompany receivables and payables denominated in currencies other than the subsidiary’s functional currency, environmental reserve charges, and charges related to the impairment of asset values. Income Tax Provision Our income tax provision represents federal, state, and international taxes on our income recognized for financial statement purposes and includes the effects of temporary differences between financial statement income and income recognized for tax return purposes. Deferred tax assets and liabilities are recorded for temporary differences between the financial reporting basis and the tax basis of assets and liabilities as adjusted for the expected benefits of utilizing net operating loss carryforwards. We record a valuation allowance to reduce our deferred tax assets to reflect the net deferred tax assets that we believe will be realized. In assessing the likelihood that we will be able to recover our deferred tax assets and the need for a valuation allowance, we consider all available evidence, both positive and negative, including historical levels of pre-tax book income, expiration of net operating losses, expectations and risks associated with estimates of future taxable income and ongoing prudent and feasible tax planning strategies, as well as current tax laws. As of December 31, 2018, we continue to record a full valuation allowance against our domestic deferred tax assets that are not offset by the reversal of deferred tax liabilities. In the future, if it is determined that we no longer have a requirement to record a valuation allowance against all or a portion of our deferred tax assets, the release of the valuation allowance would have a positive impact on our income tax provision. On December 22, 2017, the Tax Cut and Jobs Act legislation (the “Tax Act”) was enacted. The Tax Act amended the Code to reduce tax rates and to modify policies, credits, and deductions for businesses. For businesses, the Tax Act reduced the corporate federal tax rate from a maximum of 35% to a flat 21% rate. Results of Operations Year Ended December 31, 2018 Compared with Year Ended December 31, 2017 The following table sets forth our results of operations for the periods presented. (a) For a reconciliation of Adjusted EBITDA to operating profit, please see “Non-GAAP Measures.” Revenue. The following table sets forth certain information regarding our consolidated revenues for the year ended December 31, 2018, compared with the year ended December 31, 2017. (a) We present revenue growth in a constant currency to assess how our underlying businesses performed, excluding the effect of foreign currency rate fluctuations. We calculate percentage change in revenue on a constant currency basis by applying a fixed $1.30 Canadian dollar to $1.00 U.S. dollar foreign exchange rate to revenues originally booked in Canadian dollars for all applicable periods. Total revenue increased $75.6 million, or 11.3%, to $746.4 million for the year ended December 31, 2018, compared to $670.8 million for the year ended December 31, 2017. This increase was primarily driven by an increase in Cloud revenue of $130.0 million, or 32.2% from $404.3 million for the year ended December 31, 2017 to $534.3 million for the year ended December 31, 2018. The Cloud revenue increase was primarily due to an increase of $106.9 million, or 31.8%, in Cloud recurring services revenue, and $23.1 million, or 33.9%, in Cloud professional services and other revenue. The increase in Cloud recurring services revenue of $106.9 million was attributable to increases of $76.0 million from new customers, add-ons, and revenue uplift from migrations of Bureau customers; $22.9 million from the migration of Bureau customers; and $20.0 million from increased float revenue related to Cloud recurring services revenue, partially offset by customer attrition of $12.0 million. The increase in Cloud revenue was partially offset by a decline in Bureau revenue of $54.4 million, or 20.4%. There was an immaterial impact on revenue due to changes in foreign currency rate fluctuations. Please refer to the table above for our revenue growth rates on a constant currency basis. Of the decline in Bureau revenue, approximately 58% was driven by customer attrition and approximately 42% was attributable to customer migrations to Dayforce. Excluding the impact of migrations, our annual Bureau revenue retention rate was 86.9% in 2018 and 89.7% in 2017. For the year ended December 31, 2018, recurring services revenue from payroll Bureau customers accounted for $161.2 million, and tax-only Bureau recurring services revenue accounted for $48.2 million. The payroll Bureau customers consist of approximately 1.5 million active users, of which approximately 1.4 million are customers that we believe could be candidates for migration to Dayforce. Some of our customers are not candidates to migrate to Dayforce due to a variety of factors, including the type of functionality that they require and their system configuration. Of the approximately 1.4 million active users that we believe could be candidates for migration to Dayforce, small businesses accounted for 21% of the total number of active users, mid-sized businesses accounted for 28% of the total number of active users, and enterprise businesses accounted for 51% of the total number of active users. Cloud revenue by solution. The following table presents our Cloud revenue for both recurring and professional services and other, for both our Dayforce and Powerpay solution for the periods presented. Cloud revenue was $534.3 million for 2018, an increase of 32.2% when compared to 2017. Dayforce revenue grew 38.5%, and Powerpay revenue grew 8.2% in 2018 as compared to 2017. There was an immaterial impact on revenue due to changes in foreign currency rate fluctuations. Please refer to the table above for our revenue growth rates on a constant currency basis. Our new business sales to Dayforce and Powerpay customers comprised 82% of our increase in Cloud revenue for the year ended December 31, 2018, and the remaining 18% consisted primarily of customer migration to Dayforce from our Bureau solutions. As we migrate our Bureau customers to Dayforce, we typically experience a revenue increase from such customers driven by increased product density on the Dayforce platform. This revenue increase can vary by customer, but has been 22% on average since 2016, as measured at the time of initial migration. Float revenue. Investment income from invested customer trust funds included in revenue was $67.0 million and $46.5 million for the years ended December 31, 2018 and 2017, respectively. The average float balance for our customer trust funds for the year ended December 31, 2018 was $3,361.5 million, compared to $3,228.2 million for the year ended December 31, 2017. The average yield was 2.00% during the year ended December 31, 2018, an increase of 55 basis points compared to the average yield for the year ended December 31, 2017. Based on current investment practices, an increase in market investment rates of 100 basis points would increase float revenue by approximately $17 million over the twelve months following a rate increase. In addition to interest rate risks, we also have exposure to risks associated with changes in laws and regulations that may affect customer fund balances. For example, a change in regulations, either reducing the amount of taxes to be withheld or allowing less time to remit taxes to government authorities, would reduce our average customer trust fund balances and float revenue. There are no incremental costs of revenue associated with increases or declines in float revenue. Cost of revenue. Total cost of revenue for the year ended December 31, 2018, was $425.8 million, an increase of $18.3 million, or 4.5%, compared to the year ended December 31, 2017. Of the total $18.3 million increase, $2.1 million was attributable to IPO-related share-based compensation expense. Excluding IPO-related items, cost of revenue increased $16.2 million. Recurring services cost of revenue increased by $3.5 million for the year ended December 31, 2018, compared to the year ended December 31, 2017, due to additional costs incurred to support the growing Dayforce customer base, partially offset by reductions in costs to support our Bureau customers. The reduction in cost of revenue for professional services and other of $3.6 million for the year ended December 31, 2018, compared to the year ended December 31, 2017, was primarily due to productivity improvements in implementing new customers. In accordance with Accounting Standards Codification (“ASC”) 350, we are required to capitalize certain software development costs. Please refer to Note 2, “Summary of Significant Accounting Policies,” for further discussion of our accounting policy for internally developed software costs. Costs related to software development activities that do not qualify for capitalization, such as development, quality assurance, testing of new technologies, enhancements to our existing solutions that do not result in additional functionality, and costs related to the management of our solutions are presented as product development and management expense. The increase in product development and management expense of $15.4 million for the year ended December 31, 2018, compared to the year ended December 31, 2017, reflects increases in Dayforce product development efforts. For the years ended December 31, 2018, and 2017, our investment in software development was $54.9 million and $45.0 million, respectively, consisting of $29.6 million and $19.0 million of research and development expense, which is included within product development and management expense, and $25.3 million and $26.0 million of capitalized software development, respectively. Depreciation and amortization expense associated with cost of revenue increased by $3.0 million for the year ended December 31, 2018, compared to the year ended December 31, 2017, as we continue to capitalize Dayforce related and other development costs and subsequently amortize those costs. The table below presents total gross margin and solution gross margins for the periods presented: Total gross margin is defined as total gross profit as a percentage of total revenue, inclusive of product development and management costs as well as depreciation and amortization associated with cost of revenue. Gross margin for each solution in the table above is defined as total revenue less cost of revenue for the applicable solution as a percentage of total revenue for that related solution, exclusive of any product development and management or depreciation and amortization cost allocations. The overall 11.3% increase in revenue outpaced the 4.5% increase in cost of revenue, and gross profit increased by $57.3 million, or 21.8%, as we continued to leverage our investment in people and processes to realize economies of scale. Cloud recurring services gross margin was 68.2% for the year ended December 31, 2018, compared to 62.8% for the year ended December 31, 2017. The increase in Cloud recurring services gross margin reflects an increase in the proportion of Dayforce customers live for more than two years, which increased from 59% as of December 31, 2017 to 63% as of December 31, 2018, and was also attributable to consistent configuration of new customers, which enabled us to realize economies of scale in customer support and hosting costs. Professional services and other gross margin was (40.8)% for the year ended December 31, 2018, improving from (87.8)% for the year ended December 31, 2018, reflecting an increase in profitable post go-live professional services and productivity improvements in implementing new customers. Selling, general, and administrative expense. Selling, general, and administrative expense increased $47.7 million for the year ended December 31, 2018, compared to the year ended December 31, 2017. Of the total $47.7 million increase, $24.5 million was attributable to transaction expenses associated with our IPO, debt refinancing, and secondary offering, including $11.3 million in sponsor management termination fees, $6.0 million in IPO-related share-based compensation expense, $3.7 million in other IPO transactions costs, and $3.5 million in restructuring consulting expenses. Excluding transaction-related items, selling, general, and administrative expense increased $23.2 million, primarily due to sales and marketing expense, which increased by $13.4 million. We continue to invest in our sales and marketing efforts, as we drive growth in our Cloud solutions, particularly in Dayforce. The increase in selling, general, and administrative expenses also reflected increases in employee related costs and increased costs associated with being a public company. Other (income) expense, net. For the year ended December 31, 2018, we incurred $2.9 million of other income, net, compared to $7.3 million of other expense, net, for the year ended December 31, 2017. The other (income) expense, net, for the years ended December 31, 2018, and 2017, was primarily related to remeasurement gains and losses an intercompany payable denominated in a foreign currency, which was repaid in the second quarter of 2018. Operating profit. We realized operating profit of $52.8 million for the year ended December 31, 2018, compared to an operating profit of $33.0 million for the year ended December 31, 2017. Excluding the impact of $24.5 million in transaction costs within selling, general, and administrative expense, and $2.1 million in other increased share-based compensation expense related to the IPO within cost of revenue, operating profit would have been $79.4 million for the year ended December 31, 2018. This $46.4 million increase was primarily due to a $75.6 million increase in revenue and gross margin improvement. Interest expense, net. Interest expense for the year ended December 31, 2018, was $83.2 million, compared to $87.1 million for the year ended December 31, 2017. This reduction was primarily due to the refinancing of our debt, which resulted in a reduction in interest expense of $30.6 million upon the extinguishment of the Senior Notes in April 2018, representing seven fewer months of interest on the Senior Notes as compared to the prior year, partially offset by a loss on extinguishment of debt of $25.7 million. As of December 31, 2018, a 100 point basis increase in the London Inter-bank Offered Rate (“LIBOR”) rates would result in an approximately $7 million increase in our interest expense over the ensuring twelve-month period. Please refer to Note 9, “Debt,” for additional information. Income tax expense. For the year ended December 31, 2018, we had income tax expense of $7.7 million, compared to income tax benefit of $49.6 million for the year ended December 31, 2017. The $57.3 million increase in tax expense is primarily attributable to the $59.4 million tax benefit recorded during the year ended December 31, 2017, reflecting the revaluation of our deferred tax assets and liabilities upon the initial implementation of the Tax Act. Loss from discontinued operations. As a result of the LifeWorks Disposition, the financial results of the LifeWorks business have been included within discontinued operations for all periods presented. For the year ended December 31, 2018, we had a loss from discontinued operations of $25.8 million, compared to $6.0 million for the year ended December 31, 2017. The loss from discontinued operations for the year ended December 31, 2018, is primarily related to income tax expense incurred as a result of the LifeWorks Disposition. Net loss attributable to Ceridian. Net loss attributable to Ceridian was $63.4 for the year ended December 31, 2018, primarily due to $52.3 million of expenses incurred related to our IPO, debt refinancing, and secondary offering transactions, partially offset by an increase in gross profit. Net loss attributable to Ceridian was $9.2 for the year ended December 31, 2017, primarily due to a tax benefit of approximately $59.4 million related to the 2017 tax reform legislation. Please refer to the “Our History” section above for additional information on the financial statement impacts of our IPO, debt refinancing, and secondary offering transactions. Adjusted EBITDA. Adjusted EBITDA increased by $39.3 million for the year ended December 31, 2018, compared to the year ended December 31, 2017, and Adjusted EBITDA margin increased to 21.0% in 2018 from 17.6% in 2017. Year Ended December 31, 2017 Compared with Year Ended December 31, 2016 The following table sets forth our results of operations for the periods presented. (a) For a reconciliation of Adjusted EBITDA to operating profit, please see “Non-GAAP Measures.” Revenue. The following table sets forth certain information regarding our consolidated revenues for the year ended December 31, 2017, compared with the year ended December 31, 2016. (a) We present revenue growth in a constant currency to assess how our underlying businesses performed excluding the effect of foreign currency rate fluctuations. We calculate percentage change in revenue on a constant currency basis by applying a fixed $1.30 Canadian dollar to $1.00 U.S. dollar foreign exchange rate to revenues originally booked in Canadian dollars for all applicable periods. Total revenue increased $47.4 million, or 7.6%, to $670.8 million for the year ended December 31, 2017, compared to $623.4 million for the year ended December 31, 2016. This increase was primarily driven by an increase in Cloud revenue of $106.5 million, or 35.8%, from $297.8 million for the year ended December 31, 2016 to $404.3 million for the year ended December 31, 2017. The Cloud revenue increase was driven by an increase of $96.7 million, or 40.4%, in Cloud recurring services revenue, and $9.8 million, or 16.8%, in Cloud professional services and other revenue. The increase in Cloud recurring services revenue of $96.7 million was due to $68.0 million from new customers, add-ons, and revenue uplift from migrations of Bureau customers; $28.1 million from the migration of Bureau customers; $10.0 million from increased float revenue related to Cloud recurring services revenue; partially offset by customer losses of $9.4 million. The increase in Cloud revenue was partially offset by a decline in Bureau recurring services revenue of $56.7 million, or 17.8%. On a constant currency basis, total revenue grew 6.8%. This adjusted revenue growth was driven by an increase of 34.5% in Cloud revenue, partially offset by a decline of 18.6% in Bureau revenue. On a constant currency basis, Cloud revenue growth for the year ended December 31, 2017, compared to the year ended December 31, 2016, was driven by Cloud recurring services revenue, which increased by 39.0%, and professional services and other revenue, which increased by 15.9%, as we continued to sign and to activate new customers. Of the decline in Bureau revenue, approximately 50% was driven by customer attrition and approximately 50% was driven by customer migrations to Dayforce. Excluding the impact of migrations, our annual Bureau revenue retention rate was 89.7% in 2017 and 87.4% in 2016. For the year ended December 31, 2017, recurring services revenue from payroll Bureau customers accounted for $210.2 million and tax-only Bureau recurring services revenue accounted for $52.1 million. The payroll Bureau customers consist of approximately 1.9 million active users, of which approximately 1.7 million of these active users are with customers that we believe could be candidates for migration to Dayforce. Some of our customers are not candidates to migrate to Dayforce due to a variety of factors, including the type of functionality that they require and their system configuration. Of the approximately 1.7 million active users, small businesses accounted for 20% of the total number of active users, mid-sized businesses accounted for 30% of the total number of active users, and enterprise businesses accounted for 50% of the total number of active users. Cloud revenue by solution. The following table presents our Cloud revenue for both recurring and professional services and other, for both our Dayforce and Powerpay solution for the periods presented. Cloud revenue was $404.3 million during 2017, an increase of 35.8% when compared to 2016. Dayforce revenue grew 46.1%, and Powerpay revenue grew 7.1% during 2017 as compared to 2016. Our new business sales to Dayforce customers comprised 74% of our increase in Cloud revenue for the year ended December 31, 2017, and the remaining 26% consisted primarily of customer migration to Dayforce from our Bureau solutions. Float revenue. Investment income from invested customer trust funds included in revenue was $46.5 million and $39.1 million for the years ended December 31, 2017 and 2016, respectively. The average float balance for our customer trust funds for the year ended December 31, 2017, was $3,228.2 million, compared to $3,260.4 million for the year ended December 31, 2016. The yield was 1.44% during the year ended December 31, 2017, an increase of 24 basis points compared to the year ended December 31, 2016. In addition to interest rate risks, we also have exposure to risks associated with changes in laws and regulations that may affect customer fund balances. For example, a change in regulations, either reducing the amount of taxes to be withheld or allowing less time to remit taxes to government authorities, would reduce our average customer trust fund balances and float revenue. There are no incremental costs of revenue associated with increases or declines in float revenue. Cost of revenue. Total cost of revenue for the year ended December 31, 2017, was $407.5 million, an increase of $11.1 million, or 2.8%, compared to the year ended December 31, 2016. During 2017, we changed the presentation and classification of certain expenses within our statements of operations to better facilitate comparisons with revenue and expenses of similar businesses, to better align our income statement presentation with the way management and reporting of our business has evolved internally, and to enhance our overall disclosure and understanding of the business for external users. We reallocated certain expenses between cost of recurring services revenue, cost of professional services and other revenue, and selling, general, and administrative expense. The net impact of these reallocations was to increase total cost of revenue by $3.4 million and to reduce selling, general, and administrative expense by $3.4 million. These changes in presentation and classification represent a change in estimate and have been accounted for on a prospective basis. Therefore, to facilitate the discussion in this section, the following table presents the actual reported costs and expenses as well as the costs and expenses on a pro forma basis as if the changes to allocation methodologies in 2017 had been in effect in 2016: The increase in total cost of revenue for year ended December 31, 2017, compared to the year ended December 31, 2016, included a net reallocation of $3.4 million from selling, general, and administrative expense due to a change in estimate of expense allocations. Excluding the effect of these reallocations, total cost of revenue would have increased by $7.7 million, or 1.9%. Recurring services cost of revenue was reduced by $17.6 million for the year ended December 31, 2017, compared to the year ended December 31, 2016. This reduction included a reallocation of $31.5 million of costs from recurring services cost of revenue, consisting primarily of $13.4 million in technology and facilities expenses, $10.9 million in finance related expenses, and $9.3 million in corporate function expenses. Excluding the effect of these reallocations, recurring services cost of revenue would have increased by $13.9 million due to additional costs incurred to support the growing Dayforce customer base, partially offset by reductions in Bureau costs. The increase in cost of revenue for professional services and other of $20.2 million for the year ended December 31, 2017, compared to the year ended December 31, 2016, included a net reallocation of $23.1 million of costs to professional services and other cost of revenue, primarily $23.2 million of technology and facilities expenses. Excluding the effect of these reallocations, professional services and other cost of revenue would have been reduced by $2.9 million, as we achieved productivity improvements in implementing new customers. The increase in product development and management expense of $0.3 million for the year ended December 31, 2017, compared to the year ended December 31, 2016, included the reallocation of $3.6 million of costs to product development and management, primarily $7.9 million in technology and facilities expenses, offset by $2.8 million in corporate function expenses. Excluding the effect of these reallocations, product development and management expense would have been reduced by $3.3 million, due to reductions in product management costs associated with our Bureau solution and technology expenses, partially offset by higher headcount to support the continued development of the Dayforce platform. Depreciation and amortization expense associated with cost of revenue increased by $8.2 million for the year ended December 31, 2017, compared to the year ended December 31, 2016. Excluding the effect of these reallocations of $8.2 million, depreciation and amortization expense would have been consistent with 2016. The table below presents total gross margin and solution gross margins for the periods presented, both as presented and on a pro forma basis as if the changes to allocation methodologies of certain costs in 2017 discussed above had been in effect in 2016. Selling, general, and administrative expense. Selling, general, and administrative expense was reduced by $2.3 million for the year ended December 31, 2017, compared to the year ended December 31, 2016. This reduction included the reallocation of $3.4 million of costs. Excluding the effect of these reallocations, selling, general, and administrative expense would have increased by $1.1 million, reflecting increases in sales and marketing expenses and share-based compensation expense, partially offset by reductions in restructuring consulting fees, severance expense, sponsor management fees and other cost reduction measures related to our declining Bureau solutions. Other expense, net. For the year ended December 31, 2017, we incurred $7.3 million of other expense, net, compared to $12.9 million, for the year ended December 31, 2016. The other expense, net, for the year ended December 31, 2017, was primarily related to foreign currency remeasurement losses on intercompany receivables or payables denominated in foreign currencies. The other expense, net, for the year ended December 31, 2016, was primarily related to an impairment of $10.2 million to our trade name intangible asset and an increase of $5.9 million to our environmental reserve liability to reflect more stringent remediation requirements, partially offset by foreign currency remeasurement gains on intercompany receivables or payables denominated in foreign currencies. Please refer to Note 12, “Supplementary Data to Statement of Operations,” for further discussion. Operating profit (loss). We realized operating profit of $33.0 million for the year ended December 31, 2017, compared to an operating loss of $11.2 million for the year ended December 31, 2016. This $44.2 million increase was primarily due to a $47.4 million increase in revenue and gross margin improvement. Interest expense, net. Interest expense, net, for the year ended December 31, 2017, was $87.1 million, compared to $87.4 million for the year ended December 31, 2016. Income tax (benefit) expense. For the year ended December 31, 2017, we had an income tax benefit of $49.6 million, compared to income tax expense of $6.7 million for the year ended December 31, 2016. Income tax benefit for the year ended December 31, 2017, was primarily related to a tax benefit of approximately $59.4 million related to the 2017 tax reform legislation, of which $26.4 million was attributable to the revaluation of our deferred tax assets and liabilities and $33.0 million was attributable to the reduction in our valuation allowance. (Loss) income from discontinued operations. For the year ended December 31, 2017, we had a loss from discontinued operations of $6.0 million, compared to income from discontinued operation of $12.5 million for the year ended December 31, 2016. The loss from discontinued operations for the year ended December 31, 2017, was primarily related to our LifeWorks business. Income from discontinued operations for the year ended December 31, 2016, was primarily attributable to proceeds of $10.7 million from our Divested Benefits Businesses, net of tax, which were sold in a series of transactions in the third quarter of 2015, and our United Kingdom business, which was sold in the second quarter of 2016, resulting in a gain on sale of $5.9 million. Net loss attributable to Ceridian. Net loss attributable to Ceridian improved by $83.7 million to $9.2 million for the year ended December 31, 2017, compared to $92.9 million for the year ended December 31, 2016. Adjusted EBITDA. Adjusted EBITDA increased by $32.3 million for the year ended December 31, 2017, compared to the year ended December 31, 2016, and Adjusted EBITDA margin increased to 17.6% in 2017 from 13.7% in 2016. Quarterly Results of Operations The following table sets forth statements of operations data for each of the quarters presented. We have prepared the quarterly statements of operations data on a basis consistent with the audited consolidated financial statements. In the opinion of management, the financial information reflects all adjustments, consisting of normal recurring adjustments, which we consider necessary for a fair presentation of this data. This information should be read in conjunction with the audited consolidated financial statements and related notes. The results of historical periods are not necessarily indicative of the results for any future period. Liquidity and Capital Resources Our primary sources of liquidity are our existing cash and equivalents, cash provided by operating activities, borrowings under our credit facilities, and proceeds from equity offerings. As of December 31, 2018, we had cash and equivalents of $217.8 million and availability under our revolving credit facility of $300.0 million. No cash amounts were drawn on the revolving credit facility during 2018. Our total indebtedness was $678.3 million as of December 31, 2018. Please refer to Note 9, “Debt,” to our consolidated financial statements, for further information on our debt. Our primary liquidity needs are related to funding of general business requirements, including the payment of interest and principal on our indebtedness, capital expenditures, pension contributions, and product development. Our customer trust funds are held and invested with the primary objectives being to protect the principal balance and to ensure adequate liquidity to meet cash flow requirements. Accordingly, we maintain on average approximately 46% of customer trust funds in liquidity portfolios with maturities ranging from one to 120 days, consisting of high-quality bank deposits, money market mutual funds, commercial paper, or collateralized short-term investments; and we maintain on average approximately 54% of customer trust funds in fixed income portfolios with maturities ranging from 120 days to 10 years, consisting of U.S. Treasury and agency securities, Canada government and provincial securities, as well as highly rated asset-backed, mortgage-backed, municipal, corporate and bank securities. To maintain sufficient liquidity in the trust to meet payment obligations, we also have financing arrangements and may pledge fixed income securities for short-term financing. The assets held in trust are intended for the specific purpose of satisfying client fund obligations and therefore are not freely available for our general business use. We believe that our cash flow from operations, availability under our revolving credit facility, and available cash and equivalents will be sufficient to meet our liquidity needs for the foreseeable future. We anticipate that to the extent that we require additional liquidity, it will be funded through the issuance of equity, the incurrence of additional indebtedness, or a combination thereof. We cannot assure you that we will be able to obtain this additional liquidity on reasonable terms, or at all. Additionally, our liquidity and our ability to meet our obligations and to fund our capital requirements are also dependent on our future financial performance, which is subject to general economic, financial, and other factors that are beyond our control. Accordingly, we cannot assure you that our business will generate sufficient cash flow from operations or that future borrowings will be available from additional indebtedness or otherwise to meet our liquidity needs. Although we have no specific current plans to do so, if we decide to pursue one or more significant acquisitions, we may incur additional debt or sell additional equity to finance such acquisitions, which would result in additional expenses or dilution. Statements of Cash Flows Changes in cash flows due to purchases of customer trust fund marketable securities, proceeds from the sale or maturity of customer trust fund marketable securities, and the net increase (decrease) of restricted cash held to satisfy customer trust fund obligations, as well as the carrying value of customer trust fund accounts as of period end dates can vary significantly due to several factors, including the specific day of the week the period ends, which impacts the timing of funds collected from customers and payments made to satisfy customer obligations to employees, taxing authorities, and others. For example, December 31, 2018 was a Monday, when trust fund balances are generally lower; whereas, the last business day of 2017 was a Friday, when trust fund balances are generally higher. The customer trust funds are fully segregated from our operating cash accounts and are evaluated and tracked separately by management. Therefore, to provide meaningful information to the readers, the following discussion is regarding the net cash flows excluding customer trust funds. Operating Activities Net cash provided by operating activities from continuing operations of $10.7 million during the year ended December 31, 2018, was primarily attributable to operating profit of $52.8 million, partially offset by a $45.0 million reduction in cash as a result of net changes in working capital. The $45.0 million reduction in net working capital was primarily attributable to a reduction of $22.1 million in liabilities for employee compensation and benefits, primarily due to payments of accrued incentive compensation and pension contributions, and a $15.7 million reduction in liabilities for accrued interest, associated with our debt refinancing. Included within net cash flows provided by operating activities for the year ended December 31, 2018, was $74.5 million in cash interest payments on our long-term debt, $18.5 million in pension payments, and $16.7 million in cash taxes, net of refunds received. Net cash used in operating activities from continuing operations of $29.4 million during the year ended December 31, 2017, was primarily attributable to operating losses of $4.5 million, net changes in working capital of $37.2 million, and a deferred tax benefit of $62.3 million, partially offset by certain non-cash items, primarily $53.8 million of depreciation and amortization and $16.1 million of share-based compensation expense. Net changes in working capital were driven by employee compensation and benefits, primarily pension contributions, accrued taxes, and prepaid expenses. Net cash used in operating activities from continuing operations of $73.2 million during the year ended December 31, 2016, was primarily attributable to operating losses of $105.3 million with offsetting adjustments for certain non-cash items and net changes in working capital. The adjustments for non-cash items included $53.2 million of depreciation and amortization, $12.5 million of share-based compensation expense, a $10.4 million asset impairment, and a $5.9 million adjustment to our environmental reserve liability, partially offset by $8.3 million of deferred income tax benefit. Net changes in working capital of $49.3 million were primarily driven by pension contributions exceeding pension expense. Investing Activities During the year ended December 31, 2018, net cash used in investing activities from continuing operations, excluding customer trust fund activity, was $40.2 million, including $32.2 million in capital expenditures for software and technology and $8.0 million in capital expenditures for property and equipment. During the year ended December 31, 2017, net cash used in investing activities from continuing operations excluding customer trust fund activity was $51.1 million, primarily related to capital expenditures, partially offset by proceeds from divestitures. Our capital expenditures included $33.1 million for software and technology and $17.5 million for property and equipment. During the year ended December 31, 2016, net cash provided by investing activities from continuing operations excluding customer trust fund activity was $68.7 million, primarily related to the net proceeds from divestitures of $101.6 million, offset by capital expenditures. Our capital expenditures included $25.5 million for software and technology and $7.4 million for property and equipment. Financing Activities Net cash provided by financing activities from continuing operations, excluding the change in customer trust fund obligations, was $163.5 million during the year ended December 31, 2018. This cash inflow is primarily attributable to the net proceeds received from our IPO and concurrent private placement of $595.0 million, a net increase in the principal of our term loan of $23.0 million, and proceeds from the issuance of common stock upon exercise of stock options of $45.8 million, partially offset by a $475.0 million payment to redeem our Senior Notes and debt refinancing costs of $23.3 million. Net cash provided by financing activities from continuing operations excluding the change in customer trust fund obligations was $50.7 million during the year ended December 31, 2017, primarily related to the funding of the remaining $75.2 million from the issuance of Senior Preferred Stock, partially offset by a $25.9 million payment made on our term debt. Net cash provided by financing activities from continuing operations excluding the change in customer trust fund obligation was $63.2 million during the year ended December 31, 2016, related to proceeds received from the issuance of Senior Preferred Stock, partially offset by payments made on our term debt. Cash Flows from Discontinued Operations During the year ended December 31, 2018, net cash used in discontinued operations was $1.2 million. During the year ended December 31, 2017, net cash used in discontinued operations was $10.6 million. During the year ended December 31, 2016, net cash used in discontinued operations was $1.9 million. The cash flows from discontinued operations for all periods primarily relate to changes in working capital. Backlog We do not believe that any measure of backlog is a meaningful indicator of revenues that can be expected for a particular future period as the amount and timing can be influenced by multiple factors, including the timing of the completion of implementation, the accuracy and success of implementation services provided by us and by third parties, the timing in which new customers go-live, and our ability to meet service level commitments. Seasonality We have in the past and expect in the future to experience seasonal fluctuations in our revenues and new customer contracts with the fourth quarter historically being our strongest quarter for new customer contracts, renewals, and customer go-lives. Although the growth of our Cloud solutions and the ratable nature of our fees makes this seasonality less apparent in our overall results of operations, we expect our revenue to fluctuate quarterly and to be higher in the fourth and first quarters of each year. Fourth quarter revenue is driven by year-end processing fees and Dayforce customer go-lives; and first quarter revenue is driven by revenue earned for printing of year-end tax packages. Off-Balance Sheet Arrangements As of December 31, 2018, we did not have any “off-balance sheet arrangements” (as such term is defined in Item 303 of Regulation S-K). Our Indebtedness On April 30, 2018, Ceridian entered into a credit agreement pursuant to which the lenders agreed to provide Senior Credit Facilities, consisting of the Senior Term Loan in the original principal amount of $680.0 million and a $300.0 million Revolving Facility. The Revolving Facility may, at our option, be made available in United States Dollars, Canadian Dollars, Euros and/or Pounds Sterling; up to $70.0 million may, at our option, be made available for letters of credit and $100.0 million may, at our option, be made available for swingline loans (denominated in Canadian Dollars and/or United States Dollars). The Senior Term Loan will mature on April 30, 2025. We are required to make annual amortization payments in respect of the Senior Term Loan in an amount equal to 1.00% of the original principal amount thereof, payable in equal quarterly installments of 0.25% of the original principal amount of the first lien term loan. The Revolving Facility matures on April 30, 2023 and does not require amortization payments. The obligations of Ceridian under the Senior Credit Facilities are secured by first priority security interests in substantially all of the assets of Ceridian and the guarantors, subject to permitted liens and other exceptions. All of our subsidiaries are guarantors under the Senior Credit Facilities, subject to certain exceptions. The Senior Credit Facilities contain financial covenants and certain business covenants, including restrictions on dividend payments, which Ceridian must comply with during the term of the agreement. As of December 31, 2018, Ceridian was in full compliance with the terms of the Senior Credit Facilities. Borrowings under the Senior Credit Facilities bear interest at a rate per annum equal to: 1. in the case of borrowings denominated in U.S. dollars on any day (a) at Ceridian’s election, either (i) an amount (not less than 1.00%) equal to the greater of (A) a base rate determined by reference to the rate of interest per annum announced by Deutsche Bank AG New York Branch (“DBNY”) as its prime rate on such day, (B) the federal funds effective rate on such date plus 1/2 of 1.00% and (C) the London interbank offered rate (“LIBOR”) plus 1.00% or (ii) if available, LIBOR for U.S. dollars determined by reference to the applicable Reuters screen page two business days prior to the commencement of the interest period relevant to the subject borrowing, adjusted for certain additional costs, which may not be less than 0.00% plus (b) an applicable margin; 2. in the case of borrowings under the Revolving Facility denominated in Canadian Dollars on any day (a) at Ceridian’s election, either (i) the rate of interest per annum quoted or established as the “prime rate” of Deutsche Bank AG Canada Branch plus an applicable margin or (ii) CDOR for Canadian dollars determined by reference to the applicable Reuters screen page on date of the commencement of the interest period relevant to the subject borrowing, adjusted for certain additional costs, which may not be less than 0.00% plus (b) an applicable margin; 3. in the case of borrowings under the Revolving Facility denominated in Euros on any day, (a) The London interbank offered rate in Euros (“EURIBOR”) determined by reference to the applicable Reuters screen page two business days prior to the commencement of the interest period relevant to the subject borrowing, which may not be less than 0.00% plus (b) an applicable margin; or 4. in the case of borrowings under the Revolving Facility denominated in Pounds Sterling, (a) Sterling LIBOR determined by reference to the applicable Reuters screen page one business day prior to the commencement of the interest period relevant to the subject borrowing, which may not be less than 0.00% plus (b) an applicable margin. The applicable margin for the Senior Term Loan is (i) 3.25% per annum, in the case of LIBOR loans and (ii) 2.25% per annum, in the case of base rate loans. Such applicable margin will be reduced by 0.25% per annum if the corporate family rating of Ceridian from Moody’s is B2 or better, each such reduction being effective during the period commencing on the date of such change in rating becomes effective and ending on the date immediately preceding the effective date of next change in rating. The applicable margin for loans under the Revolving Facility is determined in accordance with the table set forth below: We are also required to pay a customary annual administration fee to the administrative agent under the Senior Credit Facilities. For an additional description of the Senior Credit Facilities, please refer to Note 9, “Debt,” to our consolidated financial statements. Contractual Obligations The following table sets forth our contractual obligations and other commercial commitments as of December 31, 2018, whether or not they appear on our consolidated balance sheet. Variable interest payments are projected based on an interest rate forecast in effect at the end of 2018. All amounts in the table may reflect rounding. (a) We have not estimated our pension funding obligations beyond 2027, and thus, any potential future contributions have been excluded from the table. Our long-term debt obligations are described in Note 9, “Debt,” to our consolidated financial statements. The lease payments represent scheduled payments under the terms of the lease agreements. We conduct substantially all of our operations in leased facilities. Most of these leases contain renewal options and require payments for taxes, insurance, and maintenance. We also lease equipment for use in our business. Payments of retirement plan obligations include employer commitments to fund our defined benefit and postretirement plans and do not include estimated future benefit payments to participants expected to be made from liquidation of the assets in our defined benefit plan trusts. At December 31, 2018, our defined benefit pension plans had a projected benefit obligation that exceeded the fair value of the plans’ assets by $145.8 million and our postretirement benefit plan had an accumulated benefit obligation that exceeded the fair value of the plans’ assets by $16.8 million. We expect to satisfy these remaining obligations through investment income from and appreciation in the fair value of plan assets held in trust and from future employer contributions. The amount of our obligation to vendors for capital expenditures at December 31, 2018 was not material, and no such amount is included in the table above. Critical Accounting Policies and Estimates Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements and related notes, which have been prepared in accordance with GAAP. The preparation of these financial statements and related notes requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue, and expenses. Certain of our accounting policies require the application of significant judgment by management in selecting the appropriate assumptions for calculating financial estimates. By their nature, these judgments are subject to an inherent degree of uncertainty. These judgments are based on our historical experience, terms of existing contracts, our evaluation of trends in the industry, information provided by our customers, and information available from other outside sources, as appropriate. We evaluate our estimates and judgments on an on-going basis. Our actual results may differ from these estimates. Please refer to Note 2, “Summary of Significant Accounting Policies,” for a description of our significant accounting policies. The accounting policies that we believe to be the most critical to an understanding of our financial condition and results of operations and that require the most complex and subjective management judgments are discussed below. Revenue Recognition We recognize revenue from the sale of our services, net of applicable sales taxes, when the following criteria are met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services have been rendered; (3) the seller’s price to the buyer is fixed or determinable; and (4) collectability is reasonably assured. We rely on a signed contract with the customer as the persuasive evidence of a sales arrangement. We enter into revenue arrangements that may consist of multiple deliverables based on the needs of our customers. For example, our services address a broad range of employment process needs, such as payroll, payroll-related tax filing, human resource information, employee self-service capabilities, time and labor management, and recruitment and applicant screening. A customer arrangement may contain any of these elements with different elements delivered across multiple reporting periods. We have a single unit of accounting for each deliverable in a contract based on the use of estimated selling price (“ESP”) in those cases where vendor-specific objective evidence of selling price (“VSOE”) or third party evidence (“TPE”) cannot be established. Our determination of ESP involves the consideration of several factors based on the specific facts and circumstances of each contract. Specifically, we consider the cost to produce or to provide the deliverable, the anticipated margin on that deliverable, the selling price and profit margin for similar services, the value of any enhancements that have been built into the deliverable, and the characteristics of the varying markets in which the deliverable will be sold. When we are unable to establish a selling price using VSOE or TPE, we use ESP in the allocation of arrangement consideration. The objective of ESP is to determine the price at which we would transact a sale if the service were sold on a standalone basis. We regularly review VSOE, TPE, and ESP and maintain internal controls over the establishment and updates of these estimates. There were no material impacts during the period, nor do we currently expect a material impact in the near term from changes in VSOE, TPE, or ESP. Deferred revenue consists primarily of customer billings in advance of revenues being recognized from our contracts. Deferred revenue also includes certain deferred professional services fees that are accounted for as a single unit of accounting with subscription fees and are recognized as revenues over the same period as the related customer contract. Deferred revenue that is anticipated to be recognized during the succeeding twelve-month period is recorded as current deferred revenue, and the remaining portion is recorded as noncurrent. Recently Issued Accounting Pronouncements Please refer to Note 2, “Summary of Significant Accounting Policies,” for a full discussion of recent accounting pronouncements. Non-GAAP Measures Adjusted EBITDA and Adjusted EBITDA Margin We believe that Adjusted EBITDA and Adjusted EBITDA margin, non-GAAP financial measures, are useful to management and investors as supplemental measures to evaluate our overall operating performance. Adjusted EBITDA is a component of our management incentive plan and Adjusted EBITDA and Adjusted EBITDA margin are used by management to assess performance and to compare our operating performance to our competitors. We define Adjusted EBITDA as net income or loss before interest, taxes, depreciation, and amortization, as adjusted to exclude net income or loss from discontinued operations, sponsor management fees, non-cash charges for asset impairments, gains or losses on assets and liabilities held in a foreign currency other than the functional currency of a company subsidiary, share-based compensation expense, severance charges, restructuring consulting fees, transaction costs, and environmental reserve charges. Adjusted EBITDA margin is determined by calculating the percentage Adjusted EBITDA is of total revenue. Management believes that Adjusted EBITDA and Adjusted EBITDA margin are helpful in highlighting management performance trends because Adjusted EBITDA and Adjusted EBITDA margin exclude the results of decisions that are outside the control of operating management. Our presentation of Adjusted EBITDA and Adjusted EBITDA margin are intended as supplemental measures of our performance that are not required by, or presented in accordance with, GAAP. Adjusted EBITDA and Adjusted EBITDA margin should not be considered as alternatives to operating profit (loss), net income (loss), earnings per share, or any other performance measures derived in accordance with GAAP, or as measures of operating cash flows or liquidity. Our presentation of Adjusted EBITDA and Adjusted EBITDA margin should not be construed to imply that our future results will be unaffected by similar items to those eliminated in this presentation. Adjusted EBITDA and Adjusted EBITDA margin are included in this discussion because they are key metrics used by management to assess our operating performance. Adjusted EBITDA and Adjusted EBITDA margin are not defined under GAAP, are not measures of net income, operating income, or any other performance measures derived in accordance with GAAP, and are subject to important limitations. Our use of the terms Adjusted EBITDA and Adjusted EBITDA margin may not be comparable to similarly titled measures of other companies in our industry and are not measures of performance calculated in accordance with GAAP. Adjusted EBITDA and Adjusted EBITDA margin have important limitations as analytical tools, and you should not consider them in isolation or as substitutes for analysis of our results as reported under GAAP. Some of these limitations are: • Adjusted EBITDA and Adjusted EBITDA margin do not reflect our cash expenditures or future requirements for capital expenditures or contractual commitments; • Adjusted EBITDA and Adjusted EBITDA margin do not reflect changes in, or cash requirements for, our working capital needs; • Adjusted EBITDA and Adjusted EBITDA margin do not reflect any charges for the assets being depreciated and amortized that may need to be replaced in the future; • Adjusted EBITDA and Adjusted EBITDA margin do not reflect the impact of share-based compensation upon our results of operations; • Adjusted EBITDA and Adjusted EBITDA margin do not reflect the significant interest expense or the cash requirements necessary to service interest or principal payments on our debt; and • Adjusted EBITDA and Adjusted EBITDA margin do not reflect our income tax expense or the cash requirements to pay our income taxes. In evaluating Adjusted EBITDA and Adjusted EBITDA margin, you should be aware that in the future we may incur expenses similar to those eliminated in this presentation. The following table reconciles operating profit to Adjusted EBITDA for the periods presented: (1) We define EBITDA from continuing operations as net income or loss before interest, taxes, depreciation and amortization, and net income or loss from discontinued operations. (2) Represents expenses related to management, monitoring, consulting, transaction, and advisory fees and related expenses paid to the affiliates of our Sponsors pursuant to the management agreement with THL Managers VI, LLC (“THLM”) and Cannae. In April 2018, the management agreements terminated upon consummation of our IPO. Upon termination, the management agreements provided that we pay a termination fee equal to the net present value of the management fee for a seven-year period, which was $11.3 million. Please refer to Note 16 to our consolidated financial statements, “Related Party Transactions,” for further information. (3) Share-based compensation expense during the year months ended December 31, 2018, includes $8.1 million of expense recognized upon meeting the performance criteria of stock appreciation rights and performance-based stock options that were triggered by our IPO. (4) Represents costs for severance compensation paid to employees whose positions have been eliminated or who have been terminated not for cause. (5) Represents consulting fees and expenses incurred during the periods presented in connection with any acquisition, investment, disposition, recapitalization, equity offering, issuance or repayment of debt, issuance of equity interests, or refinancing. (6) Reflects charges to increase the reserve for environmental claims from a predecessor company. Please refer to Note 12 to our consolidated financial statements for further information regarding our environmental reserves. (7) Represents expenses related to the IPO and refinancing of our debt that were not eligible for capitalization. The following tables present a reconciliation of our reported results to our non-GAAP Adjusted EBITDA basis for all periods presented: (1) Other operating expenses includes sponsor management fees, intercompany foreign exchange gain, restructuring consulting fees, and transaction costs. (1) Other operating expenses includes sponsor management fees, intercompany foreign exchange loss (gain), and restructuring consulting fees. (1) Other operating expenses includes sponsor management fees, intercompany foreign exchange loss, restructuring consulting fees, asset impairments, and environmental reserve charges.
-0.005795
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<s>[INST] Overview Ceridian is a global HCM software company. We categorize our solutions into two categories: Cloud and Bureau solutions. Cloud revenue is generated from HCM solutions that are delivered via two cloud offerings: Dayforce, our flagship cloud HCM platform, and Powerpay, a cloud HR and payroll solution for the Canadian small business market. We also continue to support customers using our Bureau solutions, which we generally stopped actively selling to new customers following the acquisition of Dayforce in 2012. We invest in maintenance and necessary updates to support our Bureau customers and continue to migrate them to Dayforce. Dayforce provides HR, payroll, benefits, workforce management, and talent management functionality. Our platform is used by organizations, regardless of industry or size, to optimize management of the entire employee lifecycle, including attracting, engaging, paying, deploying, and developing their people. Dayforce was built as a single application from the ground up that combines a modern, consumergrade user experience with proprietary application architecture, including a single employee record and a rules engine spanning all areas of HCM. Dayforce provides continuous realtime calculations across all modules to enable, for example, payroll administrators access to data through the entire pay period, and managers access to realtime data to optimize work schedules. Our platform is designed to make work life better for our customers and their employees by improving HCM decisionmaking processes, streamlining workflows, exposing strategic organizational insights, and simplifying legislative compliance. The platform is designed to ease administrative work for both employees and managers, creating opportunities for companies to increase employee engagement. We are a founderled organization, and our culture combines the agility and innovation of a startup with a history of deep domain and operational expertise. We sell Dayforce through our direct sales force on a subscription peremployee, permonth (“PEPM”) basis. Our subscriptions are typically structured with an initial fixed term of between three and five years, with evergreen renewal thereafter. Dayforce can serve customers of all sizes, ranging from 100 to over 100,000 employees. We have rapidly grown the Dayforce platform to more than 3,700 live Dayforce customers, representing approximately 3.1 million active global users as of December 31, 2018. In 2018, we added over 715 net new live Dayforce customers. Our customers vary across industries, and no single customer constituted more than 1% of our revenues for the year ended December 31, 2018. We have experienced significant Cloud revenue growth at scale, particularly from Dayforce, which has grown at a compound annual growth rate (“CAGR”) of more than 55% since 2012. Our annual Cloud revenue retention rate continues to exceed 95% due to our intense focus on solving complex problems and our superior customer experience. The following table presents Dayforce revenue by quarter from 2012 to 2018. Our Business Model Our business model focuses on supporting the rapid growth of Dayforce and maximizing the lifetime value of our Dayforce customer relationships. Due to our subscription model, where we recognize subscription revenues ratably over the term of the subscription period, and high customer retention rates, we have a high level of visibility into our future revenues. The profitability of a customer to our business depends, in large part, on how long they have been a customer. Because in our current business model, PEPM subscription fees are not charged until the customer goes live, and because we incur costs in advance of receiving PEPM revenue that are not offset by our implementation fees, we estimate that it takes an average of 2.5 years before we are able to recover our implementation, customer acquisition, and other direct costs on a new Dayforce customer contract. As the proportion of Dayforce customers who have been live for two or more years increases, our related profitability increases. The following sets forth the number of live Dayforce customers at the end of each quarter presented: Over the lifetime of the customer relationship, we have the opportunity to realize additional PEPM revenue, both as the customer grows or rolls out the Dayforce solution to additional employees, and also by selling additional functionality to existing customers that do not currently utilize our full platform. We also incur costs to manage the account, to retain customers, and to sell additional functionality. These costs, however, are significantly less than the costs initially incurred to acquire and to implement the customer. How [/INST] Negative. </s>
2,019
12,599
1,725,057
Ceridian HCM Holding Inc.
2020-02-28
2019-12-31
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The following is a discussion and analysis of our financial condition and results of operations as of, and for, the periods presented. 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 thereto included elsewhere in this report. This discussion and analysis contains forward-looking statements, including statements regarding industry outlook, our expectations for the future of our business, and our liquidity and capital resources as well as other non-historical statements. These statements are based on current expectations and are subject to numerous risks and uncertainties, including but not limited to the risks and uncertainties described in “Risk Factors” and “Forward-Looking Statements.” Our actual results may differ materially from those contained in or implied by these forward-looking statements. Overview Ceridian is a global HCM software company. We categorize our solutions into two categories: Cloud and Bureau solutions. Cloud revenue is generated from HCM solutions that are delivered via two cloud offerings: Dayforce, our flagship cloud HCM platform, and Powerpay, a cloud HR and payroll solution for the Canadian small business market. We also continue to support customers using our Bureau solutions, which we generally stopped actively selling to new customers following the acquisition of Dayforce in 2012. We invest in maintenance and necessary updates to support our Bureau customers and continue to migrate them to Dayforce. Dayforce provides HR, payroll, benefits, workforce management, and talent management functionality. Our platform is used by organizations, regardless of industry or size, to optimize management of the entire employee lifecycle, including attracting, engaging, paying, deploying, and developing their people. Dayforce was built as a single application from the ground up that combines a modern, consumer-grade user experience with proprietary application architecture, including a single employee record and a rules engine spanning all areas of HCM. Dayforce provides continuous real-time calculations across all modules to enable, for example, payroll administrators access to data through the entire pay period, and managers access to real-time data to optimize work schedules. Our platform is designed to make work life better for our customers and their employees by improving HCM decision-making processes, streamlining workflows, revealing strategic organizational insights, and simplifying legislative compliance. The platform is designed to ease administrative work for both employees and managers, creating opportunities for companies to increase employee engagement. We are a founder-led organization, and our culture combines the agility and innovation of a start-up with a history of deep domain and operational expertise. We sell Dayforce through our direct sales force on a subscription per-employee, per-month (“PEPM”) basis. Our subscriptions are typically structured with an initial fixed term of between three and five years, with evergreen renewal thereafter. Dayforce can serve customers of all sizes, ranging from 100 to over 100,000 employees. We have rapidly grown the Dayforce platform to more than 4,350 live Dayforce customers, representing approximately 3.9 million active global users as of December 31, 2019. In 2019, we added over 640 net new live Dayforce customers. Our customers vary across industries, and no single customer constituted more than 1% of our revenues for the year ended December 31, 2019. We have experienced significant Cloud revenue growth at scale, particularly from Dayforce, which has grown at a compound annual growth rate (“CAGR”) of more than 50% since 2012. Our annual Cloud revenue retention rate continues to exceed 95% due to our focus on solving complex problems and our superior customer experience. The following table presents Dayforce revenue by quarter from 2012 to 2019. Our Business Model Our business model focuses on supporting the rapid growth of Dayforce and maximizing the lifetime value of our Dayforce customer relationships. Due to our subscription model, where we recognize subscription revenues ratably over the term of the subscription period, and our high customer retention rates, we have a high level of visibility into our future revenues. The profitability of a customer to our business depends, in large part, on how long they have been a customer. Because in our current business model, PEPM subscription fees are not charged until the customer goes live, and because we incur costs in advance of receiving PEPM revenue that are not offset by our implementation fees, we estimate that it takes approximately 2 years before we are able to recover our implementation, customer acquisition, and other direct costs on a new Dayforce customer contract. Over the lifetime of the customer relationship, we have the opportunity to realize additional PEPM revenue, both as the customer grows or rolls out the Dayforce solution to additional employees, and also by selling additional functionality to existing customers that do not currently utilize our full platform. We also incur costs to manage the account, to retain customers, and to sell additional functionality. These costs, however, are significantly less than the costs initially incurred to acquire and to implement the customer. How We Assess Our Performance In assessing our performance, we consider a variety of performance indicators in addition to revenue and net income. Set forth below is a description of our key performance measures. (a) Annual Cloud revenue retention rate and Cloud annualized recurring revenue are calculated on an annual basis, and the disclosure reflects data as of the most recent fiscal year end. Please see below for further explanation. (b) For a reconciliation of Adjusted EBITDA to operating profit, please refer to the “Non-GAAP Measures” section. Live Dayforce Customers We use the number of customers live on Dayforce as an indicator of future revenue and the overall performance of the business and to assess the performance of our implementation services. As shown in the following table, the number of customers live on Dayforce has increased from 482 as of December 31, 2012 to 4,363 as of December 31, 2019. In addition, we had approximately 500 net new Dayforce customers contracted, but not yet live on Dayforce as of December 31, 2019. We expect the majority of these Dayforce customers to be taken live in 2020. For 2019, our 4,363 live Dayforce customers represented approximately 3.9 million active global users. As our business and go-to-market strategy continues to evolve, in 2019, we modified our customer segmentation for increased relevance. The Dayforce customer data disclosed below has been updated to reflect this new customer segmentation for all periods presented. We market Dayforce to customers of all sizes, including small (under 500 employees), major (500 to 5,999 employees), and enterprise (6,000 or more employees). For 2019, small businesses accounted for 12% of the total number of active global users, major businesses accounted for 52% of the total number of active global users, and enterprise businesses accounted for 36% of the total number of active global users. From 2018 to 2019, live Dayforce customers increased from 3,718 to 4,363, a net increase of 645. Of the customers taken live during 2019, 72% represented net new customers to Dayforce, and the remainder were migration customers from our Bureau solution. Of the net new customers to Dayforce, small businesses accounted for 11% of the total number of active global users, major businesses accounted for 49% of the total number of active global users, and enterprise businesses accounted for 40% of the total number of active global users. Of the migration customers, small businesses accounted for 15% of the total number of active global users, major businesses accounted for 56% of the total number of active global users, and enterprise businesses accounted for 29% of the total number of active global users. From 2017 to 2018, live Dayforce customers increased from 3,001 to 3,718, a net increase of 717. Of the customers taken live during 2018, 77% represented net new customers to Dayforce and the remainder were migration customers from our Bureau solutions. Of the net new customers to Dayforce, small businesses accounted for 9% of the total number of active global users, major businesses accounted for 57% of the total number of active global users, and enterprise businesses accounted for 34% of the total number of active global users. Of the migration customers, small businesses accounted for 23% of the total number of active global users, major businesses accounted for 64% of the total number of active global users, and enterprise businesses accounted for 13% of the total number of active global users. The following table sets forth the number of live Dayforce customers at the end of the years presented: Annual Cloud Revenue Retention Rate Our annual Cloud revenue retention rate measures the percentage of revenues that we retain from our existing Cloud customers. We use this retention rate as an indicator of customer satisfaction and future revenues. We calculate the annual Cloud revenue retention rate as a percentage, where the numerator is the Cloud annualized recurring revenue for the prior year, less the Cloud annualized recurring revenue from lost Cloud customers during that year; and the denominator is the Cloud annualized recurring revenue for the prior year. Our annual Cloud revenue retention rate has been 95% or above for the years ended December 31, 2019, 2018, and 2017. We set annual targets for Cloud revenue retention rate and monitor progress toward those targets on a quarterly basis by reviewing known and anticipated customer losses. Our Cloud revenue retention rate may fluctuate as a result of a number of factors, including the mix of Cloud solutions used by customers, the level of customer satisfaction, and changes in the number of users live on our Cloud solutions. Cloud Annualized Recurring Revenue (“ARR”) We derive the majority of our Cloud revenues from recurring fees, primarily PEPM subscription charges. We also derive recurring revenue from fees related to the rental and maintenance of clocks, charges for once-a-year services, such as year-end tax statements, and investment income on our customer funds held in trust before such funds are remitted to taxing authorities, customer employees, or other third parties. To calculate Cloud ARR, we start with recurring revenue at year end, subtract the once-a-year charges, annualize the revenue for customers live for less than a full year to reflect the revenue that would have been realized if the customer had been live for a full year, and add back the once-a-year charges. We set annual targets for Cloud ARR and monitor progress toward those targets on a quarterly basis. Constant Currency Revenue We present revenue on a constant currency basis to assess how our underlying business performed, excluding the effect of foreign currency rate fluctuations. We believe this non-GAAP financial measure is useful to management and investors. We have calculated revenue on a constant currency basis by applying a fixed rate of $1.30 Canadian dollar to $1.00 U.S. dollar foreign exchange rate to revenues originally booked in Canadian dollars for all applicable historical periods. Please refer to the “Non-GAAP Measures” section for additional information on our constant currency revenue. Adjusted EBITDA and Adjusted EBITDA margin We believe that Adjusted EBITDA and Adjusted EBITDA margin, non-GAAP financial measures, are useful to management and investors as supplemental measures to evaluate our overall operating performance. Adjusted EBITDA is a component of our management incentive plan and Adjusted EBITDA and Adjusted EBITDA margin are used by management to assess performance and to compare our operating performance to our competitors. We define Adjusted EBITDA as net income or loss before interest, taxes, depreciation, and amortization, as adjusted to exclude net income or loss from discontinued operations, sponsor management fees, non-cash charges for asset impairments, gains or losses on assets and liabilities held in a foreign currency other than the functional currency of a company subsidiary, share-based compensation expense and related employer taxes, severance charges, restructuring consulting fees, transaction costs, and certain other non-recurring charges. Adjusted EBITDA margin is determined by calculating the percentage that Adjusted EBITDA is of total revenue. Management believes that Adjusted EBITDA and Adjusted EBITDA margin are helpful in highlighting management performance trends because Adjusted EBITDA and Adjusted EBITDA margin exclude the results of decisions that are outside the normal course of our business operations. Please refer to the “Results of Operations” section below for a discussion of Adjusted EBITDA and Adjusted EBITDA margin. Our History Ceridian was acquired in 2007 by affiliates and co-investors of THL and Cannae. In April 2012, Ceridian acquired Dayforce Corporation, which had built Dayforce, a cloud HCM solution. In the months following the acquisition, Dayforce founder, David D. Ossip, was named Chief Executive Officer of Ceridian HCM, and shortly thereafter, we generally stopped actively selling our Bureau solutions to new customers in the United States to focus our resources on expanding the Dayforce platform and growing Cloud solutions. For each quarter since September 30, 2016, our Cloud revenue has surpassed our Bureau revenue. Cloud revenue grew from 41% of total revenue during the quarter ended December 31, 2015, to 83% of total revenue during the quarter ended December 31, 2019. As part of our strategy to focus on the growth of our Cloud solutions business, we undertook the following initiatives to simplify our business model: (i) sold our consumer-directed benefit services business in 2013, (ii) merged Comdata, our payment systems business unit, with FleetCor Technologies in 2014, (iii) sold our benefits administration and post-employment compliance business in 2015, (iv) sold our United Kingdom and Ireland Bureau businesses and a portion of our operations that supported such businesses in Mauritius in 2016, and (v) contributed our LifeWorks employee assistance program business to a joint venture, LifeWorks, in 2016, then distributed our ownership in this joint venture to a holding company owned by our stockholders in April 2018 (the “LifeWorks Disposition”). As a result of these transactions, we primarily sell Dayforce and Powerpay, which we believe simplifies our business model and positions us well for continued growth. Our benefits administration and post-employee compliance business, our United Kingdom and Ireland businesses, our divested Mauritius operations, and our LifeWorks joint venture are presented as discontinued operations in our financial statements. Our consumer-directed benefits services business and our benefits administration and post-employment compliance business are collectively referred to as our “Divested Benefits Businesses.” After the LifeWorks Disposition, management has concluded that we have one operating and reportable segment. This conclusion aligns with how management monitors operating performance, allocates resources, and deploys capital. Please refer to Note 3, “Discontinued Operations,” to our consolidated financial statements for further information regarding these transactions. On April 30, 2018, we completed our IPO, in which we issued and sold 21,000,000 shares of common stock at a public offering price of $22.00 per share. We granted the underwriters a 30-day option to purchase an additional 3,150,000 shares of common stock at the offering price, which was exercised in full. A total of 24,150,000 shares of common stock were issued on April 30, 2018, with gross proceeds of $531.3 million from the IPO before deducting underwriting discounts, commissions, and other offering expenses. Immediately subsequent to the closing of our IPO on April 30, 2018, THL / Cannae Investors LLC, one of our existing stockholders controlled by THL and Cannae, purchased from us in a private placement $100.0 million of our common stock at a price per share equal to the offering price. Based on the offering price of $22.00 per share, 4,545,455 shares were issued in this private placement. Please refer to Note 1, “Organization,” for further discussion of the IPO transaction. We applied a portion of the net proceeds from the IPO to satisfy and to discharge the indenture governing our outstanding $475.0 million principal amount Senior Notes, and they were redeemed on May 30, 2018. Concurrently, we also refinanced our remaining debt under our (i) $702.0 million (original principal amount) Senior Term Debt and (ii) $130.0 million Revolving Credit Facility, including accrued interest and related costs and expenses, with new senior credit facilities consisting of a $680.0 million term loan debt facility and a $300.0 million revolving credit facility. Please refer to Note 10, “Debt,” for further discussion of the debt transactions. Components of Our Results of Operations Revenues We generate recurring revenues primarily from recurring fees charged for the use of our Cloud solutions, Dayforce and Powerpay, as well as from our Bureau solutions. We also generate professional services and other revenue associated primarily with the work performed to assist customers with the planning, design, and implementation of their cloud-based solution. Our solutions are typically provided through long-term customer relationships that result in a high level of recurring revenue. We also generate recurring services revenue from investment income on our Cloud and Bureau customer funds held in trust before such funds are remitted to taxing authorities, customer employees, or other third parties. We refer to this investment income as float revenue. For Dayforce, we primarily charge monthly recurring fees on a PEPM basis, generally one-month in advance of service, based on the number and type of solutions provided to the customer and the number of employees and other users at the customer. Our standard Dayforce contracts are generally for a three to five-year period. The average time it takes to implement Dayforce typically ranges from three months for smaller customers to nine months for larger customers. Once Dayforce is implemented, the customer goes live, and we begin to generate recurring revenue. We also provide outsourced human resource solutions to certain of our Dayforce customers, which are tailored to meet their individual needs, and entail performing the duties of a customer’s human resources department, including payroll processing, time and labor management, performance management, and recruiting, as needed. The Powerpay offering is our solution designed primarily for small market Canadian customers. The typical Powerpay customer has fewer than 20 employees, and the majority of the revenue is generated from recurring fees charged on a per-employee, per-process basis. Typical processes include the customer’s payroll runs, year-end tax packages, and delivery of customers’ remittance advices or checks. Powerpay can typically be implemented on a remote basis within one to three days, at which point we start receiving recurring fees. For our Bureau solutions, we typically charge recurring fees on a per-process basis. Typical processes include the customer’s payroll runs, year-end tax packages, and delivery of customers’ remittance advices or checks. In addition to customers who use our payroll services, certain customers use our tax filing services on a stand-alone basis; and we have started to sell stand-alone tax services again in 2019. Our outsourced human resource solutions are tailored to meet the needs of individual customers, and entail our contracting to perform many of the duties of a customer’s human resources department, including payroll processing, time and labor management, performance management, and recruiting. We also perform individual services for customers, such as check printing, wage attachment and disbursement, and ACA management. Cost of Revenue Cost of revenue consists of costs to deliver our solutions. Most of these costs are recognized as incurred. Some costs of revenue are recognized in the period that a service is sold and delivered. Other costs of revenue are recognized over the period of use or in proportion to the related revenue. The costs recognized as incurred consist primarily of customer service staff costs, customer technical support costs, implementation personnel costs, costs of hosting applications, consulting and purchased services, delivery services, and royalties. The costs of revenue recognized over the period of use are depreciation and amortization, rentals of facilities and equipment, and direct and incremental costs associated with deferred implementation service revenue. Cost of recurring services revenues primarily consists of costs to provide maintenance and technical support to our customers and the costs of hosting our applications. The cost of recurring services revenues also includes compensation and other employee-related expenses for data center staff, payments to outside service providers, data center expenses, and networking expenses. Cost of professional services and other revenues primarily consists of costs to provide implementation consulting services and training to our customers, as well as the cost of time clocks. Costs to provide implementation consulting services include compensation and other employee-related expenses for professional services staff, costs of subcontractors, and travel. Implementation consulting services are expected to continue to be primarily associated with the implementation of our Cloud solutions. Product development and management expense, included in cost of revenue, consists of costs related to software development activities that do not qualify for capitalization, such as development, quality assurance, testing of new technologies, and enhancements to our existing solutions that do not result in additional functionality. Product development and management expense also includes costs related to the management of our solutions. Depreciation and amortization related to cost of revenue primarily consists of amortization of capitalized software. Selling, General, and Administrative Expense Selling expense includes costs related to maintaining a direct marketing infrastructure and sales force and other direct marketing efforts, such as marketing events, advertising, telemarketing, direct mail, and trade shows. Advertising costs are expensed as incurred. Our sales and marketing expenses are expected to continue to be primarily associated with selling and marketing our Cloud solutions. General and administrative expense includes costs that are not directly related to delivery of services, selling efforts, or product development and management, primarily consisting of corporate-level costs, such as administration, finance, legal, and human resources, as well as management fees payable to affiliates of THL and Cannae, until termination of the management agreements upon IPO in April 2018. Also included in this category are depreciation, and amortization of other intangible assets not reflected in cost of revenue, and the provision for doubtful accounts receivable. Other Expense, net Other expense, net includes the results of transactions that are not appropriately classified in another category. These items include certain foreign currency translation gains and losses resulting mainly from intercompany receivables and payables denominated in currencies other than the subsidiary’s functional currency, net periodic benefit plan expense, and charges related to the impairment of asset values. Income Tax Provision Our income tax provision represents federal, state, and international taxes on our income recognized for financial statement purposes and includes the effects of temporary differences between financial statement income and income recognized for tax return purposes. Deferred tax assets and liabilities are recorded for temporary differences between the financial reporting basis and the tax basis of assets and liabilities as adjusted for the expected benefits of utilizing net operating loss carryforwards. We record a valuation allowance to reduce our deferred tax assets to reflect the net deferred tax assets that we believe will be realized. As of December 31, 2019, we will continue to record a valuation allowance against certain deferred tax assets including some state net operating loss carryovers. On December 22, 2017, the Tax Cut and Jobs Act legislation (the “Tax Act”) was enacted. The Tax Act amended the Code to reduce tax rates and to modify policies, credits, and deductions for businesses. For businesses, the Tax Act reduced the corporate federal tax rate from a maximum of 35% to a flat 21% rate. Results of Operations Year Ended December 31, 2019 Compared with Year Ended December 31, 2018 The following table sets forth our results of operations for the periods presented. (a) For a reconciliation of Adjusted EBITDA to operating profit, please refer to the “Non-GAAP Measures” section. Revenue. The following table sets forth certain information regarding our consolidated revenues for the year ended December 31, 2019, compared with the year ended December 31, 2018. (a) We present revenue growth in a constant currency to assess how our underlying business performed, excluding the effect of foreign currency rate fluctuations. We calculate percentage change in revenue on a constant currency basis by applying a fixed $1.30 Canadian dollar to $1.00 U.S. dollar foreign exchange rate to revenues originally booked in Canadian dollars for all applicable periods. Total revenue increased $83.4 million, or 11.3%, to $824.1 million for the year ended December 31, 2019, compared to $740.7 million for the year ended December 31, 2018. This increase was primarily driven by an increase in Cloud revenue of $131.2 million, or 24.8%, from $528.8 million for the year ended December 31, 2018, to $660.0 million for the year ended December 31, 2019. The Cloud revenue increase was primarily due to an increase of $102.3 million, or 24.6%, in Cloud recurring services revenue, and $28.9 million, or 25.6%, in Cloud professional services and other revenue. The increase in Cloud recurring services revenue of $102.3 million was attributable to increases of $85.4 million from new customers, add-ons, and revenue uplift from migrations of Bureau customers; $19.3 million from the migration of Bureau customers; and $13.7 million from increased float revenue allocated to Cloud recurring services revenue, partially offset by customer attrition of $16.1 million. The increase in Cloud revenue was partially offset by a decline in Bureau revenue of $47.8 million, or 22.6%. Of the decline in Bureau revenue, approximately 40% was attributable to customer migrations to Dayforce. Excluding the impact of migrations, our annual Bureau revenue retention rate was 83.2% in 2019 and 86.9% in 2018. For the year ended December 31, 2019, recurring services revenue from Bureau payroll customers accounted for $116.2 million, and Bureau stand-alone tax recurring services revenue accounted for $45.9 million of this total. The payroll Bureau customers consist of approximately 1.0 million active users, of which approximately 0.9 million are customers that we believe could be candidates for migration to Dayforce. Some of our customers are not candidates to migrate to Dayforce due to a variety of factors, including the type of functionality that they require and their system configuration. Of the approximately 0.9 million active users that we believe could be candidates for migration to Dayforce, small businesses accounted for 23% of the total number of active users, major businesses accounted for 42% of the total number of active users, and enterprise businesses accounted for 35% of the total number of active users. On a constant currency basis, total revenue grew 12.1% reflecting a 25.7% increase in Cloud revenue, partially offset by a 22.1% decline in Bureau revenue. Cloud revenue growth reflected a 25.6% increase in Cloud recurring revenue and a 26.3% increase in Cloud professional services and other revenue. Please refer to the “Non-GAAP Measures” section for additional information on our constant currency revenue. Cloud revenue by solution. Cloud revenue was $660.0 million for 2019, an increase of $131.2 million, or 24.8% when compared to 2018. Dayforce revenue grew 30.2%, and Powerpay revenue declined 1.1% in 2019 as compared to 2018. On a constant currency basis, Dayforce revenue increased 30.9%, and Powerpay revenue increased 1.1% for the year-ended December 31, 2019, compared to the year ended December 31, 2018. Our new business sales to Dayforce and Powerpay customers comprised 85% of our increase in Cloud revenue for the year ended December 31, 2019, and the remaining 15% consisted primarily of customer migration to Dayforce from our Bureau solutions. As we migrate our Bureau customers to Dayforce, we typically experience a revenue increase from such customers driven by increased product density on the Dayforce platform. This revenue increase can vary by customer, but has been 27% on average since 2017, as measured at the time of initial migration. Float revenue. Investment income from invested customer trust funds included in revenue was $80.2 million and $67.0 million for the years ended December 31, 2019, and 2018, respectively. The average float balance for our customer trust funds for the year ended December 31, 2019, was $3,427.3 million, compared to $3,361.5 million for the year ended December 31, 2018. On a constant currency basis, the average float balance for our customer trust funds increased 2.8% for the year ended December 31, 2019, compared to year ended December 31, 2018. The average yield was 2.34% during the year ended December 31, 2019, an increase of 34 basis points compared to the average yield for the year ended December 31, 2018. For the year ended December 31, 2019, approximately 36% of our average float balance consisted of Canadian customer trust funds, compared to approximately 38% for the year ended December 31, 2018. Based on current market conditions, portfolio composition, and investment practices, a 100 basis point change in market investment rates would result in approximately $18 million of change in float revenue over the ensuing twelve month period. In addition, we also have exposure to risks associated with changes in laws and regulations that may affect customer fund balances. For example, a change in regulations, either reducing the amount of taxes to be withheld or allowing less time to remit taxes to government authorities, would reduce our average customer trust fund balances and float revenue. There are no incremental costs of revenue associated with changes in float revenue. Cost of revenue. Total cost of revenue for the year ended December 31, 2019, was $455.9 million, an increase of $30.1 million, or 7.1%, compared to the year ended December 31, 2018. Recurring services cost of revenue increased by $1.5 million for the year ended December 31, 2019, compared to the year ended December 31, 2018, due to additional costs incurred to support the growing Dayforce customer base, partially offset by reductions in costs to support our Bureau customers. The increase in cost of revenue for professional services and other of $17.6 million for the year ended December 31, 2019, compared to the year ended December 31, 2018, primarily due to additional costs incurred to implement new customers. Product development and management expense increased $8.9 million for the year ended December 31, 2019, compared to the year ended December 31, 2018, reflecting increases in Dayforce product development efforts, including the build out of our international offerings, and increases in product management labor costs. For the years ended December 31, 2019, and 2018, our investment in software development was $66.7 million and $54.9 million, respectively, consisting of $34.1 million and $29.6 million of research and development expense, which is included within product development and management expense, and $32.6 million and $25.3 million of capitalized software development, respectively. Please refer to Note 2, “Summary of Significant Accounting Policies,” for further discussion of our accounting policy for capitalizing internally developed software costs. Depreciation and amortization expense associated with cost of revenue increased by $2.1 million for the year ended December 31, 2019, compared to the year ended December 31, 2018, as we continue to capitalize Dayforce related and other development costs and subsequently amortize those costs. Gross profit. The following table presents total gross margin and solution gross margins for the periods presented: Total gross margin is defined as total gross profit as a percentage of total revenue, inclusive of product development and management costs as well as depreciation and amortization associated with cost of revenue. Gross margin for each solution in the table above is defined as total revenue less cost of revenue for the applicable solution as a percentage of total revenue for that related solution, exclusive of any product development and management or depreciation and amortization cost allocations. The overall 11.3% increase in revenue outpaced the 7.1% increase in cost of revenue, and gross profit increased by $53.3 million, or 16.9%, as we continued to leverage our investment in people and processes to realize economies of scale. Cloud recurring services gross margin was 69.6% for the year ended December 31, 2019, compared to 66.1% for the year ended December 31, 2018. The increase in Cloud recurring services gross margin reflects an increase in the proportion of Dayforce customers live for more than two years, which increased from 63% as of December 31, 2018 to 69% as of December 31, 2019, and was also attributable to consistent configuration that has enabled us to realize economies of scale in customer support and hosting costs. Professional services and other gross margin was (4.0)% for the year ended December 31, 2019, improving from (14.3)% for the year ended December 31, 2018, reflecting continued productivity improvements in implementing new customers. Selling, general, and administrative expense. Selling, general, and administrative expense increased $37.1 million for the year ended December 31, 2019, compared to the year ended December 31, 2018. Excluding the impact of share-based compensation and related employer taxes, sponsor management fees, restructuring consulting fees, transaction costs associated with our IPO and debt refinancing, severance expense, and certain other non-recurring charges; selling, general, and administrative expenses would have increased $31.1 million. This adjusted increase of $31.1 million was primarily due to a $25.7 million increase in sales and marketing expenses and other employee related costs. Please refer to the “Non-GAAP Measures” section for additional information on the excluded items. Operating profit. We realized operating profit of $72.3 million for the year ended December 31, 2019, compared to $56.1 million for the year ended December 31, 2018. Excluding the impact of share-based compensation and related employer taxes, sponsor management fees, restructuring consulting fees, transaction costs associated with our IPO and debt refinancing, severance expense, and certain other non-recurring charges; operating profit would have been $132.7 million and $106.7 million for the year ended December 31, 2019, and 2018, respectively. This $26.0 million adjusted increase was primarily due to a $83.4 million increase in revenue and gross margin improvement. Interest expense, net. Interest expense, net for the year ended December 31, 2019, was $32.4 million, compared to $83.2 million for the year ended December 31, 2018. This $50.8 million reduction in interest expense, net was primarily due to a $47.3 million reduction in interest expense attributed to the refinancing of our debt during 2018, and an increase in interest income during the year ended December 31, 2019. Under our current credit agreement, a 100 basis point change in the London Inter-bank Offered Rate (“LIBOR”) rates would result in an approximately $7 million change in our interest expense, net over the ensuring twelve-month period. Please refer to Note 10, “Debt,” for additional information. Other expense (income), net. For the year ended December 31, 2019, we incurred $5.6 million of other expense, net, compared to $0.2 million of other income, net, for the year ended December 31, 2018. The other expense, net, for the year ended December 31, 2019, was comprised of net periodic pension expense of $5.2 million and foreign currency translation loss of $0.4 million. The other income, net for the year ended December 31, 2018, was comprised of foreign currency translation gains of $2.9 million, partially offset by net periodic benefit plan expense of $2.7 million. The foreign currency translation gains for the year ended December 31, 2018, were primarily related to an intercompany payable of a U.S. subsidiary denominated in Canadian dollars, which was repaid in the second quarter of 2018. Income tax (benefit) expense. For the year ended December 31, 2019, we had income tax benefit of $44.4 million, compared to income tax expense of $8.4 million for the year ended December 31, 2018. The $52.8 million change primarily reflects a tax benefit of $62.6 million from the release of our valuation allowance, a $7.2 million reduction in the tax expense attributable to U.S. taxes on foreign earnings, and a $6.2 million reduction in tax expense attributable to the Global Intangible Low Taxed Income tax (“GILTI”), partially offset by a $12.9 million increase in tax expense attributable to improved operating results, a $9.7 million increase in state tax expense, and a $2.6 million increase in the base erosion anti-abuse tax (“BEAT”). BEAT and GILTI were enacted as a part of the 2017 Tax Reform. The IRS continues to issue 2017 Tax Reform administrative guidance, which could impact tax expense related to these Tax Reform provision in future periods. Please refer to Note 16, “Income Taxes,” for additional information on the release of our valuation allowance. Loss from discontinued operations. As a result of the LifeWorks Disposition, the financial results of the LifeWorks business have been included within discontinued operations for all periods presented. For the year ended December 31, 2018, we had a loss from discontinued operations of $25.8 million, primarily related to income tax expense incurred as a result of the LifeWorks Disposition. Net income (loss) attributable to Ceridian. Net income was $78.7 for the year ended December 31, 2019, primarily due to a tax benefit of $62.6 million from the release of our valuation allowance. Net loss attributable to Ceridian was $60.6 million for the year ended December 31, 2018, primarily due to $51.0 million of expense related to our IPO and debt refinancing. Adjusted EBITDA. Adjusted EBITDA increased by $24.0 million to $184.6 million, for the year ended December 31, 2019, compared to the year ended December 31, 2018, and Adjusted EBITDA margin increased to 22.4% in 2019 from 21.7% in 2018. Year Ended December 31, 2018 Compared with Year Ended December 31, 2017 The following table sets forth our results of operations for the periods presented. (a) For a reconciliation of Adjusted EBITDA to operating profit, please refer to the “Non-GAAP Measures” section. Revenue. The following table sets forth certain information regarding our consolidated revenues for the year ended December 31, 2018, compared with the year ended December 31, 2017. (a) We present revenue growth in a constant currency to assess how our underlying business performed excluding the effect of foreign currency rate fluctuations. We have calculated percentage change in revenue on a constant currency basis by applying a fixed $1.30 Canadian dollar to $1.00 U.S. dollar foreign exchange rate to revenues originally booked in Canadian dollars for all applicable periods. Total revenue increased $64.5 million, or 9.5%, to $740.7 million for the year ended December 31, 2018, compared to $676.2 million for the year ended December 31, 2017. This increase was primarily driven by an increase in Cloud revenue of $118.9 million, or 29.0% from $409.9 million for the year ended December 31, 2017 to $528.8 million for the year ended December 31, 2018. The Cloud revenue increase was primarily due to an increase of $104.1 million, or 33.4%, in Cloud recurring services revenue, and $14.8 million, or 15.1%, in Cloud professional services and other revenue. The increase in Cloud recurring services revenue of $104.1 million was attributable to increases of $73.2 million from new customers, add-ons, and revenue uplift from migrations of Bureau customers; $22.9 million from the migration of Bureau customers; and $20.0 million from increased float revenue related to Cloud recurring services revenue, partially offset by customer attrition of $12.0 million. The increase in Cloud revenue was partially offset by a decline in Bureau revenue of $54.4 million, or 20.4%. There was an immaterial impact on revenue due to changes in foreign currency rate fluctuations. Please refer to the “Non-GAAP Measures” section for additional information on our constant currency revenue. Of the decline in Bureau revenue, approximately 58% was driven by customer attrition and approximately 42% was attributable to customer migrations to Dayforce. Excluding the impact of migrations, our annual Bureau revenue retention rate was 86.9% in 2018 and 89.7% in 2017. For the year ended December 31, 2018, recurring services revenue from payroll Bureau customers accounted for $161.1 million, and Bureau stand-alone tax recurring services revenue accounted for $48.2 million. The payroll Bureau customers consisted of approximately 1.5 million active users, of which approximately 1.4 million were customers that we believe could be candidates for migration to Dayforce. Some of our customers are not candidates to migrate to Dayforce due to a variety of factors, including the type of functionality that they require and their system configuration. Of the approximately 1.4 million active users that we believe could be candidates for migration to Dayforce, small businesses accounted for 21% of the total number of active users, mid-sized businesses accounted for 28% of the total number of active users, and enterprise businesses accounted for 51% of the total number of active users. Cloud revenue was $528.8 million for 2018, an increase of 29.0% when compared to 2017. Dayforce revenue grew 34.4%, and Powerpay revenue grew 8.2% in 2018 as compared to 2017. There was an immaterial impact on revenue due to changes in foreign currency rate fluctuations. Please refer to the table above for our revenue growth rates on a constant currency basis. Our new business sales to Dayforce and Powerpay customers comprised 81% of our increase in Cloud revenue for the year ended December 31, 2018, and the remaining 19% consisted primarily of customer migration to Dayforce from our Bureau solutions. As we migrate our Bureau customers to Dayforce, we typically experience a revenue increase from such customers driven by increased product density on the Dayforce platform. This revenue increase can vary by customer, but has been 22% on average since 2016, as measured at the time of initial migration. Float revenue. Investment income from invested customer trust funds included in revenue was $67.0 million and $46.5 million for the years ended December 31, 2018, and 2017, respectively. The average float balance for our customer trust funds for the year ended December 31, 2018 was $3,361.5 million, compared to $3,228.2 million for the year ended December 31, 2017. The average yield was 2.00% during the year ended December 31, 2018, an increase of 55 basis points compared to the average yield for the year ended December 31, 2017. In addition, we also have exposure to risks associated with changes in laws and regulations that may affect customer fund balances. For example, a change in regulations, either reducing the amount of taxes to be withheld or allowing less time to remit taxes to government authorities, would reduce our average customer trust fund balances and float revenue. There are no incremental costs of revenue associated with changes in float revenue. Cost of revenue. Total cost of revenue for the year ended December 31, 2018, was $425.8 million, an increase of $19.1 million, or 4.7%, compared to the year ended December 31, 2017. Of the total $19.1 million increase, $2.1 million was attributable to IPO-related share-based compensation expense. Excluding IPO-related items, cost of revenue increased $17.0 million. Recurring services cost of revenue increased by $3.5 million for the year ended December 31, 2018, compared to the year ended December 31, 2017, due to additional costs incurred to support the growing Dayforce customer base, partially offset by reductions in costs to support our Bureau customers. The reduction in cost of revenue for professional services and other of $2.8 million for the year ended December 31, 2018, compared to the year ended December 31, 2017, was primarily due to productivity improvements in implementing new customers. Product development and management expense increased $15.4 million for the year ended December 31, 2018, compared to the year ended December 31, 2017, reflects increases in Dayforce product development efforts. For the years ended December 31, 2018, and 2017, our investment in software development was $54.9 million and $45.0 million, respectively, consisting of $29.6 million and $19.0 million of research and development expense, which is included within product development and management expense, and $25.3 million and $26.0 million of capitalized software development, respectively. Please refer to Note 2, “Summary of Significant Accounting Policies,” for further discussion of our accounting policy for capitalizing internally developed software costs. Depreciation and amortization expense associated with cost of revenue increased by $3.0 million for the year ended December 31, 2018, compared to the year ended December 31, 2017, as we continue to capitalize Dayforce related and other development costs and subsequently amortize those costs. Gross profit. The following table presents total gross margin and solution gross margins for the periods presented: Total gross margin is defined as total gross profit as a percentage of total revenue, inclusive of product development and management costs as well as depreciation and amortization associated with cost of revenue. Gross margin for each solution in the table above is defined as total revenue less cost of revenue for the applicable solution as a percentage of total revenue for that related solution, exclusive of any product development and management or depreciation and amortization cost allocations. The overall 9.5% increase in revenue outpaced the 4.7% increase in cost of revenue, and gross profit increased by $45.4 million, or 16.8%, as we continued to leverage our investment in people and processes to realize economies of scale. Cloud recurring services gross margin was 66.1% for the year ended December 31, 2018, compared to 59.9% for the year ended December 31, 2017. The increase in Cloud recurring services gross margin reflects an increase in the proportion of Dayforce customers live for more than two years, which increased from 59% as of December 31, 2018 to 63% as of December 31, 2018, and was also attributable to consistent configuration of new customers, which enabled us to realize economies of scale in customer support and hosting costs. Professional services and other gross margin was (14.3)% for the year ended December 31, 2018, improving from (32.0)% for the year ended December 31, 2018, reflecting an increase in profitable post go-live professional services and productivity improvements in implementing new customers. Selling, general, and administrative expense. Selling, general, and administrative expense increased $44.7 million for the year ended December 31, 2018, compared to the year ended December 31, 2017. Excluding the impact of share-based compensation and related employer taxes, sponsor management fees, restructuring consulting fees, transaction costs associated with our IPO and debt refinancing, and severance expense; selling, general, and administrative expenses would have increased $17.9 million. This adjusted increase of $17.9 million was primarily due to a $10.5 million increase in sales and marketing expenses, increases in employee related costs, and increases in costs associated with being a public company. We continue to invest in our sales and marketing efforts as we drive growth in Dayforce. Operating profit. We realized operating profit of $56.1 million for the year ended December 31, 2018, compared to an operating profit of $55.4 million for the year ended December 31, 2017. Excluding the impact of share-based compensation and related employer taxes, sponsor management fees, restructuring consulting fees, transaction costs associated with our IPO and debt refinancing, and severance expense; operating profit would have been $106.7 million and $79.0 million for the years ended December 31, 2018, and 2017, respectively. This $27.7 million adjusted increase was primarily due to a $64.5 million increase in revenue and gross margin improvement. Interest expense, net. Interest expense for the year ended December 31, 2018, was $83.2 million, compared to $87.1 million for the year ended December 31, 2017. This reduction was primarily due to the refinancing of our debt, which resulted in a reduction in interest expense of $30.6 million upon the extinguishment of the Senior Notes in April 2018, representing seven fewer months of interest on the Senior Notes as compared to the prior year, partially offset by a loss on extinguishment of debt of $25.7 million. Please refer to Note 10, “Debt,” for additional information. Other (income) expense, net. For the year ended December 31, 2018, we incurred $0.2 million of other income, net, compared to $8.8 million of other expense, net, for the year ended December 31, 2017. The other income, net, for the years ended December 31, 2018, was comprised primarily of foreign currency remeasurement gain of $2.9 million related to an intercompany payable of a U.S. subsidiary denominated in Canadian dollars, partially offset by net periodic pension expense of $2.7 million. The other expense, net for the year ended December 31, 2017 was comprised of foreign currency remeasurement of loss of $7.3 million, and net periodic pension expense of $1.5 million. Income tax expense (benefit). For the year ended December 31, 2018, we had income tax expense of $8.4 million, compared to income tax benefit of $48.5 million for the year ended December 31, 2017. The $56.9 million increase in tax expense is primarily attributable to the $59.4 million tax benefit recorded during the year ended December 31, 2017, reflecting the revaluation of our deferred tax assets and liabilities upon the initial implementation of the Tax Act. Loss from discontinued operations. As a result of the LifeWorks Disposition, the financial results of the LifeWorks business have been included within discontinued operations for all periods presented. For the year ended December 31, 2018, we had a loss from discontinued operations of $25.8 million, compared to $6.0 million for the year ended December 31, 2017. The loss from discontinued operations for the year ended December 31, 2018, is primarily related to income tax expense incurred as a result of the LifeWorks Disposition. Net (loss) income attributable to Ceridian. Net loss attributable to Ceridian was $60.6 million for the year ended December 31, 2018, primarily due to $51.0 million of expense related to our IPO and debt refinancing. Net income attributable to Ceridian was $3.3 million for the year ended December 31, 2017, primarily due to a tax benefit of approximately $59.4 million related to the 2017 tax reform legislation. Adjusted EBITDA. Adjusted EBITDA increased by $29.2 million for the year ended December 31, 2018, compared to the year ended December 31, 2017, and Adjusted EBITDA margin increased to 21.7% in 2018 from 19.4% in 2017. Quarterly Results of Operations The following table sets forth statements of operations data for each of the quarters presented. We have prepared the quarterly statements of operations data on a basis consistent with the audited consolidated financial statements. In the opinion of management, the financial information reflects all adjustments, consisting of normal recurring adjustments, which we consider necessary for a fair presentation of this data. This information should be read in conjunction with the audited consolidated financial statements and related notes. The results of historical periods are not necessarily indicative of the results for any future period. Liquidity and Capital Resources Our primary sources of liquidity are our existing cash and equivalents, cash provided by operating activities, borrowings under our credit facilities, and proceeds from equity offerings. As of December 31, 2019, we had cash and equivalents of $281.3 million and availability under our revolving credit facility of $300.0 million. No cash amounts were drawn on the revolving credit facility during 2019. Our total debt balance was $683.9 million as of December 31, 2019. Please refer to Note 10, “Debt,” to our consolidated financial statements, for further information on our debt. On March 26, 2019, Moody’s Investor Service upgraded the rating of our senior secured credit facilities from B3 to B2, which reduced the floating rate term debt interest rate from LIBOR plus 3.25% to LIBOR plus 3.00%, so long as the rating is maintained. The 25 basis point rate reduction will result in savings of approximately $1.7 million over the ensuing twelve-month period. Our primary liquidity needs are related to funding of general business requirements, including the payment of interest and principal on our debt, capital expenditures, pension contributions, and product development. Our customer trust funds are held and invested with the primary objectives being to protect the principal balance and to ensure adequate liquidity to meet cash flow requirements. In accordance with these objectives, we maintain approximately 47% of customer trust funds in liquidity portfolios with maturities ranging from one to 120 days, consisting of high-quality bank deposits, money market mutual funds, commercial paper, or collateralized short-term investments; and we maintain on average approximately 53% of customer trust funds in fixed income portfolios with maturities ranging from 120 days to 10 years, consisting of U.S. Treasury and agency securities, Canada government and provincial securities, as well as highly rated asset-backed, mortgage-backed, municipal, corporate and bank securities. To maintain sufficient liquidity in the trust to meet payment obligations, we also have financing arrangements and may pledge fixed income securities for short-term financing. The assets held in trust are intended for the specific purpose of satisfying client fund obligations and therefore are not freely available for our general business use. We believe that our cash flow from operations, availability under our revolving credit facility, and available cash and equivalents will be sufficient to meet our liquidity needs for the foreseeable future. We anticipate that to the extent that we require additional liquidity, it will be funded through the issuance of equity, the incurrence of additional indebtedness, or a combination thereof. We cannot assure you that we will be able to obtain this additional liquidity on reasonable terms, or at all. Additionally, our liquidity and our ability to meet our obligations and to fund our capital requirements are also dependent on our future financial performance, which is subject to general economic, financial, and other factors that are beyond our control. Accordingly, we cannot assure you that our business will generate sufficient cash flow from operations or that future borrowings will be available from additional indebtedness or otherwise to meet our liquidity needs. Although we have no specific current plans to do so, if we decide to pursue one or more significant acquisitions, we may incur additional debt or sell additional equity to finance such acquisitions, which would result in additional expenses or dilution. Statements of Cash Flows Changes in cash flows due to purchases of customer trust fund marketable securities and proceeds from the sale or maturity of customer trust fund marketable securities, as well as the carrying value of customer trust fund accounts as of period end dates can vary significantly due to several factors, including the specific day of the week the period ends, which impacts the timing of funds collected from customers and payments made to satisfy customer obligations to employees, taxing authorities, and others. The customer trust funds are fully segregated from our operating cash accounts and are evaluated and tracked separately by management. Therefore, we have provided the table below excluding the cash flows and restricted cash and equivalents held within our customer trust funds to provide supplemental information regarding the cash flows related to our core. Operating Activities Net cash provided by operating activities, excluding customer trust fund activity, was $61.8 million during the year ended December 31, 2019, primarily attributed to net income of $78.7 million and the net impact of adjustments for certain non-cash items of $33.4 million, partially offset by a $61.5 million reduction in cash as a result of net changes in working capital. Adjustments for certain non-cash items primarily related to $57.1 million of depreciation and amortization and $36.5 million of non-cash share-based compensation expense, partially offset by a $69.4 million of deferred income tax benefit. Net changes in working capital were primarily attributable to a $19.5 million decrease in working capital related to other assets and liabilities, a $16.4 million increase in trade and other receivables, an $11.1 million reduction in accrued taxes, and an $11.1 million reduction in liabilities for employee compensation and benefits, primarily due to pension contributions. Included within net cash flows provided by operating activities for the year ended December 31, 2019, was $37.4 million in cash interest payments on our long-term debt, $35.9 million in cash taxes, net of refunds received, and $18.0 million in pension contributions. Net cash provided by operating activities from continuing operations of $10.7 million during the year ended December 31, 2018, was primarily attributable to operating profit of $56.1 million, partially offset by a $48.5 million reduction in cash as a result of net changes in working capital. The $48.5 million reduction in cash as a result of net changes in working capital was primarily attributable to a reduction of $22.1 million in liabilities for employee compensation and benefits, primarily due to payments of accrued incentive compensation and pension contributions, $16.7 million reduction in other assets and liabilities, and a $15.7 million reduction in liabilities for accrued interest, associated with our debt refinancing. Included within net cash flows provided by operating activities for the year ended December 31, 2018, was $74.5 million in cash interest payments on our long-term debt, $18.5 million in pension contributions, and $16.7 million in cash taxes, net of refunds received. Net cash used in operating activities from continuing operations of $29.4 million during the year ended December 31, 2017, was primarily attributable to net working capital reduction of $50.8 million and a deferred tax benefit of $61.2 million, partially offset by certain non-cash items, primarily $53.8 million of depreciation and amortization, and $16.1 million of share-based compensation expense. Net changes in working capital were driven by employee compensation and benefits, primarily pension contributions, accrued taxes, and prepaid expenses. Investing Activities During the year ended December 31, 2019, net cash used in investing activities, excluding customer trust fund activity, was $85.4 million, related to capital expenditures of $55.2 million and acquisition costs, net of cash acquired, of $30.2 million. Our capital expenditures included $38.9 million for software and technology and $16.3 million in capital expenditures for property and equipment. During the year ended December 31, 2018, net cash used in investing activities, excluding customer trust fund activity, was $40.2 million, including $32.2 million in capital expenditures for software and technology and $8.0 million for property and equipment. During the year ended December 31, 2017, net cash used in investing activities from continuing operations, excluding customer trust fund activity, was $51.1 million, primarily related to capital expenditures, partially offset by proceeds from divestitures. Our capital expenditures included $33.1 million for software and technology and $17.5 million for property and equipment. Financing Activities Net cash provided by financing activities, excluding the change in customer trust fund obligations, was $79.8 million during the year ended December 31, 2019. This cash inflow was primarily attributable to proceeds from the issuance of common stock under share-based compensation plans of $87.0 million, partially offset by payments on our long-term debt obligations of $7.2 million. The payments on our long-term debt obligations included $6.8 million in payments towards our Senior Term Loan and $0.4 million in payments towards our financing lease obligations. Net cash provided by financing activities, excluding the change in customer trust fund obligations, was $163.5 million during the year ended December 31, 2018. This cash inflow was primarily attributable to the net proceeds received from our IPO and concurrent private placement of $595.0 million, a net increase in the principal of our term loan of $23.0 million, and proceeds from the issuance of common stock upon exercise of stock options of $45.8 million, partially offset by a $475.0 million payment to redeem our Senior Notes and debt refinancing costs of $23.3 million. Net cash provided by financing activities, excluding the change in customer trust fund obligations, was $50.7 million during the year ended December 31, 2017, related to the funding of the remaining $75.2 million from the issuance of Senior Preferred Stock, partially offset by a $25.9 million payment made on our term debt. Cash Flows from Discontinued Operations During the year ended December 31, 2018, net cash used in discontinued operations was $1.2 million. During the year ended December 31, 2017, net cash used in discontinued operations was $10.6 million. The cash flows from discontinued operations for all periods primarily related to changes in working capital. Backlog Backlog is equivalent to our remaining performance obligations, which represents contracted revenue for recurring services and fixed price professional services, primarily implementation services, that has not yet been recognized, including deferred revenue and unbilled amounts that will be recognized as revenue in future periods. Please refer to Note 13, “Revenue,” to our consolidated financial statements for further discussion of our remaining performance. Seasonality We have in the past and expect in the future to experience seasonal fluctuations in our revenues and new customer contracts with the fourth quarter historically being our strongest quarter for new customer contracts, renewals, and customer go-lives. Although the growth of our Cloud solutions and the ratable nature of our fees makes this seasonality less apparent in our overall results of operations, we expect our revenue to fluctuate quarterly and to be higher in the fourth and first quarters of each year. Fourth quarter revenue is driven by year-end processing fees and Dayforce customer go-lives; and first quarter revenue is driven by revenue earned for printing of year-end tax packages. Off-Balance Sheet Arrangements As of December 31, 2019, we did not have any “off-balance sheet arrangements” (as such term is defined in Item 303 of Regulation S-K). Our Indebtedness On April 30, 2018, Ceridian entered into a credit agreement pursuant to which the lenders agreed to provide Senior Credit Facilities, consisting of the Senior Term Loan in the original principal amount of $680.0 million and a $300.0 million Revolving Facility. The Revolving Facility may, at our option, be made available in United States Dollars, Canadian Dollars, Euros and/or Pounds Sterling; up to $70.0 million may, at our option, be made available for letters of credit and $100.0 million may, at our option, be made available for swingline loans (denominated in Canadian Dollars and/or United States Dollars). The Senior Term Loan will mature on April 30, 2025. We are required to make annual amortization payments in respect of the Senior Term Loan in an amount equal to 1.00% of the original principal amount thereof, payable in equal quarterly installments of 0.25% of the original principal amount of the first lien term loan. The Revolving Facility matures on April 30, 2023 and does not require amortization payments. The obligations of Ceridian under the Senior Credit Facilities are secured by first priority security interests in substantially all of the assets of Ceridian and the guarantors, subject to permitted liens and other exceptions. All of our subsidiaries are guarantors under the Senior Credit Facilities, subject to certain exceptions. The Senior Credit Facilities contain financial covenants and certain business covenants, including restrictions on dividend payments, which Ceridian must comply with during the term of the agreement. As of December 31, 2019, Ceridian was in full compliance with the terms of the Senior Credit Facilities. Borrowings under the Senior Credit Facilities bear interest at a rate per annum equal to: 1. in the case of borrowings denominated in U.S. dollars on any day (a) at Ceridian’s election, either (i) an amount (not less than 1.00%) equal to the greater of (A) a base rate determined by reference to the rate of interest per annum announced by Deutsche Bank AG New York Branch (“DBNY”) as its prime rate on such day, (B) the federal funds effective rate on such date plus 1/2 of 1.00% and (C) the London interbank offered rate (“LIBOR”) plus 1.00% or (ii) if available, LIBOR for U.S. dollars determined by reference to the applicable Reuters screen page two business days prior to the commencement of the interest period relevant to the subject borrowing, adjusted for certain additional costs, which may not be less than 0.00% plus (b) an applicable margin; 2. in the case of borrowings under the Revolving Facility denominated in Canadian Dollars on any day (a) at Ceridian’s election, either (i) the rate of interest per annum quoted or established as the “prime rate” of Deutsche Bank AG Canada Branch plus an applicable margin or (ii) CDOR for Canadian dollars determined by reference to the applicable Reuters screen page on date of the commencement of the interest period relevant to the subject borrowing, adjusted for certain additional costs, which may not be less than 0.00% plus (b) an applicable margin; 3. in the case of borrowings under the Revolving Facility denominated in Euros on any day, (a) The London interbank offered rate in Euros (“EURIBOR”) determined by reference to the applicable Reuters screen page two business days prior to the commencement of the interest period relevant to the subject borrowing, which may not be less than 0.00% plus (b) an applicable margin; or 4. in the case of borrowings under the Revolving Facility denominated in Pounds Sterling, (a) Sterling LIBOR determined by reference to the applicable Reuters screen page one business day prior to the commencement of the interest period relevant to the subject borrowing, which may not be less than 0.00% plus (b) an applicable margin. As of December 31, 2019, the applicable margin for the Senior Term Loan is (i) 3.00% per annum, in the case of LIBOR loans and (ii) 2.00% per annum, in the case of base rate loans. On March 26, 2019, Moody’s Investor Service upgraded the rating of our senior secured credit facilities from B3 to B2, which reduced the floating rate term debt interest rate from LIBOR plus 3.25% to LIBOR plus 3.00%, so long as the rating is maintained. The applicable margin for loans under the Revolving Facility is determined in accordance with the table set forth below: We are also required to pay a customary annual administration fee to the administrative agent under the Senior Credit Facilities. For an additional description of the Senior Credit Facilities, please refer to Note 10, “Debt,” to our consolidated financial statements. Contractual Obligations The following table sets forth our contractual obligations and other commercial commitments as of December 31, 2019, whether or not they appear on our consolidated balance sheet. Variable interest payments are projected based on an interest rate forecast in effect at the end of 2019. All amounts in the table may reflect rounding. (a) We have not estimated our pension funding obligations beyond 2028, and thus, any potential future contributions have been excluded from the table. Our long-term debt obligations are described in Note 10, “Debt,” to our consolidated financial statements. The lease payments represent scheduled payments under the terms of the lease agreements. We conduct substantially all of our operations in leased facilities. Most of these leases contain renewal options and require payments for taxes, insurance, and maintenance. We also lease equipment for use in our business. Payments of retirement plan obligations include employer commitments to fund our defined benefit and postretirement plans and do not include estimated future benefit payments to participants expected to be made from liquidation of the assets in our defined benefit plan trusts. At December 31, 2019, our defined benefit pension plans had a projected benefit obligation that exceeded the fair value of the plans’ assets by $121.6 million and our postretirement benefit plan had an accumulated benefit obligation that exceeded the fair value of the plans’ assets by $15.4 million. We expect to satisfy these remaining obligations through investment income from and appreciation in the fair value of plan assets held in trust and from future employer contributions. The amount of our obligation to vendors for capital expenditures at December 31, 2019 was not material, and no such amount is included in the table above. Critical Accounting Policies and Estimates Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements and related notes, which have been prepared in accordance with GAAP. The preparation of these financial statements and related notes requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue, and expenses. Certain of our accounting policies require the application of significant judgment by management in selecting the appropriate assumptions for calculating financial estimates. By their nature, these judgments are subject to an inherent degree of uncertainty. These judgments are based on our historical experience, terms of existing contracts, our evaluation of trends in the industry, information provided by our customers, and information available from other outside sources, as appropriate. We evaluate our estimates and judgments on an on-going basis. Our actual results may differ from these estimates. Please refer to Note 2, “Summary of Significant Accounting Policies,” for a description of our significant accounting policies. The accounting policies that we believe to be the most critical to an understanding of our financial condition and results of operations and that require the most complex and subjective management judgments are discussed below. Revenue Recognition The core principle of ASC Topic 606 is that revenue is recognized 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. In accordance with ASC Topic 606, we perform the following steps to determine revenue to be recognized: 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. The significant majority of our two major revenue sources (recurring and professional services and other) are derived from contracts with customers. Recurring revenues are primarily related to our cloud subscription performance obligations. Professional services and other revenues are primarily related to professional services for our cloud customers (including implementation services to activate new accounts, as well as post-go live professional services typically billed on a time and materials basis) and, to a much lesser extent, fees for other non-recurring services, including sales of time clocks and certain client reimbursable out-of-pocket expenses. Fees charged to cloud subscription performance obligations are generally priced either on a per-employee, per-month (“PEPM”) basis for a given month or on a per-employee, per-process basis for a given process, both based on usage; and fees charged for professional services are typically priced on a fixed fee basis for activating new accounts and on a time and materials basis for post go-live professional services. Our recurring cloud subscription performance obligations are generally priced based on the number of active customer employees, as of the signing of the contract, at the contract PEPM rate over the initial contract term. Our professional services are generally based on a fixed fee charged to our customers for activating new accounts and on a time and materials basis for post go-live professional services. There is typically no variable consideration related to our recurring cloud subscriptions or our activation services, nor do they include a significant financing component, non-cash consideration, or consideration payable to a customer. Our recurring cloud subscriptions are typically billed one month in advance while our professional services are billed over the implementation period for activation of new accounts and as work is performed for post go-live professional services. Our cloud services arrangements include multiple performance obligations, and transaction price allocations are based on the stand-alone selling price ("SSP") for each performance obligation. Our contract renewal rates serve as an observable input to establish SSP for our recurring cloud subscription performance obligations. The SSP for professional services performance obligations is estimated based on market conditions and observable inputs, including rates charged by third parties to perform implementation services. For our performance obligations, the consideration allocated to cloud subscription revenues is recognized as recurring revenues, typically commencing with the date the customer processes their first live payroll using the solution (referred to as the "go-live" date). The consideration allocated to professional services to activate a new account is recognized as professional services revenues based on the proportion of total work performed, using reasonably dependable estimates (in relation to progression through the implementation phase), by solution. Recently Issued Accounting Pronouncements Please refer to Note 2, “Summary of Significant Accounting Policies,” for a full discussion of recent accounting pronouncements. Non-GAAP Measures Constant Currency Revenue The following tables set forth certain information regarding our revenue on a constant currency basis for the years ended December 31, 2019, 2018, and 2017. We present revenue on a constant currency basis to assess how our underlying business performed excluding the effect of foreign currency rate fluctuations. We have calculated revenue on a constant currency basis by applying a fixed planning rate of $1.30 Canadian dollar to $1.00 U.S. dollar foreign exchange rate to revenue originally booked in Canadian dollars for all applicable periods. Adjusted EBITDA and Adjusted EBITDA Margin We believe that Adjusted EBITDA and Adjusted EBITDA margin, non-GAAP financial measures, are useful to management and investors as supplemental measures to evaluate our overall operating performance. Adjusted EBITDA is a component of our management incentive plan and Adjusted EBITDA and Adjusted EBITDA margin are used by management to assess performance and to compare our operating performance to our competitors. We define Adjusted EBITDA as net income or loss before interest, taxes, depreciation, and amortization, as adjusted to exclude net income or loss from discontinued operations, sponsor management fees, non-cash charges for asset impairments, gains or losses on assets and liabilities held in a foreign currency other than the functional currency of a company subsidiary, share-based compensation expense and related employer taxes, severance charges, restructuring consulting fees, transaction costs, and certain other non-recurring charges. Adjusted EBITDA margin is determined by calculating the percentage Adjusted EBITDA is of total revenue. Management believes that Adjusted EBITDA and Adjusted EBITDA margin are helpful in highlighting management performance trends because Adjusted EBITDA and Adjusted EBITDA margin exclude the results of decisions that are outside the control of operating management. Our presentation of Adjusted EBITDA and Adjusted EBITDA margin are intended as supplemental measures of our performance that are not required by, or presented in accordance with, GAAP. Adjusted EBITDA and Adjusted EBITDA margin should not be considered as alternatives to operating profit (loss), net income (loss), earnings per share, or any other performance measures derived in accordance with GAAP, or as measures of operating cash flows or liquidity. Our presentation of Adjusted EBITDA and Adjusted EBITDA margin should not be construed to imply that our future results will be unaffected by similar items to those eliminated in this presentation. Adjusted EBITDA and Adjusted EBITDA margin are included in this discussion because they are key metrics used by management to assess our operating performance. Adjusted EBITDA and Adjusted EBITDA margin are not defined under GAAP, are not measures of net income, operating income, or any other performance measures derived in accordance with GAAP, and are subject to important limitations. Our use of the terms Adjusted EBITDA and Adjusted EBITDA margin may not be comparable to similarly titled measures of other companies in our industry and are not measures of performance calculated in accordance with GAAP. Adjusted EBITDA and Adjusted EBITDA margin have important limitations as analytical tools, and you should not consider them in isolation or as substitutes for analysis of our results as reported under GAAP. Some of these limitations are: • Adjusted EBITDA and Adjusted EBITDA margin do not reflect our cash expenditures or future requirements for capital expenditures or contractual commitments; • Adjusted EBITDA and Adjusted EBITDA margin do not reflect changes in, or cash requirements for, our working capital needs; • Adjusted EBITDA and Adjusted EBITDA margin do not reflect any charges for the assets being depreciated and amortized that may need to be replaced in the future; • Adjusted EBITDA and Adjusted EBITDA margin do not reflect the impact of share-based compensation upon our results of operations; • Adjusted EBITDA and Adjusted EBITDA margin do not reflect the significant interest expense or the cash requirements necessary to service interest or principal payments on our debt; and • Adjusted EBITDA and Adjusted EBITDA margin do not reflect our income tax expense or the cash requirements to pay our income taxes. • Adjusted EBITDA and Adjusted EBITDA margin do not reflect certain other non-recurring charges. In evaluating Adjusted EBITDA and Adjusted EBITDA margin, you should be aware that in the future we may incur expenses similar to those eliminated in this presentation. The following table reconciles operating profit to Adjusted EBITDA for the periods presented: (a) We define EBITDA from continuing operations as net income (loss) before interest, taxes, depreciation and amortization, and net income (loss) from discontinued operations. (b) Represents expenses related to management, monitoring, consulting, transaction, and advisory fees and related expenses paid to the affiliates of THL and Cannae pursuant to the management agreement with THL Managers VI, LLC (“THLM”) and Cannae. In April 2018, the management agreements terminated upon consummation of our IPO. (c) Represents share-based compensation expense and related employer taxes. (d) Represents costs for severance compensation paid to employees whose positions have been eliminated, resulting primarily from the shift of business from our Bureau solutions to our Cloud solutions. (e) Represents consulting fees and expenses incurred during the periods presented in connection with any acquisition, investment, disposition, recapitalization, equity offering, issuance or repayment of debt, issuance of equity interests, or refinancing. (f) Represents loss on unrecovered duplicate payments associated with our isolated service incident. Please refer to Note 18, “Commitments and Contingencies” for further discussion. (g) Represents expenses related to the IPO and refinancing of our debt that were not eligible for capitalization. The following tables present a reconciliation of our reported results to our non-GAAP Adjusted EBITDA basis for all periods presented: (a) Other operating expenses includes intercompany foreign exchange loss (gain), restructuring consulting fees, and other non-recurring charges. (a) Other operating expenses includes sponsor management fees, intercompany foreign exchange loss (gain), restructuring consulting fees, and transaction costs. (a) Other operating expenses includes sponsor management fees, intercompany foreign exchange loss (gain), and restructuring consulting fees.
-0.006156
-0.005958
0
<s>[INST] Overview Ceridian is a global HCM software company. We categorize our solutions into two categories: Cloud and Bureau solutions. Cloud revenue is generated from HCM solutions that are delivered via two cloud offerings: Dayforce, our flagship cloud HCM platform, and Powerpay, a cloud HR and payroll solution for the Canadian small business market. We also continue to support customers using our Bureau solutions, which we generally stopped actively selling to new customers following the acquisition of Dayforce in 2012. We invest in maintenance and necessary updates to support our Bureau customers and continue to migrate them to Dayforce. Dayforce provides HR, payroll, benefits, workforce management, and talent management functionality. Our platform is used by organizations, regardless of industry or size, to optimize management of the entire employee lifecycle, including attracting, engaging, paying, deploying, and developing their people. Dayforce was built as a single application from the ground up that combines a modern, consumergrade user experience with proprietary application architecture, including a single employee record and a rules engine spanning all areas of HCM. Dayforce provides continuous realtime calculations across all modules to enable, for example, payroll administrators access to data through the entire pay period, and managers access to realtime data to optimize work schedules. Our platform is designed to make work life better for our customers and their employees by improving HCM decisionmaking processes, streamlining workflows, revealing strategic organizational insights, and simplifying legislative compliance. The platform is designed to ease administrative work for both employees and managers, creating opportunities for companies to increase employee engagement. We are a founderled organization, and our culture combines the agility and innovation of a startup with a history of deep domain and operational expertise. We sell Dayforce through our direct sales force on a subscription peremployee, permonth (“PEPM”) basis. Our subscriptions are typically structured with an initial fixed term of between three and five years, with evergreen renewal thereafter. Dayforce can serve customers of all sizes, ranging from 100 to over 100,000 employees. We have rapidly grown the Dayforce platform to more than 4,350 live Dayforce customers, representing approximately 3.9 million active global users as of December 31, 2019. In 2019, we added over 640 net new live Dayforce customers. Our customers vary across industries, and no single customer constituted more than 1% of our revenues for the year ended December 31, 2019. We have experienced significant Cloud revenue growth at scale, particularly from Dayforce, which has grown at a compound annual growth rate (“CAGR”) of more than 50% since 2012. Our annual Cloud revenue retention rate continues to exceed 95% due to our focus on solving complex problems and our superior customer experience. The following table presents Dayforce revenue by quarter from 2012 to 2019. Our Business Model Our business model focuses on supporting the rapid growth of Dayforce and maximizing the lifetime value of our Dayforce customer relationships. Due to our subscription model, where we recognize subscription revenues ratably over the term of the subscription period, and our high customer retention rates, we have a high level of visibility into our future revenues. The profitability of a customer to our business depends, in large part, on how long they have been a customer. Because in our current business model, PEPM subscription fees are not charged until the customer goes live, and because we incur costs in advance of receiving PEPM revenue that are not offset by our implementation fees, we estimate that it takes approximately 2 years before we are able to recover our implementation, customer acquisition, and other direct costs on a new Dayforce customer contract. Over the lifetime of the customer relationship, we have the opportunity to realize additional PEPM revenue, both as the customer grows or rolls out the Dayforce solution to additional employees, and also by selling additional functionality to existing customers that do not currently utilize our full platform. We also incur costs to manage the account, to retain customers, and to sell additional functionality. These costs, however, are significantly less than the costs initially incurred to acquire and to implement the customer. How We Assess Our Performance In assessing our performance, we consider a variety of performance indicators in addition to revenue and net income. Set forth below is a description of our key performance measures. (a) Ann [/INST] Negative. </s>
2,020
12,748
1,725,579
Pluralsight, Inc.
2019-02-21
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 consolidated financial statements and related notes 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 sections titled “Risk Factors” and “Special Note Regarding Forward-Looking Statements” included elsewhere in this Annual Report on Form 10-K. Overview We are a leading provider of technology skill development solutions for businesses and individuals. We started operations in 2004 and focused initially on in-person ILT, and, in anticipation of increasing demand for online solutions, we shifted entirely to an online delivery model in 2011. Since 2011, we have extended our offering to include new content areas and additional features. Through our cloud-based technology skills platform, we enable businesses to innovate in an era of rapid technological change and digital transformation by equipping their employees with the latest technology skills. Out platform provides a broad range of tools, including skill and role assessments, a curated library of expert-authored courses, directed learning paths, interactive labs, and business analytics. Through these features, we provide businesses with visibility into the technical strengths of their workforce, allowing them to better align resources, provide targeted skill development in line with company goals, and advance the skills of individuals and teams. We derive substantially all of our revenue from the sale of subscriptions to our platform. We sell subscriptions primarily to business customers through our direct sales team, as well as through our website. Individual customers can also purchase subscriptions directly through our website. Our subscription pricing is calculated on a per-user basis. We recognize subscription revenue ratably over the life of the contract, which for business customers generally ranges from one to three years. As of December 31, 2018, we have 16,756 business customers, including over 810,000 business users, compared to 575,000 business users as of December 31, 2017. Our customers include over 340 of the 2018 Fortune 500. We have achieved significant growth in recent periods. For the years ended December 31, 2018, 2017, and 2016, our billings totaled $293.6 million, $205.8 million, and $149.2 million, representing year-over-year growth of 43%, 38%, and 15%, respectively. Our billings from business customers for the same periods were $248.2 million, $163.0 million, and $104.9 million, respectively, representing year-over-year growth of 52%, 55%, and 25%, respectively. Our net loss for the years ended December 31, 2018, 2017, and 2016, was $128.6 million, $96.5 million, and $20.6 million, respectively, which reflects our substantial investments in the future growth of our business. We continue to make investments in our business to execute our growth strategy. Key elements of our strategy include: attracting new customers, expanding deployments to existing customers, expanding internationally, and continuing to expand our skills platform, including the breadth of our content library and capabilities of our platform features. In May 2018, we completed our IPO of 23,805,000 shares of Class A common stock at a public offering price of $15.00 per share. We received $332.1 million in proceeds, net of underwriting discounts and commissions, which we used to purchase LLC Units from Pluralsight Holdings at a price per unit equal to the IPO price. Following the IPO, we caused Pluralsight Holdings to repay in full its outstanding long-term debt of $137.7 million. Key Business Metrics We monitor business customers, billings, and certain related key business metrics to help us evaluate our business, identify trends affecting our business, formulate business plans, and make strategic decisions. Business Customers We use the number of business customers to measure and monitor the growth of our business and the success of our sales and marketing activities, and believe that the growth of our business customer base is indicative of our long-term billings and revenue growth potential. We define a business customer as a unique account in our customer relationship management system that had an active paying subscription at the end of the period presented. Each unique account in our customer relationship management system is considered a unique business customer as the system does not create unique accounts for individual customers, and, in some cases, there may be more than one business customer within a single organization. Billings We use billings to measure and monitor our ability to provide our business with the working capital generated by upfront payments from our customers and our ability to sell subscriptions to our platform to both existing and new customers. Billings represent our total revenue plus the change in deferred revenue in the period, as presented in our consolidated statements of cash flows. Billings in any particular period represent amounts invoiced to our customers and reflect subscription renewals and upsells to existing customers plus sales to new customers. Our pricing and subscription periods vary for business customers and individual customers. Subscription periods for our business customers generally range from one to three years, with a majority being one year, as we only recently began offering subscription periods greater than one year. We typically invoice our business customers in advance in annual installments. Subscription periods for our individual customers range from one month to one year and we typically invoice them in advance in monthly or annual installments. We use billings from business customers and our percentage of billings from business customers to measure and monitor our ability to sell subscriptions to our platform to business customers. We believe that billings from business customers will be a significant source of future revenue growth and a key factor affecting our long-term performance. We expect our billings from business customers to continue to increase as a percentage of billings over the long term. As our billings continue to grow in absolute terms, we expect our billings growth rate to decline over the long term as we achieve scale in our business. As we recognize revenue from subscription fees ratably over the term of the contract, due to the difference in timing of billings received and when we recognize revenue, changes to our billings and billings growth rates are not immediately reflected in our revenue and revenue growth rates. Dollar-Based Net Retention Rate Our ability to upsell our platform across our business customers, particularly our enterprise customers, and expand such customers’ usage of our platform across their organizations, is further highlighted by our strong dollar-based net retention rate. We use our dollar-based net retention rate to measure our ability to retain and expand the revenue generated from our existing business customers. Our dollar-based net retention rate compares our subscription revenue from the same set of customers across comparable periods. We calculate our dollar-based net retention rate on a trailing four- quarter basis. To calculate our dollar-based net retention rate, we first calculate the subscription 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 revenue from cohort customers for the four most recent quarters, or numerator period, and the denominator is the sum of subscription 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 was 128% and 117% at December 31, 2018 and 2017, respectively. Components of Results of Operations Revenue We derive substantially all of our revenue from the sale of subscriptions to our platform. A small portion of our revenue is derived from providing professional services, which generally consist of content creation or other consulting services. Amounts that have been invoiced are initially recorded as deferred revenue and are recognized ratably as revenue over the subscription period. Subscription terms typically range from one year to three years for business customers and one month to one year for individual customers, and begin on the date access to our platform is made available to the customer. Most of our subscriptions to business customers are billed in annual installments even if customers are contractually committed by multi-year agreements. Cost of Revenue, Gross Profit and Gross Margin Cost of revenue includes certain direct costs associated with delivering our platform and includes costs for author fees, amortization of our content library, hosting and delivery fees, merchant processing fees, depreciation of capitalized software development costs for internal-use software, employee-related costs, including equity-based compensation expense associated with our customer support organization, and third-party transcription costs. Gross profit, or revenue less cost of revenue, and gross margin, or gross profit as a percentage of revenue, has been and will continue to be affected by various factors, including the mix of subscriptions we sell, the costs of author fees and costs associated with third-party hosting services, and the extent to which we expand our customer support and professional services organizations. We expect our gross margin to increase over the long term primarily due to a decrease in author fees as a percentage of revenue, although our gross margin may fluctuate from period to period depending on the interplay of the factors described above. Operating Expenses Our operating expenses are classified as sales and marketing, technology and content, and general and administrative. For each of these categories, the largest component is employee-related costs, which include salaries and bonuses, equity-based compensation expense, and employee benefit costs. We allocate shared overhead costs such as information technology infrastructure and facility-related costs based on headcount in each category. Sales and Marketing Sales and marketing expenses consist primarily of employee compensation costs of our sales and marketing employees, including salaries, benefits, bonuses, commissions, equity-based compensation expense, and allocated overhead costs. Commissions earned by our sales force are expensed as incurred. Other sales and marketing costs include user events, search engine and email marketing, content syndication, lead generation, and online banner and video advertising. The increases in sales and marketing expenses were driven primarily by increased employee compensation costs as we added headcount to support our growth as well as increased marketing and event related costs, including for Pluralsight LIVE, our user conference. We expect that our sales and marketing expenses will increase in absolute dollars for the foreseeable future and, in the near term, may increase as a percentage of our revenue as we hire additional sales and marketing personnel, increase our marketing activities, and grow our domestic and international operations. Additionally, our sales and marketing expenses may fluctuate as a percentage of our revenue from period to period depending on the timing of expenditures. However, we expect sales and marketing expenses to decrease as a percentage of revenue over the long term. Technology and Content Technology costs consist principally of research and development activities including personnel costs, consulting services, other costs associated with platform development efforts, and allocated overhead costs. Content costs consist principally of personnel costs and other activities associated with content development, course production, curriculum direction, and allocated overhead costs. Technology and content costs are expensed as incurred, except for certain costs relating to the development of internal-use software, including software used to upgrade and enhance our platform and applications supporting our business, which are capitalized and amortized over the estimated useful lives of one to three years. The increases in technology and content expenses were driven primarily by increased employee compensation costs as we added headcount to support our growth. We expect that our technology and content expenses will increase in absolute dollars for the foreseeable future and, in the near term, may increase as a percentage of our revenue as we continue to increase the functionality of and enhance our platform and develop new content and features. Additionally our technology and content expense may fluctuate as a percentage of our revenue from period to period depending on the timing of expenditures. However, we expect technology and content expenses to decrease as a percentage of revenue over the long term. General and Administrative General and administrative expenses consist of personnel costs and related expenses for executive, finance, legal, people operations, and administrative personnel, including salaries, benefits, bonuses, and equity-based compensation expense; professional fees for external legal, accounting, recruiting, and other consulting services; and allocated overhead costs. The increases in general and administrative expenses were driven primarily by increased employee compensation costs as we added headcount to support our growth as well as an increase in equity-based compensation charges following the completion of our IPO as certain vesting conditions of our employee equity awards became probable. We have incurred and expect to incur additional general and administrative expenses as a result of our organizational structure, including additional tax, accounting, and legal expenses, and operating as a public company, including expenses related to compliance with the rules and regulations of the SEC and listing standards of the applicable stock exchange, additional insurance expenses, investor relations activities, and increased legal, audit, and consulting fees. We also expect to increase the size of our general and administrative function to support our increased compliance requirements and the growth of our business. As a result, we expect that our general and administrative expenses will increase in absolute dollars for the foreseeable future and, in the near term, may increase as a percentage of our revenue. Additionally, our general and administrative expenses may fluctuate as a percentage of our revenue from period to period depending on the timing of expenditures. However, we expect general and administrative expenses to decrease as a percentage of revenue over the long term. Other (Expense) Income Other (expense) income consists primarily of interest expense on long-term debt, losses related to the extinguishment of our long-term debt, interest income on cash and cash equivalents, and gains or losses on foreign currency transactions. We used a portion of our IPO proceeds to repay our long-term debt, which has and will result in decreases to interest expense. In the future, we also expect interest income to increase as a result of our increased cash and cash equivalents balance following the IPO. Results of Operations The following tables set forth selected consolidated statements of operations data and such data as a percentage of revenue for each of the periods indicated: ________________________ (1) Includes equity-based compensation expense as follows: (2) Includes amortization of acquired intangible assets as follows: Comparison of the Years Ended December 31, 2018 and 2017 Revenue Revenue was $232.0 million for the year ended December 31, 2018, compared to $166.8 million for the year ended December 31, 2017, an increase of $65.2 million, or 39%. The increase in revenue was primarily due to a $62.9 million, or 50%, increase in revenue from business customers, driven by an increase of 2,293 business customers from 14,463 business customers as of December 31, 2017 to 16,756 business customers as of December 31, 2018, as well as increased sales to our existing business customers, as evidenced by our dollar-based net retention rate of 128% for the year ended December 31, 2018. In addition, revenue from individual customers increased by $2.3 million as a result of an increase in price on our individual monthly subscription fee and the release of our premium individual subscription product. Cost of Revenue and Gross Profit Cost of revenue was $62.6 million for the year ended December 31, 2018, compared to $49.8 million for the year ended December 31, 2017, an increase of $12.7 million, or 26%. The increase in cost of revenue was primarily due to an increase of $7.6 million in author fees, consistent with our revenue growth, an increase of $1.3 million in depreciation of capitalized software development costs primarily due to an increase in amounts capitalized for internal-use software related to features added to our platform, an increase of $1.1 million in amortization of acquired intangible assets and course creation costs and an increase of $1.1 million in hosting and delivery fees to accommodate our growing customer base. Gross profit was $169.5 million for the year ended December 31, 2018, compared to $117.0 million for the year ended December 31, 2017, an increase of $52.5 million, or 45%. The increase in gross profit was the result of the increase in our revenue during the year ended December 31, 2018. Gross margin increased from 70% for the year ended December 31, 2017 to 73% for the year ended December 31, 2018 due to a decrease in amortization of acquired intangible assets and a decrease in author fees as a percentage of revenue. Operating Expenses Sales and Marketing Sales and marketing expenses were $153.6 million for the year ended December 31, 2018, compared to $103.5 million for the year ended December 31, 2017, an increase of $50.2 million, or 48%. The increase was primarily due to an increase of $45.1 million in employee compensation costs, including an increase in equity-based compensation expense of $11.7 million, as we added headcount to support our growth. Of the increase in equity-based compensation expense, approximately $1.6 million was related to a cumulative catch-up adjustment recorded upon completion of the IPO as the vesting condition for certain restricted stock units, or RSUs, was satisfied by the expiration of the lock-up period following the IPO. In addition, there was an increase of $5.2 million related to allocated overhead costs primarily driven by our headcount growth and an increase of $2.7 million due to additional travel expenses primarily driven by our additional headcount. These increases were partially offset by a decrease of $3.0 million in marketing and event costs, as a result of optimizing our digital marketing expenditures to more efficient channels. Technology and Content Technology and content expenses were $66.0 million for the year ended December 31, 2018, compared to $49.3 million for the year ended December 31, 2017, an increase of $16.7 million, or 34%. The increase was primarily due to an increase of $16.3 million in employee compensation costs, including an increase in equity-based compensation expense of $6.8 million, as we added headcount to support our growth. Of the increase in equity-based compensation expense, approximately $0.9 million was related to a cumulative catch-up adjustment recorded upon completion of the IPO as the vesting condition for certain RSUs was satisfied by the expiration of the lock-up period following the IPO. In addition, there was an increase of $1.7 million related to allocated overhead costs primarily driven by our headcount growth. These increases were offset by an increase of $1.6 million in capitalized software development costs. General and Administrative General and administrative expenses were $68.4 million for the year ended December 31, 2018, compared to $47.0 million for the year ended December 31, 2017, an increase of $21.4 million, or 46%. The increase was primarily due to an increase of $17.0 million in employee compensation costs, including $13.9 million in equity-based compensation expense, as we added headcount to support our growth. Of the increase in equity-based compensation expense, approximately $5.3 million was related to a cumulative catch-up adjustment recorded upon completion of the IPO as the vesting condition for certain RSUs was satisfied by the expiration of the lock-up period following the IPO. In addition, there was an increase of $2.6 million related to allocated overhead costs primarily driven by our headcount growth and an increase of $1.5 million for professional services primarily driven by the additional costs of operating as a public company. Other (Expense) Income Interest expense decreased primarily as a result of our repayment of long-term debt in May 2018. In connection with the repayment, we incurred a loss on debt extinguishment of $4.1 million. Other income, net was $1.5 million for the year ended December 31, 2018, compared to $0.1 million for the year ended December 31, 2017, an increase of $1.4 million. The increase was primarily due to additional interest income earned from our increased cash equivalents as a result of net proceeds from our IPO. Comparison of the Years Ended December 31, 2017 and 2016 Revenue Revenue was $166.8 million for the year ended December 31, 2017, compared to $131.8 million for the year ended December 31, 2016, an increase of $35.0 million, or 27%. The increase in revenue was primarily due to a $36.2 million, or 41%, increase in revenue from business customers, driven by an increase of 2,420 business customers from 12,043 business customers as of December 31, 2016 to 14,463 business customers as of December 31, 2017, as well as increased sales to our existing business customers as evidenced by our 117% dollar-based net retention rate for the year ended December 31, 2017, partially offset by a $1.2 million decrease in revenue from individual customers, driven, in part, by our strategic shift to focus more of our sales and marketing efforts on business customers. Cost of Revenue and Gross Profit Cost of revenue was $49.8 million for the year ended December 31, 2017, compared to $40.2 million for the year ended December 31, 2016, an increase of $9.7 million, or 24%. The increase in cost of revenue was primarily due to an increase of $6.2 million in author fees, an increase of $1.1 million in hosting and delivery fees to accommodate our growing customer base, an increase of $0.7 million in depreciation of capitalized software development costs primarily due to an increase in amounts capitalized for internal-use software related to features added to our platform, an increase of $0.6 million in amortization of acquired intangible assets and course creation costs, and an increase of $0.4 million in employee-related costs related to increased customer support headcount. Gross profit was $117.0 million for the year ended December 31, 2017, compared to $91.7 million for the year ended December 31, 2016, an increase of $25.3 million, or 28%. The increase in gross profit was the result of the increase in our revenue during the year ended December 31, 2017. Gross margin remained consistent at 70% for each of the years ended December 31, 2017 and 2016. Operating Expenses Sales and Marketing Sales and marketing expenses were $103.5 million for the year ended December 31, 2017, compared to $51.2 million for the year ended December 31, 2016, an increase of $52.2 million, or 102%. The increase was primarily due to an increase of $36.3 million in employee compensation costs, including an increase in equity-based compensation expense of $1.2 million, as we added headcount to support our growth. In addition, there was an increase of $9.3 million in marketing and event costs, including for Pluralsight LIVE, our first-ever user conference, an increase of $4.1 million related to allocated overhead costs driven by our headcount growth, and an increase of $2.3 million due to additional travel expenses related to additional headcount. Technology and Content Technology and content expenses were $49.3 million for the year ended December 31, 2017, compared to $36.2 million for the year ended December 31, 2016, an increase of $13.1 million, or 36%. The increase was primarily due to an increase of $12.6 million in employee compensation costs, including an increase in equity-based compensation expense of $0.2 million, as we added headcount to support our growth, and an increase of $0.7 million related to allocated overhead costs primarily driven by our headcount growth, partially offset by an increase of $0.3 million in capitalized software development costs. General and Administrative General and administrative expenses were $47.0 million for the year ended December 31, 2017, compared to $18.1 million for the year ended December 31, 2016, an increase of $28.8 million, or 159%. The increase was primarily due to an increase of $10.5 million in employee compensation costs, including an additional $2.9 million in equity-based compensation expense, primarily due to additional headcount to support our growth, as well as one-time non-cash equity-based compensation charges of $9.9 million associated with a sale of common units held by an affiliate of one of our co-founders to certain of our existing investors at a price in excess of fair value, and $2.1 million related to the conversion of common units of Pluralsight Holdings into Class B common units of Pluralsight Holdings for our co-founder and Chief Executive Officer. In addition, there was an increase of $3.6 million related to allocated overhead costs primarily driven by our headcount growth and an increase of $1.8 million for professional services. Other (Expense) Income Interest expense increased primarily as a result of increased borrowings of long-term debt and higher interest rates. As of December 31, 2017, we had a principal balance of $116.6 million in long-term debt outstanding, compared to $85.0 million as of December 31, 2016. The interest rate on the long-term debt outstanding as of December 31, 2017 and 2016 was 10.20% and 5.50%, respectively. We also incurred a loss on debt extinguishment resulting from the refinancing of our long-term debt in June 2017. This loss is primarily the result of unamortized debt issuance costs and accrued interest on the date of extinguishment. Quarterly Results of Operations The following tables set forth selected unaudited quarterly consolidated statements of operations data for each of the eight quarters in the period ended December 31, 2018, as well as the percentage of revenue that each line item represents for each quarter. The information for each of these quarters has been prepared on the same basis as our audited annual consolidated financial statements and, in the opinion of management, includes all adjustments, which consist only of normal recurring adjustments necessary for the fair statement of the results of operations for these periods in accordance with GAAP. This data should be read in conjunction with our audited consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. These quarterly results of operations are not necessarily indicative of our results of operations for a full year or any future period. ________________________ (1) Includes equity-based compensation expense as follows: (2) Includes amortization of acquired intangible assets as follows: (3) Represents net loss per share of Class A common stock and weighted-average shares of Class A common stock outstanding for only the periods following the Reorganization Transactions and Pluralsight, Inc.'s IPO described in Note 1-Organization and Description of Business. See Note 13-Net Loss Per Share for additional details. Quarterly Revenue Trends Our quarterly revenue increased sequentially for all periods presented due primarily to increases in billings from sales of subscriptions to our platform to business customers. Quarterly Costs and Expenses Trends Cost of revenue generally increased sequentially for all periods presented due primarily to the continued expansion of our content library and related author fees, hosting and delivery, and increased employee headcount within our customer support organization. For the three months ended September 30, 2018, cost of revenue decreased compared to the three months ended June 30, 2018, in part because of a decrease in amortization of acquired intangible assets. Our operating expenses generally increased sequentially across the quarters presented, primarily due to the addition of personnel to support our growth. Our operating expenses generally increase significantly during the fourth quarter of each year due to the increase in our billings from business customers attributable to large enterprise buying patterns typical in the software industry. Key Business Metrics ________________________ (1) See the section titled “-Key Business Metrics-Business customers” for additional information. (2) See the section titled “-Key Business Metrics-Billings” for additional information. Liquidity and Capital Resources As of December 31, 2018, our principal sources of liquidity were cash, cash equivalents, and restricted cash totaling $211.1 million, which were held for working capital purposes. Our cash equivalents are comprised primarily of money market funds. Our restricted cash is primarily related to a deposit required to be maintained as a result of our lease obligations related to our future headquarters. Since our inception, we have financed our operations primarily through private sales of equity securities, long-term debt facilities, and our net cash provided by operating activities. In May 2018, we completed our IPO of 23,805,000 shares of Class A common stock at a public offering price of $15.00 per share. We received $332.1 million in proceeds, net of underwriting discounts and commissions, which we used to purchase newly issued LLC Units from Pluralsight Holdings at a price per unit equal to the IPO price, net of underwriting discounts and commissions. Following the IPO, we caused Pluralsight Holdings to repay in full its outstanding long-term debt of $137.7 million and incurred a loss on debt extinguishment of $4.1 million in connection with the repayment. During the years ended December 31, 2018, 2017 and 2016, our free cash flow was negative as a result of our continued investments to support the growth of our business. We expect to continue such investments in order to sustain our growth. We expect that our free cash flow, along with our cash, cash equivalents, and restricted cash balances, will enable us to make such investments for the foreseeable future. We expect our free cash flow to improve as we experience greater scale in our business and improve operational efficiency, as well as eliminate cash paid for interest as a result of the debt repayment in May 2018. We expect to generate positive free cash flow over the long term. We believe our existing cash, cash equivalents, and restricted cash will be sufficient to meet our projected operating requirements for at least the next 12 months. Our future capital requirements will depend on many factors, including our pace of growth, subscription renewal activity, the timing and extent of spend to support the expansion of sales and marketing activities, technology and content efforts, and the continuing market acceptance of our platform. We may be required to seek additional equity or debt financing. In the event that additional financing is required from outside sources, we may not be able to raise it on terms acceptable to us, or at all. If we are unable to raise additional capital when desired, our business, results of operations, and financial condition would be adversely affected. In connection with the IPO and our UP-C structure, we entered into the TRA. As a result of the TRA, we are obligated to pass along some of these tax benefits and cash flows by making future payments to the TRA Members. Although the actual timing and amount of any payments we make to the TRA Members under the TRA will vary, such payments may be significant. Any payments we make to TRA Members 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. The following table shows cash flows for the years ended December 31, 2018, 2017, and 2016: Operating Activities Cash used in operating activities for the year ended December 31, 2018 of $5.9 million was primarily due to a net loss of $128.6 million, partially offset by equity-based compensation of $54.3 million, a favorable change in operating assets and liabilities of $43.4 million, amortization of acquired intangible assets of $8.7 million, depreciation of property and equipment of $8.3 million, debt extinguishment costs of $4.2 million, amortization of course creation costs of $2.0 million, and amortization of debt discount and debt issuance costs of $1.2 million. The net change in operating assets and liabilities was primarily due to an increase in the deferred revenue balance of $61.6 million and an increase in accrued expenses of $8.0 million, partially offset by an increase in accounts receivable of $26.2 million. Cash used in operating activities for the year ended December 31, 2017 of $12.1 million was primarily due to a net loss of $96.5 million, partially offset by a favorable change in operating assets and liabilities of $42.7 million, equity-based compensation of $21.8 million, amortization of acquired intangible assets of $8.5 million, depreciation of property and equipment of $6.7 million, amortization of debt discount and debt issuance costs of $1.8 million, and amortization of course creation costs of $1.5 million. The net change in operating assets and liabilities was primarily due to a favorable change in the deferred revenue balance of $39.0 million and an increase in accrued expenses of $18.0 million, partially offset by an unfavorable variance due to an increase in accounts receivable of $16.1 million. Cash provided by operating activities for the year ended December 31, 2016 of $4.5 million was primarily due to a net loss of $20.6 million, more than offset by amortization of acquired intangible assets of $8.0 million, amortization of course creation costs of $1.3 million, equity-based compensation of $5.7 million, a favorable change in operating assets and liabilities of $5.1 million, and depreciation of property and equipment of $4.3 million. The net changes in operating assets and liabilities resulted from an increase in the deferred revenue balance of $17.4 million and an increase in accrued expenses and other liabilities of $1.3 million, partially offset by an increase in accounts receivable of $12.9 million and decreases in the compensation portion of related party notes payable of $1.6 million. Investing Activities Cash used in investing activities for the year ended December 31, 2018 of $12.1 million was related to purchases of property and equipment of $8.8 million and purchases of our content library of $3.3 million. Cash used in investing activities for the year ended December 31, 2017 of $8.3 million was related to purchases of property and equipment of $6.0 million and purchases of content library and intangible assets of $2.4 million. Cash used in investing activities for the year ended December 31, 2016 of $13.0 million was related to purchases of property and equipment of $10.1 million, purchases of our content library and other intangible assets of $2.3 million, and $0.6 million for a business acquisition. Financing Activities Cash provided by financing activities for the year ended December 31, 2018 of $200.8 million was due to net proceeds from the IPO of $332.1 million, borrowings of long-term debt of $20.0 million, and proceeds from issuance of common stock from employee equity plans of $13.4 million, partially offset by repayments of long-term debt of $137.7 million, taxes paid related to net share settlement of $16.9 million, and payments of costs related to the IPO of $7.1 million. Cash provided by financing activities for the year ended December 31, 2017 of $29.5 million was due to $115.0 million in borrowing on long-term debt, partially offset by repayments of long-term debt of $85.0 million and payments of debt issuance costs of $0.9 million. Cash provided by financing activities for the year ended December 31, 2016 of $19.6 million consisted primarily of net proceeds from the issuance of Series C redeemable convertible preferred units of $30.3 million and deemed landlord financing proceeds of $2.2 million, partially offset by repayments of long-term debt of $8.1 million and repayments of a related party note payable of $4.8 million. Commitments and Contractual Obligations Our principal commitments and contractual obligations consist of obligations under leases for office facilities. The following table summarizes our non-cancellable contractual obligations as of December 31, 2018: ________________________ (1) We had leases that expire at various dates through 2035. The amounts above include amounts payable under operating and build-to-suit leases. 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. The table above excludes any obligations under the TRA. As a result of the exchanges made under our structure, we may incur a TRA liability, however, we do not expect to record a TRA liability until the tax benefits associated with the exchanges are more-likely-than-not to be realized. We estimate the incremental TRA liability that could result from past exchanges as of December 31, 2018 will be $5.5 million. Purchase orders, which represent authorizations to purchase rather than binding agreements, are not included, in the table above. The other contractual obligation amounts in the table above are associated with agreements that are enforceable and legally binding and that specify all significant terms, including fixed or minimum services to be used, fixed, minimum, or variable price provisions, and the approximate timing of the transaction. Obligations under contracts that we can cancel without significant penalty are not included in the table above. In the ordinary course of business, we enter into agreements in which we may agree to indemnify customers, vendors, lessors, partners, lenders, equity interest holders, and other parties with respect to certain matters, including losses resulting from claims of intellectual property infringement, damages to property or persons, business losses, or other liabilities. In addition, we have entered into indemnification agreements with our directors, executive officers, and other officers that will require us to indemnify them against liabilities that may arise by reason of their status or service as directors, officers, or employees. No demands have been made upon us to provide indemnification under such agreements and there are no claims that we are aware of that could have a material effect on our consolidated financial statements. Off-Balance Sheet Arrangements Through December 31, 2018, we did not have any relationships with unconsolidated organizations or financial partnerships, such as structured finance or special purpose entities that would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Critical Accounting Policies 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 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 date of the financial statements, as well as the reported revenue generated and 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. We believe that the accounting policies discussed below are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving management’s judgments and estimates. Revenue Recognition We derive substantially all of our revenue from subscription services (which include support services) from providing customers access to our platform. A small portion of our revenue is derived from providing professional services, which generally consist of content creation and other consulting services. We commence revenue recognition when all of the following conditions are met: (i) persuasive evidence of an arrangement exists; (ii) services are provided to the customer; (iii) the amount of fees to be paid by the customer is fixed or determinable; and (iv) collection is reasonably assured. Our subscription arrangements do not provide customers with the right to take possession of the software supporting our platform and, as a result, are accounted for as service arrangements. Revenue for subscription fees is recognized ratably over the subscription term, which typically varies from one month to three years, and begins on the date access to our platform is made available to the customer. Professional services are generally billed on a fixed-fee basis and are recognized as services are complete, provided the other revenue recognition criteria are met. Our arrangements are generally non-cancellable and nonrefundable. Taxes collected from customers are excluded from revenue. For arrangements with multiple deliverables, we evaluate whether the individual deliverables qualify as separate units of accounting. In order to treat deliverables in a multiple-element arrangement as separate units of accounting, the deliverables must have stand-alone value upon delivery and, in situations in which a general right of return exists for the delivered item, delivery or performance of the undelivered item is considered probable and substantially within our control. Our subscription services have stand-alone value as we routinely sell subscriptions separately. Our professional services have stand-alone value because we have routinely sold these services separately. Customers have no general rights of return for delivered items. If the deliverables have stand-alone value upon delivery, we account for each deliverable separately and revenue is recognized for the respective deliverables as they are delivered based on the relative selling price, which we determine by using the best estimate of selling price, as neither vendor-specific objective evidence nor third-party evidence is available. We have determined our best estimate of selling price for our deliverables based on customer size, the size and volume of its transactions, overarching pricing objectives and strategies, market and industry conditions, product-specific factors, historical sales of the deliverables and discounting practices. Deferred Revenue Deferred revenue primarily consists of billings or payments received in advance of revenue recognition from subscription services described above, including amounts billed to customers in accordance with the terms of their underlying contracts where the service period has not yet commenced but will in the near future. Deferred revenue is released to revenue as the recognition criteria are met. Amounts anticipated to be recognized within one year of the balance sheet date are recorded as deferred revenue, current; the remaining portion is recorded as non-current deferred revenue. Capitalized Software Development Costs We capitalize certain development costs incurred in connection with the development of our platform and software used in operations. Costs incurred in the preliminary stages of development are expensed as incurred. Once software has reached the development stage, internal and external costs of application development are capitalized until the software is substantially complete and ready for its intended use. Capitalization ceases upon completion of all substantial testing. We also capitalize costs related to specific upgrades and enhancements when it is probable the expenditures will result in additional functionality. We capitalized costs of $5.9 million, $3.4 million, and $3.2 million for the years ended December 31, 2018, 2017, and 2016, respectively, which were included in property and equipment. Maintenance and training costs are expensed as incurred. Equity-Based Compensation We incur equity-based compensation expense primarily from incentive units, RSUs, stock options, and purchase rights issued under the Employee Stock Purchase Plan, or ESPP. Equity awards to employees are measured and recognized in the consolidated financial statements based on the fair value of the award on the grant date. For time-based awards, the fair value of the award on the grant date is expensed on a straight-line basis over the requisite service period of the award. For awards subject to performance conditions, we record expense when the performance condition becomes probable. We record forfeitures related to equity-based compensation for its awards based on actual forfeitures as they occur. The grant date fair value of RSUs is determined using the market closing price of our Class A common stock on the date of grant. RSUs granted prior to the IPO vest upon the satisfaction of both a service condition and a liquidity condition. The liquidity condition was satisfied by the IPO, following the expiration of the lock-up period, which occurred in November 2018. Awards granted subsequent to the IPO are not subject to the liquidity condition. Prior to the IPO, we had not recorded any equity-based compensation expense associated with the RSUs as the liquidity condition was not deemed probable. Following the completion of the IPO, we recorded a cumulative adjustment to equity-based compensation expense totaling $7.8 million. The remaining unrecognized equity-based compensation expense related to RSUs will be recognized over the remaining requisite service period, using the straight-line attribution method. In connection with the IPO, we granted stock options to purchase shares of Class A common stock to certain employees. Equity-based compensation expense for Class A common stock options granted to employees is recognized based on the fair value of the awards granted, determined using the Black-Scholes option pricing model. Equity-based compensation expense is recognized as expense on a straight-line basis over the requisite service period. Equity-based compensation expense related to purchase rights issued under the ESPP is based on the Black-Scholes option pricing model fair value of the estimated number of awards as of the beginning of the offering period. Equity-based compensation expense is recognized following the straight-line attribution method over the offering period. The Black-Scholes option pricing model is affected by the share price and a number of assumptions, including the award’s expected life, risk-free interest rate, the expected volatility of the underlying stock, and expected dividends. The assumptions used in the Black-Scholes pricing model are estimated as follows: • Fair Value of Common Stock: We determine the fair value of common stock as of each grant date using the market closing price of our Class A common stock on the date of grant. • Risk-free Interest Rate: The risk-free interest rate is derived from the implied yield available on U.S. Treasury zero-coupon issues with remaining terms similar to the expected term of the options. • Expected Term: The expected term is estimated using the simplified method due to a lack of historical exercise activity for us. The simplified method calculates the expected term as the mid-point between the vesting date and the contractual expiration date of the award. For the ESPP, we use the period from the beginning of the offering period to the end of each purchase period. • Volatility: The price volatility factor is based on the historical volatilities of comparable companies as we do not have sufficient trading history for our common stock. To determine comparable companies, we consider public enterprise cloud-based application providers and select those that are similar in size, stage of life cycle, and financial leverage. We will continue to use this process until a sufficient amount of historical information regarding volatility becomes available, or until circumstances change such that the identified companies are no longer relevant, in which case, more suitable companies whose share prices are publicly available would be utilized in the calculation. • Dividend Yield: We have not and do not expect to pay dividends for the foreseeable future. We also recorded equity-based compensation expense when we or a holder of an economic interest in us purchases shares from an employee for an amount in excess of the fair value of the common units at the time of purchase. We recognize any excess value transferred in these transactions as equity-based compensation expense in the consolidated statement of operations. Business Combinations We include the results of operations of the businesses that we acquire as of the respective dates of acquisition. We allocate the fair value of the purchase price of our acquisitions to the assets acquired and liabilities assumed based on their estimated fair values. The excess of the fair value of the purchase price over the fair values of these identifiable assets and liabilities is recorded as goodwill. The determination of the value and useful lives of the intangible assets acquired involves certain judgments and estimates. These judgments can include, but are not limited to, the cash flows that an asset is expected to generate in the future and the appropriate weighted average cost of capital. Content Library, Intangible Assets, and Goodwill The content library assets have been acquired from our network of independent authors (course creation costs) and through various business combinations. We amortize the content library and other intangible assets acquired in business combinations on a straight-line basis over their estimated useful lives, which is generally five years. Periodically we assess potential impairment of our long-lived assets, which include our content library and intangible assets. We perform an impairment review whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include, but are not limited to, significant under-performance relative to historical or projected future results of operations, significant changes in the manner of our use of acquired assets or our overall business strategy, and significant industry or economic trends. When we determine that the carrying value of a long-lived asset (or asset group) may not be recoverable based upon the existence of one or more of the above indicators, we determine the recoverability by comparing the carrying amount of the asset to net future undiscounted cash flows that the asset is expected to generate and recognize an impairment charge equal to the amount by which the carrying amount exceeds the fair value of the asset. Goodwill represents the excess of the purchase price in a business combination over the fair value of net tangible and intangible assets acquired. We test goodwill for impairment annually as of October 1, or whenever events or changes in circumstances indicate that goodwill may be impaired. We initially assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more-likely-than-not that the fair value of our sole reporting unit is less than its carrying amount. If, after assessing the totality of events or circumstances, we determine it is more-likely-than-not that the fair value of the reporting unit is less than its carrying amount, then we perform a quantitative analysis by comparing the book value of net assets to the fair value of the reporting unit. If the fair value is determined to be less than the book value, an impairment charge is recorded. In assessing the qualitative factors, we consider the impact of certain key factors including macroeconomic conditions, industry and market considerations, management turnover, changes in regulation, litigation matters, changes in enterprise value, and overall financial performance. JOBS Act Accounting Election We meet the definition of an emerging growth company under the JOBS Act, which permits us to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies. We have elected to use this extended transition period until we are no longer an emerging growth company or until we affirmatively and irrevocably opt out of the extended transition period. As a result, our financial statements may not be comparable to companies that comply with new or revised accounting pronouncements applicable to public companies. Recent Accounting Pronouncements See Note 2 to Pluralsight, Inc.’s consolidated financial statements included elsewhere in this Annual Report on Form 10-K for more information.
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<s>[INST] Overview We are a leading provider of technology skill development solutions for businesses and individuals. We started operations in 2004 and focused initially on inperson ILT, and, in anticipation of increasing demand for online solutions, we shifted entirely to an online delivery model in 2011. Since 2011, we have extended our offering to include new content areas and additional features. Through our cloudbased technology skills platform, we enable businesses to innovate in an era of rapid technological change and digital transformation by equipping their employees with the latest technology skills. Out platform provides a broad range of tools, including skill and role assessments, a curated library of expertauthored courses, directed learning paths, interactive labs, and business analytics. Through these features, we provide businesses with visibility into the technical strengths of their workforce, allowing them to better align resources, provide targeted skill development in line with company goals, and advance the skills of individuals and teams. We derive substantially all of our revenue from the sale of subscriptions to our platform. We sell subscriptions primarily to business customers through our direct sales team, as well as through our website. Individual customers can also purchase subscriptions directly through our website. Our subscription pricing is calculated on a peruser basis. We recognize subscription revenue ratably over the life of the contract, which for business customers generally ranges from one to three years. As of December 31, 2018, we have 16,756 business customers, including over 810,000 business users, compared to 575,000 business users as of December 31, 2017. Our customers include over 340 of the 2018 Fortune 500. We have achieved significant growth in recent periods. For the years ended December 31, 2018, 2017, and 2016, our billings totaled $293.6 million, $205.8 million, and $149.2 million, representing yearoveryear growth of 43%, 38%, and 15%, respectively. Our billings from business customers for the same periods were $248.2 million, $163.0 million, and $104.9 million, respectively, representing yearoveryear growth of 52%, 55%, and 25%, respectively. Our net loss for the years ended December 31, 2018, 2017, and 2016, was $128.6 million, $96.5 million, and $20.6 million, respectively, which reflects our substantial investments in the future growth of our business. We continue to make investments in our business to execute our growth strategy. Key elements of our strategy include: attracting new customers, expanding deployments to existing customers, expanding internationally, and continuing to expand our skills platform, including the breadth of our content library and capabilities of our platform features. In May 2018, we completed our IPO of 23,805,000 shares of Class A common stock at a public offering price of $15.00 per share. We received $332.1 million in proceeds, net of underwriting discounts and commissions, which we used to purchase LLC Units from Pluralsight Holdings at a price per unit equal to the IPO price. Following the IPO, we caused Pluralsight Holdings to repay in full its outstanding longterm debt of $137.7 million. Key Business Metrics We monitor business customers, billings, and certain related key business metrics to help us evaluate our business, identify trends affecting our business, formulate business plans, and make strategic decisions. Business Customers We use the number of business customers to measure and monitor the growth of our business and the success of our sales and marketing activities, and believe that the growth of our business customer base is indicative of our longterm billings and revenue growth potential. We define a business customer as a unique account in our customer relationship management system that had an active paying subscription at the end of the period presented. Each unique account in our customer relationship management system is considered a unique business customer as the system does not create unique accounts for individual customers, and, in some cases, there may be more than one business customer within a single organization. Billings We use billings to measure and monitor our ability to provide our business with [/INST] Negative. </s>
2,019
8,406
1,725,579
Pluralsight, Inc.
2020-02-25
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 our consolidated financial statements and related notes 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 sections entitled “Risk Factors” and “Special Note Regarding Forward-Looking Statements” included elsewhere in this Annual Report on Form 10-K. This section of the Form 10-K generally discusses 2019 and 2018 items and year-to-year comparisons between 2019 and 2018. Discussions of 2017 items and year-to-year comparisons of 2018 to 2017 that are not included in this Form 10-K 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/A for the year ended December 31, 2018 and are hereby incorporated by reference herein and considered part of this Annual Report on Form 10-K only to the extent referenced. Overview We are a leading technology skills development platform committed to closing the global technology skills gap. Learners on our platform can quickly acquire today’s most valuable technology skills through on-demand, high-quality learning experiences delivered by subject-matter experts. Skills can be measured and assessed in real-time providing technology leaders with visibility into the capabilities of their teams and confidence their teams will deliver on critical objectives. Our platform empowers teams to keep up with the pace of technological change, puts the right people on the right projects and boosts productivity. We started operations in 2004 and focused initially on in-person instructor-led training. Anticipating the increasing demand for online solutions, we began offering online courses in 2008 and shifted entirely to an online delivery model in 2011. Since 2011, we extended our offering to include new content areas and additional features which expanded our addressable market, attracted new users, and deepened our foothold within businesses. We expanded our platform both organically through internal initiatives and through acquisitions, which have been focused on adding content and capabilities to our offerings. In 2019, we completed the acquisition of GitPrime, and we believe the addition of GitPrime, now Pluralsight Flow, enhances our platform by measuring software developer productivity. Pluralsight Flow enables technology leaders to enhance skills and drive productivity by identifying talent and areas of improvement within their teams. Our additions and improvements to our platform have enabled us to strengthen our relationships with our business customers and increase our revenue over time. We derive substantially all of our revenue from the sale of subscriptions to our platform. We sell subscriptions to our platform primarily to business customers through our direct sales team and our website. We also sell subscriptions to our platform to individual customers directly through our website. In addition, small teams often represent the “top of the funnel” for larger deployments, bringing our technology into their workplaces and proliferating usage of our platform within their companies. We are focused on attracting businesses, particularly large enterprises, to our platform and expanding their use of our platform over time. We believe there exists a significant opportunity to drive sales to large enterprises, including expanding relationships with existing customers and attracting new customers. Our ability to attract large enterprises to our platform and to expand their use of our platform will be important for the success of our business and our results of operations. We achieved significant growth in recent periods. For the years ended December 31, 2019, 2018, and 2017, our revenue totaled $316.9 million, $232.0 million, and $166.8 million, respectively, which represents year-over-year growth of 37%, 39%, and 27%, respectively. Our revenue from business customers for the same periods was $271.8 million, $188.2 million, and $125.3 million, respectively, representing year-over-year growth of 44%, 50%, and 41%. Our net loss for the years ended December 31, 2019, 2018, and 2017, was $163.6 million, $146.8 million, and $96.5 million, respectively, which reflects our substantial investments in the future growth of our business. Key Business Metrics We monitor business customers, billings, dollar-based net retention rate, and certain related key business metrics to help us evaluate our business, identify trends affecting our business, formulate business plans, and make strategic decisions. Business Customers We use the number of business customers to measure and monitor the growth of our business and the success of our sales and marketing activities and believe that the growth of our business customer base is indicative of our long-term billings and revenue growth potential. We define a business customer as a unique account in our customer relationship management system that had an active paying subscription at the end of the period presented. Each unique account in our customer relationship management system is considered a unique business customer as the system does not create unique accounts for individual customers, and, in some cases, there may be more than one business customer within a single organization. Billings We use billings to measure and monitor our ability to provide our business with the working capital generated by upfront payments from our customers and our ability to sell subscriptions to our platform to both new and existing customers. Billings represent our total revenue plus the change in deferred revenue in the period, as presented in our consolidated statements of cash flows, less the change in contract assets and unbilled accounts receivable in the period. Billings in any particular period represent amounts invoiced to our customers and reflect subscription renewals and upsells to existing customers plus sales to new customers. Our pricing and subscription periods vary for business customers and individual customers. Subscription periods for our business customers generally range from one to three years, with a majority being one year. We typically invoice our business customers in advance in annual installments. Subscription periods for our individual customers range from one month to one year and we typically invoice them in advance in monthly or annual installments. We use billings from business customers and our percentage of billings from business customers to measure and monitor our ability to sell subscriptions to our platform to business customers. We believe that billings from business customers will be a significant source of future revenue growth and a key factor affecting our long-term performance. We expect our billings from business customers to continue to increase as a percentage of billings over the long term. As our billings continue to grow in absolute terms, we expect our billings growth rate could decline over the long term as we achieve scale in our business. For example, during 2019, our billings growth rate declined compared to prior results primarily due to sales execution challenges, including (i) a lower net retention rate, (ii) being slower than planned in hiring additional sales representatives, and (iii) an increase in the length of the sales cycle as a greater portion of our billings are generated from larger enterprise customers. As a result of this performance, we reorganized our senior leadership within our sales organization, including hiring a new Chief Revenue Officer during the fourth quarter of 2019. In addition, we continue to implement ongoing changes to improve sales execution. While these changes have shown improvements in the short term, we expect that these changes will take time to produce recurring improvements in our growth rates over the long term. As we generally recognize revenue from subscription fees ratably over the term of the contract, due to the difference in timing of billings received and when we recognize revenue, changes to our billings and billings growth rates are not immediately reflected in our revenue and revenue growth rates. As a result, we expect that the decline in our billings growth rate during 2019 will reduce the growth rate of our revenue in future periods. Dollar-Based Net Retention Rate Our ability to upsell our platform across our business customers, particularly our enterprise customers, and expand such customers’ usage of our platform across their organizations, is further highlighted by our strong dollar-based net retention rate. We use our dollar-based net retention rate to measure our ability to retain and expand the revenue generated from our existing business customers. Our dollar-based net retention rate compares our subscription revenue from the same set of customers across comparable periods. We calculate our dollar-based net retention rate on a trailing four-quarter basis. To calculate our dollar-based net retention rate, we first calculate the subscription 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 revenue from cohort customers for the four most recent quarters, or numerator period, and the denominator is the sum of subscription 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. Components of Results of Operations Revenue We derive substantially all of our revenue from the sale of subscriptions to our platform. We also derive revenue from providing professional services, which generally consist of consulting, integration, or other content creation services. Amounts that have been invoiced are initially recorded as deferred revenue and are generally recognized ratably as revenue over the subscription period. Subscription terms typically range from one year to three years for business customers and from one month to one year for individual customers, and such terms begin on the date access to our platform is made available to the customer. Most of our subscriptions to business customers are billed in annual installments even if customers are contractually committed by multi-year agreements. Subscriptions that allow the customer to take software on-premise without significant penalty are recognized at a point in time when the software is made available to the customer. Cost of Revenue, Gross Profit and Gross Margin Cost of revenue includes certain direct costs associated with delivering our platform and includes costs for author fees, amortization of our content library, hosting and delivery fees, merchant processing fees, depreciation of capitalized software development costs for internal-use software, employee-related costs, including equity-based compensation expense associated with our customer support and professional services organizations, and third-party transcription costs. Gross profit, or revenue less cost of revenue, and gross margin, or gross profit as a percentage of revenue, has been and will continue to be affected by various factors, including the mix of subscriptions we sell, the cost of author fees, the costs associated with third-party hosting services, and the extent to which we expand our customer support and professional services organizations. We expect our gross margin to increase over the long term primarily due to a decrease in author fees as a percentage of revenue, although our gross margin may fluctuate from period to period depending on the interplay of the factors described above. Operating Expenses Our operating expenses are classified as sales and marketing, technology and content, and general and administrative. For each of these categories, the largest component is employee-related costs, which include salaries and bonuses, equity-based compensation expense, and employee benefit costs. We allocate shared overhead costs such as information technology infrastructure and facility-related costs based on headcount in each category. Sales and Marketing Sales and marketing expenses consist primarily of employee compensation costs of our sales and marketing employees, including salaries, benefits, bonuses, commissions, equity-based compensation expense, and allocated overhead costs. Other sales and marketing costs include user events, search engine and email marketing, content syndication, lead generation, and online banner and video advertising. The increases in sales and marketing expenses were driven primarily by increased employee compensation costs as we added headcount to support our growth as well as increased marketing and event related costs, including for Pluralsight LIVE, our user conference. We expect that our sales and marketing expenses will increase in absolute dollars for the foreseeable future and, in the near term, may increase as a percentage of our revenue as we hire additional sales and marketing personnel, increase our marketing activities, and grow our domestic and international operations. Additionally, our sales and marketing expenses may fluctuate as a percentage of our revenue from period to period depending on the timing of expenditures. However, we expect sales and marketing expenses to decrease as a percentage of revenue over the long term. Technology and Content Technology costs consist principally of research and development activities including personnel costs, consulting services, other costs associated with platform development efforts, and allocated overhead costs. Content costs consist principally of personnel costs and other activities associated with content development, course production, curriculum direction, and allocated overhead costs. Technology and content costs are expensed as incurred, except for certain costs relating to the development of internal-use software, including software used to upgrade and enhance our platform and applications supporting our business, which are capitalized and amortized over the estimated useful lives of one to three years. The increases in technology and content expenses were driven primarily by increased employee compensation costs as we added headcount to support our growth. We expect that our technology and content expenses will increase in absolute dollars for the foreseeable future and, in the near term, may increase as a percentage of our revenue as we continue to increase the functionality of and enhance our platform and develop new content and features. Additionally, our technology and content expense may fluctuate as a percentage of our revenue from period to period depending on the timing of expenditures. However, we expect technology and content expenses to decrease as a percentage of revenue over the long term. General and Administrative General and administrative expenses consist of personnel costs and related expenses for executive, finance, legal, people operations, and administrative personnel, including salaries, benefits, bonuses, and equity-based compensation expense; professional fees for external legal, accounting, recruiting, and other consulting services; and allocated overhead costs. The increases in general and administrative expenses were driven primarily by increased employee compensation costs as we added headcount to support our growth. We have incurred and expect to incur additional general and administrative expenses as a result of our organizational structure, including additional tax, accounting, and legal expenses, and operating as a public company, including expenses related to compliance with the rules and regulations of the SEC and listing standards of the applicable stock exchange, additional insurance expenses, investor relations activities, and increased legal, audit, and consulting fees. We also expect to increase the size of our general and administrative function to support our increased compliance requirements and the growth of our business. As a result, we expect that our general and administrative expenses will increase in absolute dollars for the foreseeable future and, in the near term, may increase as a percentage of our revenue. Additionally, our general and administrative expenses may fluctuate as a percentage of our revenue from period to period depending on the timing of expenditures. However, we expect general and administrative expenses to decrease as a percentage of revenue over the long term. Other Income (Expense) Other income (expense) consists primarily of interest expense on the Notes and other long-term debt, losses related to the extinguishment of our long-term debt, interest income on cash, cash equivalents, and investments, and gains or losses on foreign currency transactions. Results of Operations The following tables set forth selected consolidated statements of operations data and such data as a percentage of revenue for each of the periods indicated: ________________________ (1) Includes equity-based compensation expense as follows: (2) Includes amortization of acquired intangible assets as follows: Comparison of the Years Ended December 31, 2019 and 2018 Revenue Revenue was $316.9 million for the year ended December 31, 2019, compared to $232.0 million for the year ended December 31, 2018, an increase of $84.9 million, or 37%. The increase in revenue was primarily due to an $83.6 million, or 44%, increase in revenue from business customers, driven by an increase of 1,186 business customers from 16,756 business customers as of December 31, 2018 to 17,942 business customers as of December 31, 2019, as well as increased sales to our existing business customers, as evidenced by our dollar-based net retention rate of 123% for the year ended December 31, 2019. In addition, there was an increase of $1.3 million in revenue from individual customers. Cost of Revenue and Gross Profit Cost of revenue was $71.4 million for the year ended December 31, 2019, compared to $62.6 million for the year ended December 31, 2018, an increase of $8.7 million, or 14%. The increase in cost of revenue was primarily due to an increase of $9.5 million in author fees, an increase of $1.5 million in depreciation of capitalized software development, and an increase of $1.5 million in employee compensation costs, including $0.3 million in equity-based compensation expense, as we added headcount to support our growth. These increases were partially offset by a decrease of $3.4 million in amortization of acquired intangible assets and course creation costs. Gross profit was $245.6 million for the year ended December 31, 2019, compared to $169.4 million for the year ended December 31, 2018, an increase of $76.1 million, or 45%. The increase in gross profit was the result of the increase in our revenue during the year ended December 31, 2019. Gross margin increased from 73% for the year ended December 31, 2018 to 77% for the year ended December 31, 2019 due to a decrease in amortization of acquired intangible assets and a decrease in author fees as a percentage of revenue. Operating Expenses Sales and Marketing Sales and marketing expenses were $207.1 million for the year ended December 31, 2019, compared to $158.4 million for the year ended December 31, 2018, an increase of $48.7 million, or 31%. The increase was primarily due to an increase of $35.3 million in employee compensation costs, including $11.6 million in equity-based compensation expense, as we added headcount to support our growth. In addition, there was an increase of $7.1 million related to allocated overhead costs primarily driven by our headcount growth, an increase of $3.2 million due to additional travel expenses primarily driven by our headcount growth, and an increase in marketing and events costs of $2.1 million. Technology and Content Technology and content expenses were $102.9 million for the year ended December 31, 2019, compared to $69.3 million for the year ended December 31, 2018, an increase of $33.6 million, or 49%. The increase was primarily due to an increase of $30.3 million in employee compensation costs, including $9.4 million in equity-based compensation, as we added headcount to support our growth. In addition, there was an increase of $3.2 million related to allocated overhead costs primarily driven by our headcount growth. These increases were partially offset by a $1.2 million increase in capitalized software development costs. General and Administrative General and administrative expenses were $85.6 million for the year ended December 31, 2019, compared to $78.4 million for the year ended December 31, 2018, an increase of $7.1 million, or 9%. The increase was primarily due to an increase of $3.7 million in employee compensation costs, as we added headcount to support our growth. In addition, there was an increase of $2.2 million related to professional services primarily driven by the additional costs of operating as a public company, an increase of $1.6 million related to allocated overhead costs primarily driven by our headcount growth, an increase of $1.3 million due to additional travel expenses primarily driven by our headcount growth, an increase of $0.9 million related to costs associated with a secondary offering, and an increase of $0.8 million related to costs associated with our acquisition of GitPrime. These increases were partially offset by a decrease of $3.4 million in equity-based compensation primarily related to a cumulative catch-up adjustment recorded in 2018 following the completion of the IPO as the vesting condition for certain RSUs satisfied by the expiration of the lock-up period following the IPO became probable. Other Income (Expense) Interest expense increased primarily as a result of the interest expense and amortization of debt discount and issuance costs related to the Notes issued in March 2019. We repurchased $40.0 million in aggregate principal of the Notes in September 2019, resulting in the loss on debt extinguishment. The interest expense and loss on debt extinguishment during the year ended December 31, 2018 was the result of our long-term debt, which we repaid in full in May 2018 with the IPO proceeds. Other income, net increased primarily as a result of the additional interest income earned from our increased cash, cash equivalents and investments as a result of net proceeds from our IPO and the issuance of the Notes. Quarterly Results of Operations The following tables set forth selected unaudited quarterly consolidated statements of operations data for each of the eight quarters in the period ended December 31, 2019, as well as the percentage of revenue that each line item represents for each quarter. The information for each of these quarters has been prepared on the same basis as our audited annual consolidated financial statements and, in the opinion of management, includes all adjustments, which consist only of normal recurring adjustments necessary for the fair statement of the results of operations for these periods in accordance with GAAP. This data should be read in conjunction with our audited consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. These quarterly results of operations are not necessarily indicative of our results of operations for a full year or any future period. ________________________ (1) Includes equity-based compensation expense as follows: (2) Includes amortization of acquired intangible assets as follows: (3) Represents net loss per share of Class A common stock and weighted-average shares of Class A common stock outstanding for the portion of the periods following the Reorganization Transactions and Pluralsight, Inc.'s IPO described in Note 1 and Note 17 to Pluralsight, Inc.’s consolidated financial statements included elsewhere in this Annual Report on Form 10-K. Quarterly Revenue Trends Our quarterly revenue increased sequentially for all periods presented due primarily to increases in billings from sales of subscriptions to our platform to business customers. Quarterly Costs and Expenses Trends Cost of revenue generally increased sequentially for all periods presented due primarily to the continued expansion of our content library and related author fees, hosting and delivery, and increased employee headcount within our customer support and professional services organizations. For the three months ended September 30, 2018, cost of revenue decreased compared to the three months ended June 30, 2018, in part because of a decrease in amortization of acquired intangible assets. Our operating expenses have generally increased sequentially across the quarters presented, primarily due to the addition of personnel to support our growth. Key Business Metrics ________________________ (1) See the section entitled “-Key Business Metrics-Business customers” for additional information. (2) See the section entitled “-Key Business Metrics-Billings” for additional information. Liquidity and Capital Resources As of December 31, 2019, our principal sources of liquidity were cash, cash equivalents, restricted cash and investments totaling $557.5 million, which were held for working capital purposes. Our cash equivalents and investments are comprised primarily of highly liquid investments in money market funds, U.S. treasury securities, U.S. government agency securities, commercial paper, and corporate debt securities. Since our inception, we have financed our operations primarily through sales of equity securities, long-term debt facilities, and our net cash provided by operating activities. In March 2019, we completed our private placement of $633.5 million aggregate principal of Notes, including the exercise in full by the initial purchasers of the Notes of their option to purchase up to an additional $83.5 million principal amount of Notes. The Notes are our senior unsecured obligations. We received net proceeds of $616.7 million, after deducting the initial purchasers’ discounts and commissions and the estimated offering expenses payable by us. We used approximately $69.4 million of the net proceeds to pay the cost of the capped call transactions related thereto. On May 9, 2019, we completed the acquisition of GitPrime, a leading provider of software developer productivity software for approximately $163.8 million in cash, excluding cash acquired, working capital and transactions cost adjustments. In September 2019, we repurchased a total of $40.0 million in aggregate principal amount of our Notes for approximately $35.0 million in cash, offset by $1.3 million in proceeds we received for the termination of the related portion of the capped call transactions. Our free cash flow for the year ended December 31, 2019 was negative as a result of our continued investments to support the growth of our business. We expect to continue such investments in order to sustain our growth. We expect that our cash, cash equivalents, and restricted cash balances, will enable us to make such investments for the foreseeable future. We expect our free cash flow to improve as we experience greater scale in our business and improve operational efficiency. We expect to generate positive free cash flow over the long term. We believe our existing cash, cash equivalents, restricted cash, and investments, as well as our projected cash flows from operations, will be sufficient to meet our projected operating requirements for at least the next 12 months. Our future capital requirements will depend on many factors, including our pace of growth, subscription renewal activity, the timing and extent of spend to support the expansion of sales and marketing activities, technology and content efforts, the continuing market acceptance of our platform, and future acquisitions. We may be required to seek additional equity or debt financing. In the event that additional financing is required from outside sources, we may not be able to raise it on terms acceptable to us, or at all. If we are unable to raise additional capital when desired, our business, results of operations, and financial condition would be adversely affected. In connection with the IPO and our UP-C structure, we entered into the TRA. As a result of the TRA, we are obligated to pass along some of these tax benefits and cash flows by making future payments to the TRA Members. Although the actual timing and amount of any payments we make to the TRA Members under the TRA will vary, such payments may be significant. Any payments we make to TRA Members 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. To date, we have not made any payments under the TRA. We do not expect to make or accrue payments to TRA Members in the near future as payments to TRA members are not owed until the tax benefits generated by TRA Members are more-likely-than-not to be realized. The following table shows cash flows for the years ended December 31, 2019, 2018, and 2017: Operating Activities Cash used in operating activities for the year ended December 31, 2019 of $11.7 million was primarily due to a net loss of $163.6 million, partially offset by equity-based compensation of $90.4 million, amortization of deferred contract acquisition costs of $23.6 million, amortization of debt discount and issuance costs of $21.7 million, depreciation of property and equipment of $9.5 million, amortization of acquired intangible assets of $4.5 million, and a favorable change in operating assets and liabilities of $0.8 million. The net change in operating assets and liabilities was primarily due to an increase in deferred revenue of $62.2 million, an increase in accrued expenses and other liabilities of $5.9 million, and a decrease in right-of-use assets of $5.6 million, partially offset by an increase in accounts receivable of $37.3 million, an increase in deferred contract acquisition costs of $27.7 million, a decrease in operating lease liabilities of $6.7 million, and an increase in prepaid expenses and other assets $5.7 million. Cash used in operating activities for the year ended December 31, 2018 of $5.9 million was primarily due to a net loss of $146.8 million, partially offset by equity-based compensation of $72.5 million, a favorable change in operating assets and liabilities of $43.4 million, amortization of acquired intangible assets of $8.7 million, depreciation of property and equipment of $8.3 million, debt extinguishment costs of $4.2 million, amortization of course creation costs of $2.0 million, and amortization of debt discount and debt issuance costs of $1.2 million. The net change in operating assets and liabilities was primarily due to an increase in the deferred revenue balance of $61.6 million and an increase in accrued expenses of $8.0 million, partially offset by an increase in accounts receivable of $26.2 million. Cash used in operating activities for the year ended December 31, 2017 of $12.1 million was primarily due to a net loss of $96.5 million, partially offset by a favorable change in operating assets and liabilities of $42.7 million, equity-based compensation of $21.8 million, amortization of acquired intangible assets of $8.5 million, depreciation of property and equipment of $6.7 million, amortization of debt discount and debt issuance costs of $1.8 million, and amortization of course creation costs of $1.5 million. The net change in operating assets and liabilities was primarily due to a favorable change in the deferred revenue balance of $39.0 million and an increase in accrued expenses of $18.0 million, partially offset by an unfavorable variance due to an increase in accounts receivable of $16.1 million. Investing Activities Cash used in investing activities for the year ended December 31, 2019 of $616.7 million was primarily due to purchases of investments of $694.2 million, the purchase of a business of $163.8 million, purchases of property and equipment of $11.2 million, and purchases of our content library of $5.3 million, partially offset by proceeds from maturities of short-term investments of $252.8 million and proceeds from the sale of investments of $5.0 million. Cash used in investing activities for the year ended December 31, 2018 of $12.1 million was related to purchases of property and equipment of $8.8 million and purchases of our content library of $3.3 million. Cash used in investing activities for the year ended December 31, 2017 of $8.3 million was related to purchases of property and equipment of $6.0 million and purchases of content library and intangible assets of $2.4 million. Financing Activities Cash provided by financing activities for the year ended December 31, 2019 of $536.8 million was primarily due to net proceeds from the issuance of the Notes of $616.7 million and proceeds from the issuance of common stock from employee equity plans of $24.8 million, partially offset by the purchase of Capped Calls of $69.4 million and the repurchases of the Notes of $35.0 million. Cash provided by financing activities for the year ended December 31, 2018 of $200.8 million was due to net proceeds from the IPO of $332.1 million, borrowings of long-term debt of $20.0 million, and proceeds from issuance of common stock from employee equity plans of $13.4 million, partially offset by repayments of long-term debt of $137.7 million, taxes paid related to net share settlement of $16.9 million, and payments of costs related to the IPO of $7.1 million. Cash provided by financing activities for the year ended December 31, 2017 of $29.5 million was due to $115.0 million in borrowing on long-term debt, partially offset by repayments of long-term debt of $85.0 million and payments of debt issuance costs of $0.9 million. Commitments and Contractual Obligations Our principal commitments and contractual obligations consist of obligations under leases for office facilities. The following table summarizes our non-cancellable contractual obligations as of December 31, 2019: ________________________ (1) We signed a non-cancellable lease for our future corporate headquarters that will be constructed in Draper, Utah. The lease has not yet commenced, however, the amounts shown above reflect the expected future lease payments for this facility. 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. The table above excludes any obligations under the TRA. As a result of the exchanges made under our structure, we may incur a TRA liability, however, we have not and do not expect to record a TRA liability until the tax benefits associated with the exchanges are more-likely-than-not to be realized. Had the tax benefits been more-likely-than-not to be realized, the estimated incremental TRA liability that could result from past exchanges would have been $270.9 million as of December 31, 2019. Purchase orders, which represent authorizations to purchase rather than binding agreements, are not included in the table above. The other contractual obligation amounts in the table above are associated with agreements that are enforceable and legally binding and that specify all significant terms, including fixed or minimum services to be used, fixed, minimum, or variable price provisions, and the approximate timing of the transaction. Obligations under contracts that we can cancel without significant penalty are not included in the table above. In the ordinary course of business, we enter into agreements in which we may agree to indemnify customers, vendors, lessors, partners, lenders, equity interest holders, and other parties with respect to certain matters, including losses resulting from claims of intellectual property infringement, damages to property or persons, business losses, or other liabilities. In addition, we have entered into indemnification agreements with our directors, executive officers, and other officers that will require us to indemnify them against liabilities that may arise by reason of their status or service as directors, officers, or employees. No demands have been made upon us to provide indemnification under such agreements and there are no claims that we are aware of that could have a material effect on our consolidated financial statements. Off-Balance Sheet Arrangements Through December 31, 2019, we did not have any relationships with unconsolidated organizations or financial partnerships, such as structured finance or special purpose entities that would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Critical Accounting Policies 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 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 date of the financial statements, as well as the reported revenue generated and 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. We believe that the accounting policies discussed below are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving management’s judgments and estimates. Revenue Recognition We derive substantially all of our revenue from subscription services (which include support services) by providing customers access to our platform. We implemented the provisions of Accounting Standards Update, or ASU, 2014-09 (referred to collectively as "ASC 606") effective January 1, 2019 using the modified retrospective transition method as discussed below under the section "Recent Accounting Pronouncements." Following the adoption of ASC 606, we recognize revenue when control of these services is transferred to its customers, in an amount that reflects the consideration we expect to be entitled to in exchange for the services. Sales and other taxes collected from customers to be remitted to government authorities are excluded from revenue. We account for revenue contracts with customers by applying the following steps: • Identification of the contract, or contracts, with a customer; • Identification of the performance obligations in a contract; • Determination of the transaction price; • Allocation of the transaction price to the performance obligations in the contract; and • Recognition of revenue when, or as, performance obligations are satisfied. Our subscription arrangements generally do not provide customers with the right to take possession of the software supporting the platform and, as a result, are accounted for as service arrangements. Access to our platform represents a series of distinct services as we continually provide access to, and fulfills our obligation to, the end customer over the subscription term. The series of distinct services represents a single performance obligation that is satisfied over time. Accordingly, the fixed consideration related to subscription revenue is generally recognized on a straight-line basis over the contract term, beginning on the date that the service is made available to the customer. Our subscription contracts typically vary from one month to three years. Our arrangements are generally noncancellable and nonrefundable. Subscriptions that allow the customer to take software on-premise without significant penalty are treated as time-based licenses. These arrangements generally include access to the software over the license term, access to unspecified future product updates, maintenance, and support. Revenue for on-premise software subscriptions is recognized at a point in time when the software is made available to the customer. Revenue for access to unspecified future products, maintenance and support included with on-premise software subscriptions is recognized ratably over the contract term beginning on the date that the software is made available to the customer. We also derive revenue from providing professional services, which generally consist of consulting, integration, or other content creation services. These services are distinct from subscription services. Revenue from professional services is generally recognized as services are performed. Some 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 standalone selling prices considering market conditions and based on overall pricing objectives such as observable standalone selling prices, and other factors, including the value of contracts, types of services sold, customer demographics, and the number and types of users within such contracts. Capitalized Software Development Costs We capitalize certain development costs incurred in connection with the development of our platform and software used in operations. Costs incurred in the preliminary stages of development are expensed as incurred. Once software has reached the development stage, internal and external costs of application development are capitalized until the software is substantially complete and ready for its intended use. Capitalization ceases upon completion of all substantial testing. We also capitalize costs related to specific upgrades and enhancements when it is probable the expenditures will result in additional functionality. We capitalized costs of $8.5 million, $5.9 million, and $3.4 million for the years ended December 31, 2019, 2018, and 2017, respectively, which were included in property and equipment. Maintenance and training costs are expensed as incurred. Equity-Based Compensation We incur equity-based compensation expense primarily from incentive units, RSUs, stock options, and purchase rights issued under the Employee Stock Purchase Plan, or ESPP. Equity awards to employees are measured and recognized in the consolidated financial statements based on the fair value of the award on the grant date. For awards subject to service conditions only, the fair value of the award on the grant date is expensed on a straight-line basis over the requisite service period of the award. For awards subject to both service and performance conditions, we record expense when the performance condition becomes probable. Expense is recognized using the accelerated attribution method (on a tranche-by-tranche basis) for awards with a graded vesting schedule that are subject to both service and performance conditions. We record forfeitures related to equity-based compensation for our awards based on actual forfeitures as they occur. The grant date fair value of RSUs is determined using the market closing price of our Class A common stock on the date of grant. RSUs granted prior to the IPO vest upon the satisfaction of both a service condition and a liquidity condition. The liquidity condition was satisfied by the IPO, following the expiration of the lock-up period, which occurred in November 2018. Awards granted subsequent to the IPO are not subject to the liquidity condition. Prior to the IPO, we had not recorded any equity-based compensation expense associated with the RSUs as the liquidity condition was not deemed probable. Following the completion of the IPO, we recorded a cumulative adjustment to equity-based compensation expense totaling $17.1 million. The remaining unrecognized equity-based compensation expense related to RSUs granted prior to the IPO will be recognized over the remaining requisite service period, using the accelerated attribution method. RSUs granted subsequent to the IPO subject to service conditions only will be recognized over the remaining requisite service period, using the straight-line method. In connection with the IPO, we granted stock options to purchase shares of Class A common stock to certain employees. Equity-based compensation expense for Class A common stock options granted to employees is recognized based on the fair value of the awards granted, determined using the Black-Scholes option pricing model. Equity-based compensation expense is recognized as expense on a straight-line basis over the requisite service period. Equity-based compensation expense related to purchase rights issued under the ESPP is based on the Black-Scholes option pricing model fair value of the estimated number of awards as of the beginning of the offering period. Equity-based compensation expense is recognized following the straight-line attribution method over the offering period. The Black-Scholes option pricing model is affected by the share price and a number of assumptions, including the award’s expected life, risk-free interest rate, the expected volatility of the underlying stock, and expected dividends. The assumptions used in the Black-Scholes pricing model are estimated as follows: • Fair Value of Common Stock: We determine the fair value of common stock as of each grant date using the market closing price of our Class A common stock on the date of grant. • Risk-free Interest Rate: The risk-free interest rate is derived from the implied yield available on U.S. Treasury zero-coupon issues with remaining terms similar to the expected term of the options. • Expected Term: The expected term is estimated using the simplified method due to a lack of historical exercise activity for us. The simplified method calculates the expected term as the mid-point between the vesting date and the contractual expiration date of the award. For the ESPP, we use the period from the beginning of the offering period to the end of each purchase period. • Volatility: The price volatility factor is based on the historical volatilities of comparable companies as we do not have sufficient trading history for our common stock. To determine comparable companies, we consider public enterprise cloud-based application providers and select those that are similar in size, stage of life cycle, and financial leverage. We will continue to use this process until a sufficient amount of historical information regarding volatility becomes available, or until circumstances change such that the identified companies are no longer relevant, in which case, more suitable companies whose share prices are publicly available would be utilized in the calculation. • Dividend Yield: We have not and do not expect to pay dividends for the foreseeable future. We also recorded equity-based compensation expense when we or a holder of an economic interest in us purchases shares from an employee for an amount in excess of the fair value of the common units at the time of purchase. We recognize any excess value transferred in these transactions as equity-based compensation expense in the consolidated statement of operations. Business Combinations We include the results of operations of the businesses that we acquire as of the respective dates of acquisition. We allocate the fair value of the purchase price of our acquisitions to the assets acquired and liabilities assumed based on their estimated fair values. The excess of the fair value of the purchase price over the fair values of these identifiable assets and liabilities is recorded as goodwill. The determination of the value and useful lives of the intangible assets acquired involves certain judgments and estimates. These judgments can include, but are not limited to, the cash flows that an asset is expected to generate in the future and the appropriate weighted average cost of capital. Content Library, Intangible Assets, and Goodwill The content library assets have been acquired from our network of independent authors (course creation costs) and through various business combinations. We amortize the content library and other intangible assets acquired from our authors or in business combinations on a straight-line basis over their estimated useful lives, which is generally five years. Periodically we assess potential impairment of our long-lived assets, which include our content library and intangible assets. We perform an impairment review whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include, but are not limited to, significant under-performance relative to historical or projected future results of operations, significant changes in the manner of our use of acquired assets or our overall business strategy, and significant industry or economic trends. When we determine that the carrying value of a long-lived asset (or asset group) may not be recoverable based upon the existence of one or more of the above indicators, we determine the recoverability by comparing the carrying amount of the asset to net future undiscounted cash flows that the asset is expected to generate and recognize an impairment charge equal to the amount by which the carrying amount exceeds the fair value of the asset. Goodwill represents the excess of the purchase price in a business combination over the fair value of net tangible and intangible assets acquired. We test goodwill for impairment annually as of October 1, or whenever events or changes in circumstances indicate that goodwill may be impaired. We initially assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more-likely-than-not that the fair value of our sole reporting unit is less than its carrying amount. If, after assessing the totality of events or circumstances, we determine it is more-likely-than-not that the fair value of the reporting unit is less than its carrying amount, then we perform a quantitative analysis by comparing the book value of net assets to the fair value of the reporting unit. If the fair value is determined to be less than the book value, an impairment charge is recorded. In assessing the qualitative factors, we consider the impact of certain key factors including macroeconomic conditions, industry and market considerations, management turnover, changes in regulation, litigation matters, changes in enterprise value, and overall financial performance. Recent Accounting Pronouncements See Note 2 to Pluralsight, Inc.’s consolidated financial statements included elsewhere in this Annual Report on Form 10-K for more information. Social Impact We believe technology has the power to create freedom, equality, and opportunity around the globe. Pluralsight One is our social impact initiative dedicated to closing the technology skills gap. Pluralsight One was launched in 2017 as a social enterprise to lead our global social impact strategy in support of our mission to democratize technology skills. Pluralsight One uses our platform to further our mission by focusing on four pillars: • Opportunity: Increase access to technology skill development and promote inclusion across the globe. • Education: Revolutionize the way the world learns and address the root issues contributing to the increasing technology skills gap to prevent nonprofit organizations, educators and the populations they support from becoming left behind. • Employability: Equip individuals with the technology skills they need to access dignified employment, thrive, and keep pace in any industry. • Innovation: Invest in catalytic solutions that accelerate our mission and the missions of nonprofits around the world. We take action on these pillars through product, volunteerism, and investments: • Product: Pluralsight One creates freedom, equality and opportunity by helping nonprofits, educators, and the communities they support develop the technology skills needed to build better lives and a better future for us all. • Volunteerism: Pluralsight One empowers the Pluralsight community to transfer skills that meet identified community needs and create lasting impact through volunteerism and mentorship opportunities. • Investments: Pluralsight One fuels innovation and amplifies impact by funding solutions and programs that scale. In addition, two of our co-founders, Aaron Skonnard and Frederick Onion, have donated and intend to donate in the future a portion of their Pluralsight equity to the Pluralsight One fund, Silicon Valley Community Foundation a donor advised fund owned and operated by a 501(c)(3) public charity. We have advisory privileges over the fund, with the ability to recommend investment strategy of the donated assets, and the ability to recommend cash grants to support qualified charities, however we do not control the Pluralsight One Fund sponsors, and accordingly we do not consolidate the donor advised fund’s activities into our consolidated financial statements. Among our achievements in 2019, Great Place to Work® and FORTUNE named us as one of the Best Small & Medium Workplaces, a Best Workplace for Technology, a Best Workplace for Women, and a Best Workplace for Millennials.
0.006317
0.006354
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<s>[INST] This section of the Form 10K generally discusses 2019 and 2018 items and yeartoyear comparisons between 2019 and 2018. Discussions of 2017 items and yeartoyear comparisons of 2018 to 2017 that are not included in this Form 10K 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 10K/A for the year ended December 31, 2018 and are hereby incorporated by reference herein and considered part of this Annual Report on Form 10K only to the extent referenced. Overview We are a leading technology skills development platform committed to closing the global technology skills gap. Learners on our platform can quickly acquire today’s most valuable technology skills through ondemand, highquality learning experiences delivered by subjectmatter experts. Skills can be measured and assessed in realtime providing technology leaders with visibility into the capabilities of their teams and confidence their teams will deliver on critical objectives. Our platform empowers teams to keep up with the pace of technological change, puts the right people on the right projects and boosts productivity. We started operations in 2004 and focused initially on inperson instructorled training. Anticipating the increasing demand for online solutions, we began offering online courses in 2008 and shifted entirely to an online delivery model in 2011. Since 2011, we extended our offering to include new content areas and additional features which expanded our addressable market, attracted new users, and deepened our foothold within businesses. We expanded our platform both organically through internal initiatives and through acquisitions, which have been focused on adding content and capabilities to our offerings. In 2019, we completed the acquisition of GitPrime, and we believe the addition of GitPrime, now Pluralsight Flow, enhances our platform by measuring software developer productivity. Pluralsight Flow enables technology leaders to enhance skills and drive productivity by identifying talent and areas of improvement within their teams. Our additions and improvements to our platform have enabled us to strengthen our relationships with our business customers and increase our revenue over time. We derive substantially all of our revenue from the sale of subscriptions to our platform. We sell subscriptions to our platform primarily to business customers through our direct sales team and our website. We also sell subscriptions to our platform to individual customers directly through our website. In addition, small teams often represent the “top of the funnel” for larger deployments, bringing our technology into their workplaces and proliferating usage of our platform within their companies. We are focused on attracting businesses, particularly large enterprises, to our platform and expanding their use of our platform over time. We believe there exists a significant opportunity to drive sales to large enterprises, including expanding relationships with existing customers and attracting new customers. Our ability to attract large enterprises to our platform and to expand their use of our platform will be important for the success of our business and our results of operations. We achieved significant growth in recent periods. For the years ended December 31, 2019, 2018, and 2017, our revenue totaled $316.9 million, $232.0 million, and $166.8 million, respectively, which represents yearoveryear growth of 37%, 39%, and 27%, respectively. Our revenue from business customers for the same periods was $271.8 million, $188.2 million, and $125.3 million, respectively, representing yearoveryear growth of 44%, 50%, and 41%. Our net loss for the years ended December 31, 2019, 2018, and 2017, was $163.6 million, $146.8 million, and $96.5 million, respectively, which reflects our substantial investments in the future growth of our business. Key Business Metrics We monitor business customers, billings, dollarbased net retention rate, and certain related key business metrics to help us evaluate our business, identify trends affecting our business, formulate business plans, and make strategic decisions. Business Customers We use the number of business customers to measure and monitor the growth [/INST] Positive. </s>
2,020
8,269
1,437,958
COASTAL FINANCIAL CORP
2019-03-28
2018-12-31
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Overview We are a bank holding company that operates through our wholly owned subsidiary, Coastal Community Bank. We are headquartered in Everett, Washington, which by population is the largest city in, and the county seat of, Snohomish County. We focus on providing a wide range of banking products and services to consumers and small to medium sized businesses in the broader Puget Sound region in the state of Washington. We currently operate 14 full-service banking locations, 11 of which are located in Snohomish County, where we are the largest community bank by deposit market share, and three of which are located in neighboring counties (one in King County and two in Island County). As of December 31, 2018, we had total assets of $952.1 million, total gross loans of $767.9 million, total deposits of $803.6 million and total shareholders’ equity of $109.2 million. The following discussion and analysis presents our financial condition and results of operations on a consolidated basis. However, because we conduct all of our material business operations through Coastal Community Bank, the discussion and analysis relate to activities primarily conducted by the Bank. As a bank holding company that operates through one segment, community banking, we generate most of our revenue from interest on loans and investments. Our primary source of funding for our loans is commercial and retail deposits. We place secondary reliance on wholesale funding, primarily borrowings from the Federal Home Loan Bank, or FHLB. Our largest expenses are salaries and related employee benefits, occupancy, interest on deposits and borrowings, data processing, and provision for loan losses. Our principal lending products are commercial real estate loans, commercial and industrial loans, and to a lesser extent residential real estate loans and consumer loans. Key Factors Affecting our Business Average Balances and Interest Rates Our operating results depend primarily on our net interest income, which is the largest contributor to our net income and 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). Net interest income is primarily a function of the average balances of interest-earning assets and interest-bearing liabilities and the yields and costs with respect to these assets and liabilities. Average balances are influenced by internal considerations such as the types of products we offer and the amount of risk that we are willing to assume as well as external influences such as economic conditions, competition for loans and deposits, and interest rates. The yields generated by our loans and securities are typically affected by short-term and long-term interest rates and, in the case of loans, competition for similar products in our market area. Interest rates are often impacted by the actions of the Federal Reserve. The cost of our deposits and short-term borrowings is primarily based on short-term interest rates, which are largely driven by competition and by the actions of the Federal Reserve. The level of net interest income is influenced by movements in interest rates and the pace at which such movements occur, as well as the relationship between short- and long-term interest rates. Credit Quality We have well established loan policies and underwriting practices that have resulted in low levels of charge-offs and nonperforming assets. Through our thorough underwriting process, we strive to originate quality loans that will maintain and enhance the overall credit quality of our loan portfolio, and through our careful monitoring of our loan portfolio and prompt attention to delinquencies, we seek to minimize the impact of problem loans. However, credit trends in the markets in which we operate are largely impacted by economic conditions beyond our control and can adversely impact our financial condition. Operating Efficiency Our largest noninterest expense is salaries and employee benefits, which consist primarily of salaries and wages paid to our employees, payroll taxes, and expenses for health insurance, retirement plans and other employee benefits. Other significant operating expenses include occupancy expense, data processing expense, director and staff expense, marketing expense, and legal and professional fees. Our operating efficiency, as measured by our efficiency ratio, has gradually improved primarily because the growth of our deposits and loans has enabled our net interest income and noninterest income to outpace our expenses. When we open new branches or make substantial investments to increase our operating capacity, our operating efficiency decreases until we generate enough growth to offset the increased costs however, prior to making such investments, we focus on how best and most expediently we can achieve the growth necessary to offset the costs of these investments or new branches. Economic Conditions Our business and financial performance are affected by economic conditions generally in the United States and more directly in the markets in the Puget Sound region where we operate. The significant economic factors that are most relevant to our business and our financial performance include, but are not limited to, real estate values, interest rates and unemployment rates. In recent years, the Puget Sound region has experienced significant population gain, fueled in large part by the region’s technology industry, low unemployment and rising real estate values, all of which positively impacted our business. Results of Operations Net Income Year Ended December 31, 2018, Compared to Year Ended December 31, 2017. Net income for the year ended December 31, 2018, was $9.7 million, or $0.91 per diluted share, compared to $5.4 million, or $0.59 per diluted share, for the year ended December 31, 2017. The increase in net income over the prior year was attributable to a $5.6 million increase in net interest income, $1.3 million increase in noninterest income, and $2.2 million decrease in the provision for income taxes, as a result of the reduction in the corporate income tax rate under the Tax Cuts and Jobs Act, which decreased tax expense in 2018, and as a result of the revaluation of deferred tax assets under the Tax Cuts and Jobs Act, increased tax expense in 2017. See “Item 6 - Selected Financial Data-GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures.” These increases in net income were partially offset by $1.0 million increase in interest expense, $956,000 increase in the provision for loan losses, and $3.8 million increase in noninterest expense. Year Ended December 31, 2017, Compared to Year Ended December 31, 2016. Net income for the year ended December 31, 2017, was $5.4 million, or $0.59 per diluted share, compared to $5.0 million, or $0.54 per diluted share, for the year ended December 31, 2016. Net income for 2017 included the impact of $1.3 million in additional income tax expense that resulted from the revaluation of deferred tax assets as a result of the reduction in the corporate income tax rate under the Tax Cuts and Jobs Act. Adjusted net income, which excludes the effect of the additional income tax expense, for the year ended December 31, 2017, was $6.7 million, or $0.73 per diluted share. See “Item 6 - Selected Financial Data-GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures.” The increase in net income over the prior year was attributable to a $3.3 million increase in net interest income and a $1.0 million decrease in the provision for loan losses, which were partially offset by an $823,000 decrease in noninterest income and an $895,000 increase in noninterest expense. Net Interest Income Year Ended December 31, 2018, Compared to Year Ended December 31, 2017. Net interest income for the year ended December 31, 2018, was $34.8 million compared to $29.2 million for the year ended December 31, 2017, an increase of $5.6 million, or 19.2%. The increase in net interest income consisted of a $6.6 million, or 20.6%, increase in interest income offset by a $1.0 million, or 36.6%, increase in interest expense. The growth in interest income was primarily attributable to a $86.8 million, or 14.0%, increase in average loans outstanding for the year ended December 31, 2018, compared to the prior year, combined with a 20 basis point increase in the yield on total loans. The increase in average loans outstanding was largely due to organic growth with a continued focus on actively calling on new customers and deepening relationships with existing borrowers. Also contributing to the increase in 2018 was $46.7 million in purchased loans during 2018, which included $14.1 million in purchased pools and $32.7 million in purchased participations. The hiring of additional lending teams and lenders also contributed to loan growth, as new lenders were able to transition many of their existing customers and pending transactions to the Bank. The increase in the yield on loans was largely due to higher prepayment penalties and deferred fees recognized on loans paid off. Additionally, the composition of the loan portfolio changed slightly to loans that earn higher rates and higher fees at a quicker rate, and there were increases in average loan yields overall. The increase in interest expense for the year ended December 31, 2018, was primarily related to a $46.6 million, or 10.8%, increase in average interest-bearing deposits over the prior year. The majority of this increase is attributable to growth in core deposit accounts, which we define as deposits excluding all brokered and time deposits. Noninterest bearing deposits (such as demand or checking accounts) grew $51.2 million or 21.1%, in 2018. Savings, interest bearing checking, and money market accounts grew $42.8 million, or 11.5%, in 2018, while customer time deposits grew $6.4 million, or 7.1%. We do not regularly advertise time deposit rates or money market rates, although we occasionally advertise promotional rates in targeted portions of our market area. Our branch managers, business development officers, and lenders collaborate to provide consistent and coordinated customer service and to seek deposits from new and existing customers. For the year ended December 31, 2018, net interest margin and net interest spread were 4.24% and 3.92%, respectively, compared to 4.08% and 3.83% for the year ended December 31, 2017. Year Ended December 31, 2017, Compared to Year Ended December 31, 2016. Net interest income for the year ended December 31, 2017, was $29.2 million compared to $26.0 million for the year ended December 31, 2016, an increase of $3.2 million, or 12.3%. The increase in net interest income consisted of a $3.7 million, or 12.8%, increase in interest income offset by a $352,000, or 14.0%, increase in interest expense. The growth in interest income was primarily attributable to a $84.3 million, or 15.8%, increase in average loans outstanding for the year ended December 31, 2017, compared to the prior year, partially offset by an 18 basis point decrease in the yield on total loans. The increase in average loans outstanding was primarily due to our dual strategies of focusing on deepening relationships with existing borrowers and actively calling on new customers. The hiring of additional lenders also contributed to loan growth, as new lenders were able to transition many of their existing customers and pending transactions to the Bank. The decline in the yield on total loans reflects the competitive nature of the markets in which we operate, as well as the decline in interest income on our construction, land, and land development loans, which is one of our highest yielding loan categories. In 2017, the robust real estate market in the Puget Sound region resulted in newly constructed homes selling quickly, enabling builders to repay their loans more quickly and resulting in our maintaining a lower balance of construction and development loans. The increase in interest expense for the year ended December 31, 2017, was primarily related to a $47.1 million, or 12.2%, increase in average interest-bearing deposits over the prior year. The majority of this increase is attributable to growth in core deposit accounts, which we define as deposits excluding all time deposits. Noninterest bearing deposits (such as demand or checking accounts) grew $18.4 million, or 8.2%, in 2017. Savings, interest bearing checking, and money market accounts grew $22.7 million, or 6.5%, in 2017, while customer time deposits grew $13.5 million, or 17.5%. We do not regularly advertise time deposit rates or money market rates, although we occasionally advertise promotional rates in targeted portions of our market area. Our branch managers, business development officers, and lenders collaborate to provide consistent and coordinated customer service and to seek deposits from new and existing customers. For the year ended December 31, 2017, net interest margin and net interest spread were 4.08% and 3.83%, respectively, compared to 4.13% and 3.90% for the year ended December 31, 2016. The following table presents an analysis of net interest income, net interest spread and net interest margin for the periods indicated. Loan fees included in interest income totaled $1,288,000 and $542,000 for the years ended December 31, 2018 and 2017, respectively. For the years ended December 31, 2018 and 2017, the amount of interest income not recognized on nonaccrual loans was not material. 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 allocated to volume. Provision for Loan Losses The provision for loan losses is an expense we incur to maintain an allowance for loan losses at a level that is deemed appropriate by management to absorb inherent losses on existing loans. 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.” Year Ended December 31, 2018, Compared to Year Ended December 31, 2017. The provision for loan losses for the year ended December 31, 2018, was $1.8 million, compared to $870,000 for the year ended December 31, 2017. The increase of $956,000 was primarily due to loan growth totaling $111.1 million in 2018 compared to $60.7 million in 2017. The allowance for loan losses as a percentage of loans was 1.23% at December 31, 2018, compared to 1.22% at December 31, 2017. Net charge-offs for the year ended December 31, 2018, totaled $436,000, or 0.06% of total average loans, as compared to net charge-offs of $397,000, or 0.06% of total average loans, for the year ended December 31, 2017. Net charge-offs for both years were consistent on a percentage basis and with 2018 seeing a slight increase in dollars due to higher balance loans. Year Ended December 31, 2017, Compared to Year Ended December 31, 2016. The provision for loan losses for the year ended December 31, 2017, was $870,000, compared to $1.9 million for the year ended December 31, 2016. The decrease of $1.0 million was primarily due to loan growth totaling $60.7 million in 2017 compared to $96.9 million in 2016, as well as improved credit quality. The allowance for loan losses as a percentage of loans was 1.22% at December 31, 2017, compared to 1.27% at December 31, 2016. The lower allowance that resulted from stronger credit quality reduced the amount of provision needed for 2017. Net charge-offs for the year ended December 31, 2017, totaled $397,000, or 0.06% of total average loans, as compared to net charge-offs of $364,000, or 0.07% of total average loans, for the year ended December 31, 2016. Net charge-offs for both years were consistent on a percentage basis and were only slightly higher in 2017 as a result of higher loan balances. Noninterest Income Our primary sources of recurring noninterest income are deposit account service charges and fees, wholesale banking service fees, loan referral fees, mortgage broker fees, and sublease and lease income. Noninterest income does not include 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. The following table presents, for the periods indicated, the major categories of noninterest income: Deposit Service Charges and Fees. Deposit service charges and fees include service charges on accounts, point-of-sale fees, merchant services fees and overdraft fees. Together they constitute the largest component of our noninterest income. Deposit service charges and fees were $3.1 million for the year ended December 31, 2018, an increase of $444,000, or 17.0%, over the prior year. Service charges and fees on deposit accounts were $2.6 million for the year ended December 31, 2017, an increase of $494,000, or 23.3%, over the prior year. The increases in deposit account service charges in these periods were primarily the result of a fee income initiative to adjust the pricing of fees, types of fees, and features of our deposit accounts, as well as growth in deposit balances and accounts which also lead to more transactional fees. We were able to increase these fees without losing customers. Wholesale Banking Service Fees. We provide wholesale banking services to a customer that provides financial services to its customers. In exchange for providing these services, we earn fixed fees and reimbursement of costs incurred for providing these services. In 2018 we earned $709,000 in wholesale banking service fees. This was a new service for us in 2018, therefore no income is reported for 2017 or 2016. Loan Referral Fees. We earn loan referral fees when we originate a variable rate loan and the borrower enters into an interest rate swap agreement with a third party to fix the interest rate for an extended period, usually 20 or 25 years. We recognize the loan referral fee for arranging the interest rate swap. By facilitating interest rate swaps to our clients, we are able to provide them with a long-term, fixed interest rate without the assuming the interest rate risk. Loan referral fees were $618,000 for the year ended December 31, 2018, compared to $439,000 in the prior year, an increase of $179,000 or 40.8%. Interest rate volatility, swap rates, and the timing of loan closings all impact the demand for long-term fixed rate swaps. The recognition of loan referral fees fluctuate in response to these market conditions and as a result we may not recognize any loan referral fees in some periods. Loan referral fees were $439,000 for the year ended December 31, 2017, an increase of $16,000, or 3.8%, over the year ended December 31, 2016. Mortgage Broker Fees. We earn mortgage broker fees for residential mortgage loans that we broker through mortgage lenders. Mortgage broker fees decreased $40,000 in the year ended December 31, 2018, compared to 2017 as a result of an increase in mortgage rates that resulted in less purchasing and refinancing volume. Mortgage broker fees declined $91,000 in 2017 compared to 2016 as a result of lower volume. Gain on Sale of Loans. We typically sell in the secondary market the guaranteed portion (generally 75% of the principal balance) of the SBA and United States Department of Agriculture, or USDA, loans that we originate. Gain on sale of loans increased $162,000 to $264,000 in the year ended December 31, 2018, compared to 2017 as a result of increased focus on production after restructuring our SBA loan program in 2018. Gain on sale of loans declined to $102,000 in 2017 from $790,000 in 2016 as we reduced staff and restructured our underwriting and administration of this program, while reducing our focus on originating loans for sale. In 2018, we originated $7.8 million of SBA loans compared to $4.8 million in 2017 and $7.4 million in 2016. In 2018 we originated $814,000 in USDA loans compared to zero in 2017 and 2016. Other. This category includes a variety of other income-producing activities, annuity broker fees, and SBA and USDA servicing fees. Other noninterest income was $519,000 in the year ended December 31, 2018, and 2017. Other noninterest income decreased $382,000, or 42.4%, in 2017 compared to 2016 due primarily to a one-time $325,000 break-up settlement fee that was recognized in 2016 in connection with an acquisition transaction that was terminated in 2015. Noninterest Expense Generally, noninterest expense includes 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 expense, data processing expense, director and staff expense, marketing expense, and legal and professional fees. For the year ended December 31, 2018, noninterest expense totaled $26.2 million, an increase of $3.8 million, or 16.9%, compared to $22.4 million for the year ended December 31, 2017. For the year ended December 31, 2017, noninterest expense totaled $22.4 million, an increase of $895,000, or 4.2%, compared to $21.5 million for the year ended December 31, 2016. The following table presents, for the periods indicated, the major categories of noninterest expense: Salaries and Employee Benefits. Salaries and employee benefits are the largest component of noninterest expense and include payroll expense, incentive compensation costs, benefit plans, health insurance and payroll taxes. Salaries and employee benefits were $16.0 million for the year ended December 31, 2018, an increase of $2.6 million, or 19.7%, compared to $13.4 million for 2017. The increase was primarily due to the continued organic growth initiatives, and include increases in sales staff, including hiring new banking teams, adding lenders, staff for the newly opened Edmonds location, and additional back office staffing to support the incremental increases in banking teams, wholesale banking activities and for operation as a public company. Salaries and employee benefits were $13.4 million for the year ended December 31, 2017, an increase of $1.4 million, or 11.6%, compared to $12.0 million for the year ended December 31, 2016. The increase was primarily due to an increase in staffing to support our growth objectives, including hiring additional staff for our Woodinville branch, and to enhance our compliance infrastructure. As of December 31, 2018, we had 183 full-time equivalent employees, compared to 156 at December 31, 2017, and 148 at December 31, 2016. Occupancy Expenses. Occupancy expenses were $3.3 million for the year ended December 31, 2018, compared to $3.0 million for 2017. Occupancy expenses were $3.0 million for the year ended December 31, 2017, compared to $2.7 million for the year ended December 31, 2016. This category includes building, leasehold, furniture, fixtures and equipment depreciation totaling $1.1 million, $993,000 and $895,000 for years ended December 31, 2018, 2017 and 2016, respectively. The increase of $277,000, or 9.1%, in occupancy expenses for the year ended December 31, 2018, compared to the prior year was primarily due to the recent opening of the Edmonds branch combined with a full year of occupancy expenses for the Woodinville location that was opened late in 2017. The increase of $343,000, or 12.7%, in occupancy expenses for 2017 compared to 2016 was primarily due to increased lease costs and higher building maintenance. We opened our 13th branch in Woodinville in the fall of 2017. This new branch increased our lease, depreciation, maintenance, and utility costs for 2017. Data Processing. Data processing costs were $2.0 million for the year ended December 31, 2018, compared to $1.8 million for the year ended December 31, 2017. Data processing costs were $1.8 million for the year ended December 31, 2017, compared to $2.0 million for the year ended December 31, 2016. Data processing costs include all of our customer processing, computer processing, and network costs. In 2018, we saw increases in our loan and deposit bases as well as new products and branches, all of which impact data processing expense. In 2016, we upgraded our core processing system and achieved costs savings that enabled us to grow deposits, loans, and customers while decreasing our data processing costs in 2017. We anticipate that our data processing costs will increase proportionately as we grow our customer base and deposits and loans. Other. This category includes dues and subscriptions, office supplies, mail services, telephone, examination fees, internal loan expenses, services charges from banks, operational losses, directors and officers insurance, donations, provision for unfunded commitments, and miscellaneous other expenses. Other noninterest expense increased to $2.0 million for the year ended December 31, 2018, compared to $1.8 million for the year ended December 31, 2017. The increase was primarily due to increases in office supplies, dues and subscription costs, and telephone expenses, all of which are related to increases in staffing, the addition of new banking teams and the new branch that was added in 2018. Other noninterest expense decreased to $1.8 million for the year ended December 31, 2017, compared to $2.1 million for the year ended December 31, 2016, a decrease of $328,000, or 15.3%. The decrease was primarily due to decreased loan expenses as we benefitted from stronger credit quality, lower mail service expenses, and lower directors and officers insurance expense. Income Tax Expense The amount of income tax expense we incur is impacted by the amounts of our pre-tax income, tax-exempt income and 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, deferred tax assets and liabilities are adjusted through the provision for income taxes. Valuation allowances are established when necessary to reduce our deferred tax assets to the amount expected to be realized. Year Ended December 31, 2018, Compared to Year Ended December 31, 2017. For the year ended December 31, 2018, income tax expense totaled $2.5 million, compared to $4.7 million for the year ended December 31, 2017. In 2018, the Company saw a decrease in federal income tax expense as a result of the reduced tax rate under the Tax Cuts and Jobs Act. The income tax expense for 2017 included $1.3 million in additional expense that resulted from the revaluation of our deferred tax assets as a result of the reduction in the corporate income tax rate under the Tax Cuts and Jobs Act. Excluding the effect of the charge for revaluation of our deferred tax assets, our effective tax rates for the years ended December 31, 2018 and 2017, were 20.8% and 33.3%, respectively. See “Item 6 - Selected Financial Data-GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures.”. Year Ended December 31, 2017, Compared to Year Ended December 31, 2016. For the year ended December 31, 2017, income tax expense totaled $4.7 million, compared to $2.5 million for the year ended December 31, 2016. The income tax expense for 2017 included $1.3 million in additional expense that resulted from the revaluation of our deferred tax assets as a result of the reduction in the corporate income tax rate under the Tax Cuts and Jobs Act. Excluding the effect of the charge for revaluation of our deferred tax assets, our effective tax rates for the years ended December 31, 2017 and 2016, were 33.3% and 32.9%, respectively. See “Item 6 - Selected Financial Data-GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures.”. Financial Condition Our total assets increased $146.3 million, or 18.2%, to $952.1 million as of December 31, 2018, from $805.8 million as of December 31, 2017. Our asset growth in 2018 was primarily due to $111.1 million in loan growth and a $36.0 million increase in cash and cash equivalents, offset by a decrease of $414,000 in investment securities. Our asset growth was primarily funded by $100.3 million in deposit growth during 2018, plus the $33.2 million in equity from the capital raise. Our total assets increased $65.2 million, or 8.8%, to $805.8 million as of December 31, 2017, from $740.6 million as of December 31, 2016. Our asset growth in 2017 was primarily due to $60.7 million in loan growth, which we funded primarily through growth in customer deposits. Loan Portfolio Our primary source of income is derived through interest earned on loans. A substantial portion of our loan portfolio consists of commercial and industrial loans and real estate loans secured by commercial real estate properties located in the Puget Sound region. Our loan portfolio represents the highest yielding component of our earning assets. As of December 31, 2018, loans totaled $767.9 million, an increase of $111.1 million, or 16.9%, compared to December 31, 2017. As of December 31, 2017, loans totaled $656.8 million, an increase of $60.7 million, or 10.2%, compared to $596.1 million as of December 31, 2016. These increases were primarily due to our efforts to increase income by building a diversified loan portfolio while maintaining strong credit quality. Loans as a percentage of deposits were 95.6% as of December 31, 2018, 93.4% as of December 31, 2017, and 91.9% as of December 31, 2016. We are focused on serving our communities and markets by growing loans and funding those loans with customer deposits. The following table summarizes our loan portfolio by type of loan as of the dates indicated: Commercial and Industrial Loans. Commercial and industrial loans are underwritten after evaluating and understanding the borrower’s ability to operate profitably and effectively. These loans are primarily made based on the borrower’s ability to service the debt from income. Most commercial and industrial loans are secured by the assets being financed or other business assets, such as accounts receivable or inventory, and generally include personal guarantees. Commercial and industrial loans increased $1.7 million, or 1.9%, to $90.4 million as of December 31, 2018, from $88.7 million as of December 31, 2017. The $1.7 million increase is the result of more than $31.1 million in new loans, net of $29.4 million in principal reductions and payoffs. Commercial and industrial loans increased $17.3 million, or 24.2%, to $88.7 million as of December 31, 2017, from $71.4 million as of December 31, 2016. The increase was due, in part, to our diversification strategy, which includes sourcing loans from strong markets with good returns and risk characteristics to supplement growth in our existing markets. In 2017, we purchased $9.9 million of high-quality medical equipment loans made to doctors. The loans were individually underwritten to the Bank’s standards before being funded. We may purchase additional loans of various types in the future to support the diversification of our loan portfolio and to invest excess liquidity. We may consider additional purchases of medical equipment loans after we assess the performance of our initial purchase of these loans. Construction, Land and Land Development Loans. Construction, land and land development loans are comprised of loans to fund construction, land acquisition and land development construction. The properties securing these loans are primarily located in the Puget Sound region and are comprised of both residential and commercial properties, including owner occupied properties and investor properties. Construction, land and land development loans increased $22.4 million, or 53.8%, to $64.0 million as of December 31, 2018, from $41.6 million as of December 31, 2017. The increase was primarily due to favorable economic conditions for building in our market area. Unfunded loan commitments for construction, land and land development loans increased as of December 31, 2018. We had a number of construction loans that have been approved, primarily for residential projects, where the contractor/developer had not requested the funds, resulting in our unfunded construction and development commitments to grow to $63.4 million at December 31, 2018, from $30.8 million at December 31, 2017. Construction, land and land development loans decreased $14.0 million, or 25.2%, to $41.6 million as of December 31, 2017, from $55.6 million as of December 31, 2016, as the robust real estate market in the Puget Sound region resulted in newly constructed homes selling quickly, enabling builders to repay their loans more quickly. Unfunded loan commitments for construction, land and land development loans increased to $30.8 million at December 31, 2017, from $18.9 million at December 31, 2016. Because of the strong residential real estate market in the Puget Sound region, we expect to see construction and development loans continue to pay off more quickly than we have experienced historically. Residential Real Estate Loans. We originate one-to-four family adjustable rate mortgage loans for our own loan portfolio and as a mortgage broker for mortgage lenders. Loans that we originate as a broker are not funded by us and do not appear on our balance sheet. From time to time, we purchase residential mortgages originated by other financial institutions to hold for investment with the intent to diversify our residential mortgage loan portfolio, meet certain regulatory requirements and increase our interest income. As of December 31, 2018, purchased residential real estate loans totaled $38.8 million. We also make one-to-four family loans to investors to finance their rental properties and to business owners to secure their business loans. As of December 31, 2018, residential real estate loans made to investors and business owners totaled $34.1 million. In addition, we originate home equity lines of credit and home equity term loans for our portfolio. Our residential loans increased $7.7 million, or 8.9%, to $94.7 million as of December 31, 2018, from $87.0 million as of December 31, 2017. Our residential loans increased $9.6 million, or 12.4%, to $87.0 million as of December 31, 2017, from $77.4 million as of December 31, 2016. The increases were primarily a result of our diversification strategy to supplement existing loan growth with purchased loans individually underwritten to our credit standards. Most of the one-to-four family loans that we purchase are from other lenders in the Puget Sound region or in California. Commercial Real Estate Loans. We make commercial mortgage loans collateralized by owner-occupied and non-owner-occupied real estate, as well as multi-family residential loans. The real estate securing our existing commercial real estate loans includes a wide variety of property types, such as manufacturing and processing facilities, business parks, warehouses, retail centers, convenience stores and gas stations, hotels and motels, office buildings, mixed-use residential and commercial, and other properties. Commercial real estate loans represented 67.1% of our loan portfolio at December 31, 2018, and are our largest source of revenue. Commercial real estate loans increased $78.3 million, or 17.9%, to $516.0 million as of December 31, 2018, from $437.7 million as of December 31, 2017. Commercial real estate loans increased $46.7 million, or 11.9%, to $437.7 million as of December 31, 2017, from $391.0 million as of December 31, 2016. These increases, which occurred across the various segments of our portfolio, were due to our commitment to grow this portfolio in the Puget Sound region. We actively seek commercial real estate loans in our markets and our lenders are experienced in competing for these loans. Consumer and Other Loans. Our consumer and other loans are comprised of personal lines of credit, automobile, boat, and recreational vehicle loans, and secured term loans. Consumer and other loans increased $1.5 million, or 71.4%, to $3.6 million as of December 31, 2018, from $2.1 million as of December 31, 2017. Consumer and other loans increased $782,000, or 61.3%, to $2.1 million as of December 31, 2017, from $1.3 million as of December 31, 2016. The increases in these loans were primarily a result of strong consumer confidence and economic strength in the Puget Sound region. The contractual maturity ranges of loans in our loan portfolio and the amount of such loans with fixed and floating interest rates in each maturity range as of date indicated are summarized in the following tables: The following table sets forth all loans at December 31, 2018, that are due after December 31, 2019, and have either fixed interest rates or floating or adjustable 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 applicable regulations. 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 loans are placed on nonaccrual status, all unpaid accrued interest is reversed from income and all interest accruals are stopped. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal balance. Loans are returned to accrual status if we believe that all remaining principal and interest is fully collectible and there has been at least six months of sustained repayment performance since the loan was placed on nonaccrual status. We believe our conservative lending practices and active approach to managing 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 credit quality of our loan portfolio. We have established underwriting guidelines, and we also monitor our delinquency levels for any negative or adverse trends. We actively manage problem assets to reduce our risk for loss. We had $1.8 million in nonperforming assets, including performing troubled debt restructurings, or TDRs, as of December 31, 2018, compared to $2.1 million as of December 31, 2017, of which there were $1.8 million in nonperforming loans as of December 31, 2018, compared to $2.1 million as of December 31, 2017. The decrease in nonperforming assets was the result of two of our nonperforming loans paying off. We had $2.1 million in nonperforming assets, including performing TDRs, as of December 31, 2017, compared to $8.2 million as of December 31, 2016, and we had $2.1 million in nonperforming loans as of December 31, 2017, compared to $1.6 million as of December 31, 2016. The decrease in nonperforming assets was the result of the sale of our remaining real estate owned property and the payoff of a TDR in 2017. The following table presents information regarding nonperforming assets at the dates indicated: Potential Problem Loans From a credit risk standpoint, we classify loans in one of five categories: pass, other loans especially mentioned, substandard, doubtful or loss. Within the pass category, we classify loans into one of the following five subcategories based on perceived credit risk, including repayment capacity and collateral security: minimal risk; low risk; modest risk; average risk; and acceptable risk. The classifications of loans reflect a judgment about the risks of default and loss given default. We review the risk ratings of our credits on an annual basis, or more frequently if circumstances warrant. Risk ratings are adjusted to reflect the degree of risk and loss that is believed to be inherent in each credit as of each monthly reporting period. 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). Credits rated as other loans especially mentioned show clear signs of financial weaknesses or deterioration in creditworthiness; however, such concerns are not so pronounced that we generally expect to experience significant loss within the short-term. Such credits typically maintain the ability to perform within standard credit terms and credit exposure is not as prominent as credits with a lower rating. Credits rated as substandard are those in which the normal repayment of principal and interest may be, or has been, jeopardized by reason of adverse trends or developments of a financial, managerial, economic or political nature, or important weaknesses in the collateral for the loan. A protracted workout on these credits is a distinct possibility. Prompt corrective action is therefore required to reduce exposure and to assure that adequate remedial measures are taken by the borrower. Credit exposure becomes more likely in such credits and a serious evaluation of the secondary support to the credit is performed. Credits rated as doubtful have weaknesses of substandard assets that are sufficient to make collection or liquidation in full questionable and there is a high probability of loss based on currently existing facts, conditions and values. Credits rated as loss are charged-off. We have no expectation of the recovery of any payments in respect of credits rated as loss. The following table summarizes the internal ratings of our loans as of the dates indicated: 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. 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, and current economic factors. See “-Critical Accounting Policies-Allowance for Loan Losses.” In connection with the review of our loan portfolio, we consider risk elements applicable to particular loan types or categories in assessing the quality of individual loans. Some of the risk elements we consider include: • for commercial and industrial loans, the debt service coverage ratio (income from the business in excess of operating expenses compared to loan repayment requirements), the operating results of the commercial, professional or agricultural enterprise, the borrower’s business, professional and financial ability and expertise, the specific risks and volatility of income and operating results typical for businesses in that category and the value, nature and marketability of collateral; • for commercial real estate loans, the debt service coverage ratio, operating results of the owner in the case of owner-occupied properties, the loan-to-value ratio, the age and condition of the collateral and the volatility of income, property value and future operating results typical of properties of that type; • for residential mortgage loans, the borrower’s ability to repay the loan, including a consideration of the debt-to-income ratio and employment and income stability, the loan-to-value ratio, and the age, condition and marketability of the collateral; and • for construction, land and land development loans, the perceived feasibility of the project including the ability to sell developed lots or improvements constructed for resale or the ability to lease property constructed for lease, the quality and nature of contracts for presale or prelease, if any, experience and ability of the developer and loan-to-value ratio. As of December 31, 2018, the allowance for loan losses totaled $9.4 million, or 1.23% of total loans. Our allowance for loan losses as of December 31, 2018, increased by $1.4 million, or 17.5%, compared to December 31, 2017, primarily due to growth in our loan portfolio, both organic and through purchased loans. As of December 31, 2017, the allowance for loan losses totaled $8.0 million, or 1.22% of total loans. Our allowance for loan losses as of December 31, 2017, increased by $473,000, or 6.3%, compared to December 31, 2016, primarily due to the organic growth of our loan portfolio. As of December 31, 2016 the allowance for loan losses totaled $7.5 million, or 1.25% of total loans. The following tables present, as of and for the periods indicated, an analysis of the allowance for loan losses and other related data: 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. If the Puget Sound region experiences an economic downturn, our asset quality could deteriorate or if we are successful in continuing to grow our loan portfolio, our allowance may become inadequate and material additional provisions for loan losses could be necessary. 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 allocation of the allowance for loan losses as shown in the table should neither be interpreted as an indication of future charge-offs, nor as an indication that charge-offs in future periods will necessarily occur in these amounts or in the indicated proportions. The total allowance is available to absorb losses from any loan category. Securities We use our securities portfolio primarily as a source of liquidity and collateral that can be readily sold or pledge for public deposits or other business purposes. At December 31, 2018, 87.8% of our investment portfolio consisted of U.S. Treasury securities. The remainder of our securities portfolio was invested in U.S. Government agency securities, agency collateralized mortgage obligations and mortgage-backed securities, and municipal bonds. Because we target a loan-to-deposit ratio in the range of 90% to 100%, we prioritize liquidity over the earnings of our securities portfolio. At December 31, 2018, our loan-to-deposit ratio was 95.6% and our securities portfolio represented less than 5% of assets. To the extent our securities represent more than 5% of assets, absent an immediate need for liquidity, we anticipate investing excess funds to provide a higher return. As of December 31, 2018, the carrying amount of our investment securities totaled $37.9 million, a decrease of $414,000, or 1.1%, compared to $38.3 million as of December 31, 2017. The decrease in the securities portfolio was primarily the result of the decline in fair value and pay-downs on mortgage-backed securities. As of December 31, 2017, the carrying amount of our investment securities totaled $38.3 million, an increase of $3.3 million, or 9.4%, compared to $35.0 million as of December 31, 2016. The increase in the securities portfolio was due primarily to the investment of excess cash and cash equivalent balances. Investment securities represented 4.0% and 4.8%, and 4.8% of total assets as of December 31, 2018, 2017 and 2016, respectively. Our investment portfolio consists of securities classified as available for sale and, to a lesser amount, held to maturity. The carrying values of our investment securities classified as available for sale are adjusted for unrealized gain or loss, and any gain or loss is reported on an after-tax basis as a component of other comprehensive income in shareholders’ equity. The following table summarizes the amortized cost and estimated fair value of our investment securities as of the dates shown: All of our mortgage-backed securities and collateralized mortgage obligations are U.S. Government agency securities. As of December 31, 2018, we did not hold any Fannie Mae or Freddie Mac preferred stock, corporate equity, collateralized debt obligations, collateralized loan obligations, structured investment vehicles, private label collateralized mortgage obligations, subprime, Alt-A or second lien elements in our investment portfolio. Our management evaluates securities for other-than-temporary impairment on at least a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. As of December 31, 2018, and December 31, 2017 and 2016, we did not own securities of any one issuer, other than the U.S. Government and its agencies, for which aggregate adjusted cost exceeded 10.0% of consolidated shareholders’ equity. The following table sets forth the amortized cost of held to maturity securities and the fair value of available for sale securities, maturities and approximated weighted average yield based on estimated annual income divided by the average amortized cost of our securities portfolio as of the dates indicated. The contractual maturity of a mortgage-backed security is the date at which the last underlying mortgage matures. Deposits We offer a variety of deposit products that have a wide range of interest rates and terms, including demand, savings, money market and time accounts. We rely primarily on competitive pricing policies, convenient locations, electronic delivery channels, and personalized service to attract and retain these deposits. Total deposits as of December 31, 2018, were $803.6 million, an increase of $100.3 million, or 14.3%, compared to $703.3 million as of December 31, 2017. Total deposits as of December 31, 2017, were $703.3 million, an increase of $54.6 million, or 8.4%, compared to $648.7 million as of December 31, 2016. The increases were primarily related to our successful execution of our strategy of deepening relationships with existing customers and actively seeking new customers. Noninterest-bearing deposits as of December 31, 2018, were $293.5 million, an increase of $51.2 million, or 21.1%, compared to $242.4 million as of December 31, 2017. Noninterest-bearing deposits as of December 31, 2017, were $242.4 million, an increase of $18.4 million, or 8.2%, compared to $224.0 million as of December 31, 2016. The increases were due to the collaboration of our branch managers, business development officers and lenders to grow core deposits. As a team, we actively pursue the business of new customers. Total interest-bearing account balances, excluding time deposits, as of December 31, 2018, were $413.0 million, an increase of $42.7 million, or 11.5% from $370.3 million as of December 31, 2017. Total interest-bearing account balances as of December 31, 2017, were $370.3 million, an increase of $22.7 million, or 6.5% from $347.6 million as of December 31, 2016. The increases were due to our team focusing on growing core deposits. Included in interest bearing account balances is $10.5 million in brokered demand deposits from a wholesale banking services customer as an accommodation to them. We generally do not use brokered deposits to fund loan growth and we did not use these brokered deposits to fund loan growth. The balance at December 31, 2017 and 2016 was zero. Total time deposit balances as of December 31, 2018, were $97.0 million, an increase of $6.4 million, or 7.1%, from $90.6 million as of December 31, 2017. The increase in total time deposits during the period was primarily a result of our growth initiatives. Total time deposit balances as of December 31, 2017, were $90.6 million, an increase of $13.5 million, or 17.5%, from $77.1 million as of December 31, 2016. The following table sets forth deposit balances at the dates indicated. The following table sets forth the Company’s time deposits of $100,000 or more by time remaining until maturity as of the dates indicated: Average deposits for the year ended December 31, 2018, were $745.5 million, an increase of $80.8 million, or 12.2%, compared to the year ended December 31, 2017. Average deposits for the year ended December 31, 2017, were $664.7 million, an increase of $82.4 million, or 14.2%, compared to the year ended December 31, 2016. The increases in average deposits were primarily due to our continued growth in our primary market areas and the increase in commercial lending relationships for which we also seek deposit balances and the results of business development efforts by our business development officers, branch managers and lenders. The average rate paid on total interest-bearing deposits was 0.66% for the year ended December 31, 2018, compared to 0.50% for the year ended December 31, 2017. The average rate paid on total interest-bearing deposits was 0.50% for the year ended December 31, 2017, compared to 0.55% for the year ended December 31, 2016. The following table presents the average balances and average rates paid on deposits for the periods indicated: The ratio of average noninterest-bearing deposits to average total deposits for the years ended December 31, 2018, 2017 and 2016, was 35.8%, 35.1% and 34.0%, respectively. Factors affecting the cost of funding interest-bearing assets include the volume of noninterest- and interest-bearing deposits, changes in market interest rates and economic conditions in the Puget Sound region and their impact on interest paid on deposits, as well as the ongoing execution of our growth strategies. Cost of total interest-bearing liabilities is calculated as total interest expense divided by average total interest-bearing deposits plus average total borrowings. Our cost of total interest-bearing liabilities was 0.80%, 0.64% and 0.63% for the years ended December 31, 2018, 2017 and 2016, respectively. The increase in our cost of deposits in 2018 was primarily due to higher deposit rates throughout the market resulting from rate increases from the Federal Reserve. We actively manage our interest rates on deposits, however additional increases from the Federal Reserve will impact our deposit costs. The decrease in our cost of deposits in 2017 was primarily due to pricing tactics used in 2016 to lower our deposit costs prior to interest rates increasing. Our last rate reduction was in December 2016. In 2017, we limited our deposit rates increases and received almost a full year savings on the rate reductions we deployed in 2016. Borrowings We have the ability to utilize short-term to long-term borrowings to supplement deposits to fund our lending and investment activities, each of which is discussed below. Federal Home Loan Bank (FHLB) Advances. The FHLB allows us to borrow against our line of credit, which is collateralized by certain loans. As of December 31, 2018, 2017 and 2016, total borrowing capacity of $79.3 million, $59.3 million and $60.2 million, respectively, was available under this arrangement. As of December 31, 2018 and, 2017, FHLB advances totaled $20.0 million, compared to $15.0 million at December 31, 2016. Junior Subordinated Debentures. In 2004, we issued $3.6 million in junior subordinated debentures to Coastal (WA) Statutory Trust I, or the Trust, of which we own all of the outstanding common securities. The Trust used the proceeds from the issuance of its underlying common securities and preferred securities to purchase the debentures issued by the Company. These debentures are the Trust’s only assets and the interest payments from the debentures finance the distributions paid on the preferred securities. The debentures bear interest at a rate per annum equal to the 3-month LIBOR plus 2.10%. The effective rate as of December 31, 2018, 2017 and 2016, was 4.88%, 3.69% and 3.06%, respectively. We generally have the right to defer payment of interest on the debentures at any time or from time to time for a period not exceeding five years provided that no extension period may extend beyond the stated maturity of the debentures. During any such extension period, distributions on the trust’s preferred securities will also be deferred, and our ability to pay dividends on our common stock will be restricted. The Trust’s preferred securities are mandatorily redeemable upon maturity of the debentures, or upon earlier redemption as provided in the indenture. If the debentures are redeemed prior to maturity, the redemption price will be the principal amount and any accrued but unpaid interest. We unconditionally guarantee payment of accrued and unpaid distributions required to be paid on the Trust Securities subject to certain exceptions, the redemption price with respect to any Trust securities called for redemption and amounts due if the Trust is liquidated or terminated. Subordinated Debt. In 2016, the Company issued a subordinated note to a commercial bank in the amount of $10.0 million. The note matures on August 1, 2026, and bears interest at the rate of 5.65% per year for five years and, thereafter, at a rate equal to The Wall Street Journal prime rate plus 2.50%. Principal payments of $500,000 per quarter commence November 1, 2021. We may redeem the subordinated note, in whole or in part, without premium or penalty after July 29, 2021, subject to any required regulatory approvals. Liquidity and Capital Resources Liquidity Management Liquidity refers to our capacity to meet our cash obligations at a reasonable cost. Our cash obligations require us to have cash flow that is adequate to fund loan growth and maintain on-balance sheet liquidity while meeting present and future obligations of deposit withdrawals, borrowing maturities and other contractual cash obligations. In managing our cash flows, management regularly confronts situations that can give rise to increased liquidity risk. These include funding mismatches, market constraints in accessing sources of funds and the ability to convert assets into cash. Changes in economic conditions or exposure to credit, market, and operational, legal and reputational risks also could affect the Bank’s liquidity risk profile and are considered in the assessment of liquidity management. We continually monitor our liquidity position to ensure that our assets and liabilities are managed in a manner to meet all reasonably foreseeable short-term, long-term and strategic liquidity demands. Management has established a comprehensive 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 that are commensurate with the complexity of our business activities; 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; contingency funding policies and 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 Bank’s liquidity risk management process. Our liquidity position is supported by management of our liquid assets and liabilities and access to alternative sources of funds. Our liquidity requirements are met primarily through our deposits, FHLB advances and the principal and interest payments we receive on loans and investment securities. Cash on hand, cash at third-party banks, investments available-for-sale and maturing or prepaying balances in our investment and loan portfolios are our most liquid assets. Other sources of liquidity that are routinely available to us include funds from retail, commercial, and wholesale deposits, advances from the FHLB and proceeds from the sale of loans. Less commonly used sources of funding include borrowings from the Federal Reserve discount window, draws on established federal funds lines from unaffiliated commercial banks and the issuance of debt or equity securities. We believe we have ample liquidity resources to fund future growth and meet other cash needs as necessary. The Company is a corporation separate and apart from our Bank and, therefore, must provide for its own liquidity, including liquidity required to meet its debt service requirements on its subordinated note and junior subordinated debentures. The Company’s main source of cash flow has been through equity and debt offerings. The Company has consistently retained a portion of the funds from equity and debt offerings so that is has sufficient funds for its operating and debt costs for the next two or three years. In addition, the Bank can declare and pay dividends to the Company to meet the Company’s debt and operating expenses. There are statutory and regulatory limitations that affect the ability of the Bank to pay dividends to the Company. We believe that these limitations will not impact the ability of the Bank to pay dividends to the Company to meet ongoing operating needs. For contingency purposes, the Company maintains a minimum level of cash to fund one year’s projected operating cash flow needs and the Bank manages to a minimum liquidity ratio of 10% of assets. Both of these minimum liquidity levels are on-balance sheet sources. Per policy and the Bank’s liquidity contingency plan, in event of a liquidity emergency the Bank can utilize wholesale funds in an amount up to 30% of assets. Since the Bank uses only a small portion of its borrowing capacity, the Bank has access to funds if needed in a liquidity emergency. Capital Adequacy Capital management consists of providing equity and other instruments that qualify as regulatory capital to support current and future operations. Banking regulators view capital levels as important indicators of an institution’s financial soundness. As a general matter, FDIC-insured depository institutions and their holding companies are required to maintain minimum capital levels relative to the amount and types of assets they hold. We are subject to regulatory capital requirements at the bank level. The Company will become subject to regulatory capital requirements once its consolidated assets exceed a certain threshold. That threshold is currently $3.0 billion, but the EGRRCPA requires the Federal Reserve to lift the threshold to $3.0 billion by November 21, 2018. See “Item 1: Business-Supervision and Regulation-Bank Regulation and Supervision-Capital Adequacy” for additional discussion regarding the regulatory capital requirements applicable to the Bank. As of each of December 31, 2018 and 2017, the Bank was in compliance with all applicable regulatory capital requirements, and the Bank was classified as “well capitalized” for purposes of the Federal Reserve’s 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 expect 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 Company and the Bank’s regulatory capital ratios as of the dates presented, as well as the regulatory capital ratios that are required by Federal Reserve regulations to maintain “well-capitalized” status: Contractual Obligations The following table summarizes contractual obligations and other commitments to make future payments (other than non-time deposit obligations), which consist of future cash payments associated with our contractual obligations, as of December 31, 2018. For a discussion of our borrowings, see “-Financial Condition-Borrowings.” We believe that will we be able to meet our contractual obligations as they come due. Adequate cash levels are expected through profitability, repayments from loans and securities, deposit gathering activity, access to borrowing sources and periodic loan sales. Off-Balance Sheet Items In the normal course of business, we enter into various transactions, which, 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 standby and commercial 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 commitments associated with outstanding commitments to extend credit and standby and commercial letters of credit are summarized below. Since commitments associated with commitments to extend credit and letters of credit may expire unused, the amounts shown do not necessarily reflect the actual future cash funding requirements. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have 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 upon, 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. Standby and commercial 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, we have rights to the underlying collateral, which can include commercial real estate, physical plant and property, inventory, receivables, cash and/or marketable securities. Our credit risk associated with issuing letters of credit is essentially the same as the risk involved in extending loan facilities to our customers. Quantitative and Qualitative Disclosures about Market Risk As a financial institution, our primary component of market risk is interest rate volatility. Our asset liability and funds management policy provides management with the guidelines for effective funds management, and we have established a measurement system for monitoring our net interest rate sensitivity position. We have historically managed our sensitivity position within our established guidelines. Fluctuations in interest rates will ultimately impact both the level of income and expense recorded on most of our assets and liabilities, and the market value of all interest-earning assets and interest-bearing liabilities, other than those which have a short term to maturity. Interest rate risk is the potential for economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a decrease in current fair market values. Our objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximizing income. We manage our exposure to interest rates by structuring our balance sheet in the ordinary course of business. We do not enter into instruments such as leveraged derivatives, financial options, financial future contracts or forward delivery contracts for the purpose of reducing interest rate risk. Based upon the nature of our operations, we are not subject to foreign exchange or commodity price risk. We do not own any trading assets. Our exposure to interest rate risk is managed by the Asset Liability Committee, or ALCO, of the Bank and reviewed by the Asset Liability and Investment Committee of our board of directors in accordance with policies approved by our board of directors. ALCO formulates strategies based on appropriate levels of interest rate risk. In determining the appropriate level of interest rate risk, ALCO considers the impact on earnings and capital on the current outlook on interest rates, potential changes in interest rates, regional economies, liquidity, business strategies and other factors. ALCO meets regularly to review, among other things, the sensitivity of assets and liabilities to interest rate changes, the book and market values of assets and liabilities, unrealized gains and losses, purchase and sale activities, commitments to originate loans and the maturities of investments and borrowings. Additionally, ALCO reviews liquidity, cash flows, maturities of deposits and consumer and commercial deposit activity. Management employs various methodologies to manage interest rate risk including an analysis of relationships between interest-earning assets and interest-bearing liabilities and interest rate simulations using a model. The Asset Liability and Investment Committee of our board of directors meets quarterly to review the Bank’s interest rate risk profile, liquidity position, including contingent liquidity, and investment portfolio. We use interest rate risk simulation models to test interest rate sensitivity of net interest income and fair value of equity, and the impact of changes in interest rates on other financial metrics. Contractual maturities and re-pricing opportunities of loans are incorporated in the model, as are prepayment assumptions, maturity data and call options within the investment portfolio. Average life of non-maturity deposit accounts are based on historical decay rates and assumptions and are incorporated into the model. The assumptions used are inherently uncertain and, as a result, the model cannot precisely measure future net interest income or precisely predict the impact of fluctuations in market interest rates on net interest income. Actual results will differ from the model’s simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and the application and timing of various management strategies. On a quarterly basis, we run multiple simulations under two different premises of which one is a static balance sheet and the other is a dynamic growth balance sheet. The static balance sheet approach produces results that show the interest risk currently inherent in our balance sheet at that point in time. The dynamic balance sheet includes our projected growth levels going forward and produces results that shows how net income, net interest income, and interest risk change based on our projected growth. These simulations test the impact on net interest income and fair value of equity from changes in market interest rates under various scenarios. Under the static and dynamic approaches, rates are shocked instantaneously and ramped over a 12-month horizon assuming parallel yield curve shifts. Parallel shock scenarios assume instantaneous parallel movements in the yield curve compared to a flat yield curve scenario. Non-parallel simulations are also conducted and involve analysis of interest income and expense under various changes in the shape of the yield curve including a forward curve, flat curve, steepening curve, and an inverted curve. Our internal policy regarding internal rate risk simulations currently specifies that for instantaneous parallel shifts of the yield curve, estimated net income at risk for the subsequent one- and two-year period should not decline by more than 10% for a 100 basis point shift, 15% for a 200 basis point shift, 20% for a 300 basis point shift, and 25% for a 400 basis point shift. The following tables summarize the simulated change in net interest income over a 12-month horizon as of the dates indicated: The results illustrate that the Bank is asset sensitive and generally performs better in an increasing interest rate environment. The results are primarily due to behavior of demand, money market and savings deposits during such rate fluctuations. We have found that, historically, interest rates on these deposits change more slowly than changes in the discount and federal funds rates. This assumption is incorporated into the simulation model. The assumptions incorporated into the model are inherently uncertain and, as a result, the model cannot precisely measure future net interest income or precisely predict the impact of fluctuations in market interest rates on net interest income. Actual results will differ from the model’s simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and the application and timing of various strategies. Impact of Inflation Our consolidated financial statements and related notes to those financial statements 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. Critical Accounting Policies Our accounting policies are integral to understanding our results of operations. Our accounting policies are described in greater detail in Note 1 to our consolidated financial statements included elsewhere is this report. We believe that of our accounting policies, the following may involve a higher degree of judgment and complexity: Securities Securities are classified as available for sale when they might be sold before maturity. Securities available for sale are carried at fair value. Unrealized gains and losses are excluded from earnings and reported in other comprehensive income. Securities within the available for sale portfolio may be used as part of our asset/liability strategy and may be sold in response to changes in interest rate risk, prepayment risk or other similar economic factors. Securities held to maturity are carried at cost, adjusted for the amortization of premiums and the accretion of discounts. Interest earned on these assets is included in interest income. Interest income includes amortization of purchase premium or discount. Premiums and discounts on securities are amortized using the level-yield method, except for mortgage backed securities where prepayments are anticipated. Gains and losses on sales are recorded on the trade date and determined using the specific identification method. Management evaluates debt securities for other-than-temporary impairment, or OTTI, on at least a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. For securities in an unrealized loss position, management considers the extent and duration of the unrealized loss, and the financial condition and near-term prospects of the issuer. Management also assesses whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings. For debt securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: (1) OTTI related to credit loss, which must be recognized in the income statement, and (2) OTTI related to other factors, which is recognized in other comprehensive income, net of applicable taxes. The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis. The previous amortized cost basis less the OTTI recognized in earnings becomes the new amortized cost basis of the security. Loans Held for Investment Loans held for investment are those that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of deferred loan fees and costs, and an allowance for loan losses. Loans are typically secured by specific items of collateral including business assets, consumer assets, and commercial and residential real estate. Commercial loans are expected to be repaid from cash flow from operations of businesses. Interest income is accrued on the unpaid principal balance. Loan origination fees and certain direct origination costs are deferred and recognized as adjustments to interest income using a level yield methodology and a method approximating the level yield methodology. Allowance for Loan Losses The allowance for loan losses represents management’s estimate of probable and reasonably estimable credit losses inherent in the loan portfolio. In determining the allowance, the Company estimates losses on individual impaired loans, or groups of loans which are not impaired, where the probable loss can be identified and reasonably estimated. On a quarterly basis, the Company assesses the risk inherent in the Company’s loan portfolio based on qualitative and quantitative trends in the portfolio, including the internal risk classification of loans, historical loss rates, changes in the nature and volume of the loan portfolio, industry or borrower concentrations, delinquency trends, detailed reviews of significant loans with identified weaknesses and the impacts of local, regional and national economic factors on the quality of the loan portfolio. Based on this analysis, the Company records a provision for loan losses to maintain the allowance at appropriate levels. Determining the amount of the allowance is considered a critical accounting estimate, as it requires significant judgment and the use of subjective measurements, including management’s assessment of overall portfolio quality. The Company maintains the allowance at an amount the Company believes is sufficient to provide for estimated losses inherent in the Company’s loan portfolio at each balance sheet date, and fluctuations in the provision for loan losses may result from management’s assessment of the adequacy of the allowance. Changes in these estimates and assumptions are possible and may have a material impact on the Company’s allowance, and therefore the Company’s financial position, liquidity or results of operations. Transfers of Financial Assets Management accounts for the transfers of financial assets as sales when control over the assets has been surrendered. Control is surrendered when the assets have been isolated, a transferee obtains the right to pledge or exchange the transferred assets and there is no agreement to repurchase the assets before their maturity. Management believes the loan participations sold subject to this guidance met the condition to be treated as a sale. Stock-based Compensation We grant stock options and restricted stock to our employees and directors. We record the related compensation expense based on the grant date fair value calculated in accordance with the authoritative guidance issued by FASB. We recognize these compensation costs on a straight-line basis over the requisite service period of the award. We estimate the grant date fair value of stock options using the Black-Scholes valuation model. Stock-based compensation expense related to awards of restricted stock is based on the fair value at the grant date. The determination of fair value using the Black-Scholes model is affected by the price of our common stock, as well as the input of other subjective assumptions. These assumptions include, but are not limited to, the expected term of stock options and our stock price volatility. As there has been no public market for our common stock prior to July 20, 2018, 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, based on our board of directors’ assessment of objective and subjective factors that it believed were relevant. The factors considered by our board of directors included the prices of known transactions in our common stock, the book value per share of our common stock, and our board of directors’ understanding of pricing multiples for comparable financial institutions that were not publicly traded. The assumptions underlying these valuations represented management’s best estimate, which involved inherent uncertainties and the application of management’s judgment. As a result, if we had used different assumptions or estimates, the fair value of our common stock and our stock-based compensation expense could have been materially different. Emerging Growth Company The JOBS Act permits an “emerging growth company” to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies. However, we have decided not to take advantage of this provision. As a result, we will comply with new or revised accounting standards to the same extent that compliance is required for non-emerging growth companies. Our decision to opt out of the extended transition period under the JOBS Act is irrevocable. Recently Issued Accounting Pronouncements For a discussion of the expected impact of accounting pronouncements recently issued but not adopted by us as of December 31, 2018, see Note 2 of our audited consolidated financial statements included elsewhere in this report.
0.05675
0.057077
0
<s>[INST] We are a bank holding company that operates through our wholly owned subsidiary, Coastal Community Bank. We are headquartered in Everett, Washington, which by population is the largest city in, and the county seat of, Snohomish County. We focus on providing a wide range of banking products and services to consumers and small to medium sized businesses in the broader Puget Sound region in the state of Washington. We currently operate 14 fullservice banking locations, 11 of which are located in Snohomish County, where we are the largest community bank by deposit market share, and three of which are located in neighboring counties (one in King County and two in Island County). As of December 31, 2018, we had total assets of $952.1 million, total gross loans of $767.9 million, total deposits of $803.6 million and total shareholders’ equity of $109.2 million. The following discussion and analysis presents our financial condition and results of operations on a consolidated basis. However, because we conduct all of our material business operations through Coastal Community Bank, the discussion and analysis relate to activities primarily conducted by the Bank. As a bank holding company that operates through one segment, community banking, we generate most of our revenue from interest on loans and investments. Our primary source of funding for our loans is commercial and retail deposits. We place secondary reliance on wholesale funding, primarily borrowings from the Federal Home Loan Bank, or FHLB. Our largest expenses are salaries and related employee benefits, occupancy, interest on deposits and borrowings, data processing, and provision for loan losses. Our principal lending products are commercial real estate loans, commercial and industrial loans, and to a lesser extent residential real estate loans and consumer loans. Key Factors Affecting our Business Average Balances and Interest Rates Our operating results depend primarily on our net interest income, which is the largest contributor to our net income and is the difference between the interest and fees earned on interestearning assets (such as loans and securities) and the interest expense incurred in connection with interestbearing liabilities (such as deposits and borrowings). Net interest income is primarily a function of the average balances of interestearning assets and interestbearing liabilities and the yields and costs with respect to these assets and liabilities. Average balances are influenced by internal considerations such as the types of products we offer and the amount of risk that we are willing to assume as well as external influences such as economic conditions, competition for loans and deposits, and interest rates. The yields generated by our loans and securities are typically affected by shortterm and longterm interest rates and, in the case of loans, competition for similar products in our market area. Interest rates are often impacted by the actions of the Federal Reserve. The cost of our deposits and shortterm borrowings is primarily based on shortterm interest rates, which are largely driven by competition and by the actions of the Federal Reserve. The level of net interest income is influenced by movements in interest rates and the pace at which such movements occur, as well as the relationship between short and longterm interest rates. Credit Quality We have well established loan policies and underwriting practices that have resulted in low levels of chargeoffs and nonperforming assets. Through our thorough underwriting process, we strive to originate quality loans that will maintain and enhance the overall credit quality of our loan portfolio, and through our careful monitoring of our loan portfolio and prompt attention to delinquencies, we seek to minimize the impact of problem loans. However, credit trends in the markets in which we operate are largely impacted by economic conditions beyond our control and can adversely impact our financial condition. Operating Efficiency Our largest noninterest expense is salaries and employee benefits, which consist primarily of salaries and wages paid to our employees, payroll taxes, and expenses for health insurance, retirement plans and other employee benefits. Other significant operating expenses include occupancy expense, data processing expense, director and staff expense, marketing expense, and legal and professional fees. Our operating efficiency, as measured by our efficiency ratio, has gradually improved primarily because the growth of our deposits and loans has enabled our net interest income and noninterest income to outpace our expenses. When we open new branches or make substantial investments to increase our operating capacity, our operating efficiency decreases until we [/INST] Positive. </s>
2,019
12,997
1,437,958
COASTAL FINANCIAL CORP
2020-03-12
2019-12-31
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Overview We are a bank holding company that operates through our wholly owned subsidiary, Coastal Community Bank, or the Bank. We are headquartered in Everett, Washington, which by population is the largest city in, and the county seat of, Snohomish County. We focus on providing a wide range of banking products and services to consumers and small to medium sized businesses in the broader Puget Sound region in the state of Washington. We currently operate 14 full-service banking locations, 11 of which are located in Snohomish County, where we are the largest community bank by deposit market share, and three of which are located in neighboring counties (one in King County and two in Island County). As of December 31, 2019, we had total assets of $1.129 billion, total gross loans of $939.1 million, total deposits of $968.0 million and total shareholders’ equity of $124.2 million. The following discussion and analysis presents our financial condition and results of operations on a consolidated basis. However, because we conduct all of our material business operations through the Bank, the discussion and analysis relate to activities primarily conducted by the Bank. As a bank holding company that operates through one segment, community banking, we generate most of our revenue from interest on loans and investments. Our primary source of funding for our loans is commercial and retail deposits. We place secondary reliance on wholesale funding, primarily borrowings from the Federal Home Loan Bank (FHLB). Our largest expenses are salaries and related employee benefits, occupancy, interest on deposits and borrowings, data processing, and provision for loan losses. Our principal lending products are commercial real estate loans, commercial and industrial loans, residential real estate loans, construction, land and land development loans, and to a lesser extent consumer loans. Key Factors Affecting our Business Average Balances and Interest Rates Our operating results depend primarily on our net interest income, which is the largest contributor to our net income and 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). Net interest income is primarily a function of the average balances of interest-earning assets and interest-bearing liabilities and the yields and costs with respect to these assets and liabilities. Average balances are influenced by internal considerations such as the types of products we offer and the amount of risk that we are willing to assume as well as external influences such as economic conditions, competition for loans and deposits, and interest rates. The yields generated by our loans and securities are typically affected by short-term and long-term interest rates and, in the case of loans, competition for similar products in our market area. Interest rates are often impacted by the actions of the Federal Reserve. The cost of our deposits and short-term borrowings is primarily based on short-term interest rates, which are largely driven by competition and by the actions of the Federal Reserve. The level of net interest income is influenced by movements in interest rates and the pace at which such movements occur, as well as the relationship between short- and long-term interest rates. Credit Quality We have well established loan policies and underwriting practices that have resulted in low levels of charge-offs and nonperforming assets. Through our thorough underwriting process, we strive to originate quality loans that will maintain and enhance the overall credit quality of our loan portfolio, and through our careful monitoring of our loan portfolio and prompt attention to delinquencies, we seek to minimize the impact of problem loans. However, credit trends in the markets in which we operate are largely impacted by economic conditions beyond our control and can adversely impact our financial condition. Operating Efficiency The largest component of noninterest expense is salaries and employee benefits. Other significant operating expenses include occupancy expense, data processing expense, director and staff expense, marketing expense, and legal and professional fees. Our operating efficiency, as measured by our efficiency ratio, has gradually improved primarily because the growth of our deposits and loans has enabled our net interest income and noninterest income to outpace our expenses. When we open new branches or make substantial investments to increase our operating capacity, our operating efficiency decreases until we generate enough growth to offset the increased costs however, prior to making such investments, we focus on how best and most expediently we can achieve the growth necessary to offset the costs of these investments or new branches. Economic Conditions Our business and financial performance are affected by economic conditions generally in the United States and more directly in the markets in the Puget Sound region where we operate. The significant economic factors that are most relevant to our business and our financial performance include, but are not limited to, real estate values, interest rates and unemployment rates. In recent years, the Puget Sound region has experienced significant population gain, fueled in large part by the region’s technology industry, low unemployment and rising real estate values, all of which positively impacted our business. Critical Accounting Policies Our accounting policies are integral to understanding our results of operations. Our accounting policies are described in greater detail in Note 1 to our consolidated financial statements included elsewhere is this report. We believe that of our accounting policies, the following accounting policies may involve a higher degree of judgment and complexity: Securities Securities are classified as available for sale when they might be sold before maturity. Securities available for sale are carried at fair value. Unrealized gains and losses are excluded from earnings and reported in other comprehensive income. Securities within the available for sale portfolio may be used as part of our asset/liability strategy and may be pledged or sold in response to changes in interest rate risk, prepayment risk or other similar economic factors. Securities held to maturity are carried at cost, adjusted for the amortization of premiums and the accretion of discounts and may be pledged. Interest earned on these assets is included in interest income. Interest income includes amortization of any purchase premium or discount. Premiums and discounts on securities are amortized using the level-yield method, except for mortgage backed securities where prepayments are anticipated. Gains and losses on sales are recorded on the trade date and determined using the specific identification method. Management evaluates debt securities for other-than-temporary impairment (OTTI), on at least a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. For securities in an unrealized loss position, management considers the extent and duration of the unrealized loss, and the financial condition and near-term prospects of the issuer. Management also assesses whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings. For debt securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: (1) OTTI related to credit loss, which must be recognized in the income statement, and (2) OTTI related to other factors, which is recognized in other comprehensive income, net of applicable taxes. The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis. The previous amortized cost basis less the OTTI recognized in earnings becomes the new amortized cost basis of the security. Loans Held for Investment Loans held for investment are those that management has the intent and ability to hold for the foreseeable future or until maturity or payoff at the principal and interest balance outstanding, net of deferred loan fees and costs. Loans are typically secured by specific items of collateral including business assets, consumer assets, and commercial and residential real estate. Commercial loans are expected to be repaid from cash flow from operations of businesses. Interest income is accrued on the unpaid principal balance. Loan origination fees and certain direct origination costs are deferred and recognized as adjustments to interest income using a level yield methodology or a method approximating the level yield methodology. Allowance for Loan Losses The allowance for loan losses represents management’s estimate of probable and reasonably estimable credit losses inherent in the loan portfolio. In determining the allowance, the Company estimates losses on individual impaired loans, or groups of loans which are not impaired, where the probable loss can be identified and reasonably estimated. On a quarterly basis, the Company assesses the risk inherent in the Company’s loan portfolio based on qualitative and quantitative trends in the portfolio, including the internal risk classification of loans, historical loss rates, changes in the nature and volume of the loan portfolio, industry or borrower concentrations, delinquency trends, detailed reviews of significant loans with identified weaknesses and the impacts of local, regional and national economic factors on the quality of the loan portfolio. Based on this analysis, the Company records a provision for loan losses to maintain the allowance at appropriate levels. Determining the amount of the allowance is considered a critical accounting estimate, as it requires significant judgment and the use of subjective measurements, including management’s assessment of overall portfolio quality. The Company maintains the allowance at an amount the Company believes is sufficient to provide for estimated losses inherent in the Company’s loan portfolio at each balance sheet date, and fluctuations in the provision for loan losses may result from management’s assessment of the adequacy of the allowance. Changes in these estimates and assumptions are possible and may have a material impact on the Company’s allowance, and therefore the Company’s financial position, liquidity or results of operations. Stock-based Compensation We grant stock options and restricted stock to our employees and directors. We record the related compensation expense based on the grant date fair value calculated in accordance with the authoritative guidance issued by FASB. We recognize these compensation costs on a straight-line basis over the requisite service period of the award. We estimate the grant date fair value of stock options using the Black-Scholes valuation model. Stock-based compensation expense related to awards of restricted stock is based on the fair value at the grant date. The determination of fair value using the Black-Scholes model is affected by the price of our common stock, as well as the input of other subjective assumptions. These assumptions include, but are not limited to, the expected term of stock options and our stock price volatility. As there has been no public market for our common stock prior to July 20, 2018, 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, based on our board of directors’ assessment of objective and subjective factors that it believed were relevant. The factors considered by our board of directors included the prices of known transactions in our common stock, the book value per share of our common stock, and our board of directors’ understanding of pricing multiples for comparable financial institutions that were not publicly traded. The assumptions underlying these valuations represented management’s best estimate, which involved inherent uncertainties and the application of management’s judgment. As a result, if we had used different assumptions or estimates, the fair value of our common stock and our stock-based compensation expense could have been materially different. Emerging Growth Company The JOBS Act permits an “emerging growth company” to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies. However, we have decided not to take advantage of this provision. As a result, we will comply with new or revised accounting standards to the same extent that compliance is required for non-emerging growth companies. Our decision to opt out of the extended transition period under the JOBS Act is irrevocable. Recently Issued Accounting Pronouncements For a discussion of the expected impact of accounting pronouncements recently issued but not adopted by us as of December 31, 2019, see Note 2 of our audited consolidated financial statements included elsewhere in this report. Results of Operations Net Income Year Ended December 31, 2019, Compared to Year Ended December 31, 2018. Net income for the year ended December 31, 2019, was $13.2 million, or $1.08 per diluted share, compared to $9.7 million, or $0.91 per diluted share, for the year ended December 31, 2018. The increase in net income over the prior year was attributable to a $7.2 million increase in net interest income and a $2.8 million increase in noninterest income, which were partially offset by an $4.8 million increase in noninterest expense, $920,000 increase in provision for income taxes and $718,000 increase in provision for loan losses. Year Ended December 31, 2018, Compared to Year Ended December 31, 2017. Net income for the year ended December 31, 2018, was $9.7 million, or $0.91 per diluted share, compared to $5.4 million, or $0.59 per diluted share, for the year ended December 31, 2017. The increase in net income over the prior year was attributable to a $5.6 million increase in net interest income, $1.3 million increase in noninterest income, and $2.2 million decrease in the provision for income taxes, as a result of the reduction in the corporate income tax rate under the Tax Cuts and Jobs Act, which decreased tax expense in 2018, and as a result of the revaluation of deferred tax assets under the Tax Cuts and Jobs Act, increased tax expense in 2017. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Operations-GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures.” These increases in net income were offset by $3.8 million increase in noninterest expense and $956,000 increase in the provision for loan losses. Net Interest Income Year Ended December 31, 2019, Compared to Year Ended December 31, 2018. Net interest income for the year ended December 31, 2019, was $42.0 million compared to $34.8 million for the year ended December 31, 2018, an increase of $7.2 million, or 20.7%. The increase in net interest income consisted of a $9.8 million, or 25.4%, increase in interest income offset by a $2.7 million, or 67.5%, increase in interest expense. The growth in interest income was primarily attributable to a $138.2 million, or 19.6%, increase in average loans outstanding for the year ended December 31, 2019, compared to the prior year, combined with a 20 basis point increase in the yield on total loans. The increase in average loans outstanding was primarily due to our dual strategies of focusing on deepening relationships with existing borrowers and actively calling on new customers. Also contributing to the increase in 2019 was $8.1 million in purchased participation loans. The hiring of new lending teams and lenders in 2018 contributed to loan growth in 2019 as those lenders were able to transition more customers and increase new customer relationships overall. The increase in the yield on total loans reflects the total 1.25% interest rate increases by the Federal Open Market Committee (FOMC) between December 2017 and December 2018, resulting in higher rates on new and renewing loans during that period, the benefit of which was reflected throughout 2019. The increase in interest expense for the year ended December 31, 2019, was primarily related to a $87.5 million, or 18.3%, increase in average interest-bearing deposits over the prior year. The majority of this increase is attributable to growth in core deposit accounts, which we define as deposits excluding all brokered and time deposits. Noninterest bearing deposits (such as demand or checking accounts) grew $77.7 million, or 26.5%, in 2019. NOW (which are interest bearing checking accounts) and money market accounts grew $88.0 million, or 25.1%, and savings accounts increased $793,000, or 1.5%, in 2019. Non-core deposits decreased $2.1 million in 2019 with time deposits decreasing $15.2 million, or 15.7%, partially offset by an increase in BaaS brokered deposits of $13.1 million, or 124.2%, in 2019. We do not regularly advertise time deposit rates or money market rates, although we occasionally advertise promotional rates in targeted portions of our market area. Market conditions for deposits are competitive and the aforementioned rate increase by the FOMC in 2018 resulted in a 23 basis point increase in cost of deposits as of December 31, 2019 as compared to December 31, 2018. For the year ended December 31, 2019, net interest margin and net interest spread were 4.23% and 3.76%, respectively, compared to 4.24% and 3.92% for the year ended December 31, 2018. Year Ended December 31, 2018, Compared to Year Ended December 31, 2017. Net interest income for the year ended December 31, 2018, was $34.8 million compared to $29.2 million for the year ended December 31, 2017, an increase of $5.6 million, or 19.2%. The increase in net interest income consisted of a $6.6 million, or 20.6%, increase in interest income offset by a $1.0 million, or 36.6%, increase in interest expense. The growth in interest income was primarily attributable to a $86.8 million, or 14.0%, increase in average loans outstanding for the year ended December 31, 2018, compared to the prior year, combined with a 20 basis point increase in the yield on total loans. The increase in average loans outstanding was due to organic growth initiatives with a continued focus on actively calling on new customers and deepening relationships with existing borrowers. Also contributing to the increase in 2018 was $46.7 million in purchased loans during 2018, which included $14.1 million in purchased pools and $32.7 million in purchased participations. The hiring of additional lending teams and lenders also contributed to loan growth, as new lenders were able to transition many of their existing customers and pending transactions to the Bank. The increase in the yield on loans was largely due to higher prepayment penalties and deferred fees recognized on loans paid off. Additionally, the composition of the loan portfolio changed slightly to loans that earn higher rates and higher fees at a quicker rate, and there were increases in average loan yields overall. The increase in interest expense for the year ended December 31, 2018, was primarily related to a $46.6 million, or 10.8%, increase in average interest-bearing deposits over the prior year. The majority of this increase is attributable to growth in core deposit accounts. Noninterest bearing deposits grew $51.2 million, or 21.1%, in 2018. Savings, interest bearing checking, and money market accounts grew $42.8 million, or 11.5%, in 2018, while customer time deposits grew $6.4 million, or 7.1%, in 2018. We do not regularly advertise time deposit rates or money market rates, although we occasionally advertise promotional rates in targeted portions of our market area. Our branch managers, business development officers, and lenders collaborate to provide consistent and coordinated customer service and to seek deposits from new and existing customers. For the year ended December 31, 2018, net interest margin and net interest spread were 4.24% and 3.92%, respectively, compared to 4.08% and 3.83% for the year ended December 31, 2017. The following table presents an analysis of the average balances of net interest income, net interest spread and net interest margin for the periods indicated. Loan fees included in interest income totaled $1.4 million and $1.3 million for the years ended December 31, 2019 and 2018, respectively. For the years ended December 31, 2019 and 2018, the amount of interest income not recognized on nonaccrual loans was not material. 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 allocated to volume. Provision for Loan Losses The provision for loan losses is an expense we incur to maintain an allowance for loan losses at a level that is deemed appropriate by management to absorb inherent losses on existing loans. For a description of the factors taken into account by our management in determining the allowance for loan losses see “Item 7. Management’s Discussion and Analysis of Financial Condition and Operations-Financial Condition-Allowance for Loan Losses.” Year Ended December 31, 2019, Compared to Year Ended December 31, 2018. The provision for loan losses for the year ended December 31, 2019, was $2.5 million compared to $1.8 million for the year ended December 31, 2018. The increase of $718,000 was primarily due to gross loan growth. Gross loans totaled $939.1 million in 2019 compared to $767.9 million in 2018 and grew $171.2 million in 2019 compared to $111.1 million in 2018. The allowance for loan losses as a percentage of loans was 1.22% at December 31, 2019, compared to 1.23% at December 31, 2018. Net charge-offs for the year ended December 31, 2019, totaled $481,000, or 0.06% of total average loans, as compared to net charge-offs of $436,000, or 0.06% of total average loans, for the year ended December 31, 2018. Net charge-offs for both years were consistent on a percentage basis. Year Ended December 31, 2018, Compared to Year Ended December 31, 2017. The provision for loan losses for the year ended December 31, 2018, was $1.8 million, compared to $870,000 for the year ended December 31, 2017. The increase of $956,000 was primarily due to loan growth totaling $111.1 million in 2018 compared to $60.7 million in 2017. The allowance for loan losses as a percentage of loans was 1.23% at December 31, 2018, compared to 1.22% at December 31, 2017. Net charge-offs for the year ended December 31, 2018, totaled $436,000, or 0.06% of total average loans, as compared to net charge-offs of $397,000, or 0.06% of total average loans, for the year ended December 31, 2017. Net charge-offs for both years were consistent on a percentage basis. Noninterest Income Our primary sources of recurring noninterest income are deposit account service charges and fees, BaaS fees, loan referral fees, mortgage broker fees, and sublease and lease income. Noninterest income does not include 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. The following table presents, for the periods indicated, the major categories of noninterest income: Deposit Service Charges and Fees. Deposit service charges and fees include service charges on accounts, point-of-sale fees, merchant services fees and overdraft fees. Together they constitute the largest component of our noninterest income. Deposit service charges and fees were $3.1 million for the year ended December 31, 2019, an increase of $46,000, or 1.5%, over the prior year. Despite increases in most accounts within this category, income remained fairly flat for the year ended December 31, 2019 as compared to the year ended December 31, 2018 in part due to a change in the accounting for certain point-of-sale fees which reduced fee income by $211,000 for that product in the current period. Deposit service charges and fees were $3.1 million for the year ended December 31, 2018, an increase of $444,000, or 17.0%, over the prior year. The increases in deposit service charges and fees in these periods were primarily the result of a fee income initiative to adjust the pricing of fees, types of fees, and features of our deposit accounts, as well as growth in deposit balances and accounts which also lead to more transactional fees. BaaS Fees. Our CCBX division provides BaaS offerings that enable our broker dealer and digital financial service partners to offer their customers banking services. In exchange for providing these services, we earn fixed fees, volume-based fees and reimbursement of costs depending on the contract. For the year ended December 31, 2019, which was the first full year of offering this service, we earned $2.1 million in BaaS fees, which is an increase of $1.4 million or 190.6% over the year ended December 31, 2018, where we earned $709,000 in BaaS fees. This was a new service for us late in 2018, therefore no income is reported for 2017. Beginning with the quarter ended December 31, 2019, we have changed references from “wholesale” and "wholesale banking services" to "BaaS" and “BaaS fees” in our financial statements and other information we make publicly available. We have revised prior period financial statements to make this conforming change. Loan Referral Fees. We earn loan referral fees when we originate a variable rate loan and the borrower enters into an interest rate swap agreement with a third party to fix the interest rate for an extended period, usually 20 or 25 years. We recognize the loan referral fee for arranging the interest rate swap. By facilitating interest rate swaps to our clients, we are able to provide them with a long-term, fixed interest rate without the assuming the interest rate risk. Loan referral fees were $1.4 million for the year ended December 31, 2019, an increase of $820,000, or 132.7%, over the year ended December 31, 2018. Loan referral fees were $618,000 for the year ended December 31, 2018, compared to $439,000 in the prior year, an increase of $179,000 or 40.8%. Interest rate volatility, swap rates, and the timing of loan closings all impact the demand for long-term fixed rate swaps. Income from loan referral fees fluctuate in response to these market conditions and as a result we may not recognize any loan referral fees in some periods. Mortgage Broker Fees. We earn mortgage broker fees for residential mortgage loans that we broker through mortgage lenders. Mortgage broker fees increased $232,000 for the year ended December 31, 2019 compared to the year ended December 31, 2018 as a result of higher demand and lower mortgage interest rates in our key markets, which increased the demand for new and refinanced mortgages. Mortgage broker fees decreased $40,000 in the year ended December 31, 2018, compared to the year ended December 31, 2017 as a result of an increase in mortgage rates that resulted in less purchasing and refinancing volume. Gain on Sale of Loans. We typically sell in the secondary market the guaranteed portion (generally 75% of the principal balance) of the SBA and USDA, loans that we originate. Gain on sale of loans increased to $490,000 for the year ended December 31, 2019 from $264,000 for the year ended December 31, 2018, due to an increase in loans sold. Gain on sale of loans increased $162,000 to $264,000 in the year ended December 31, 2018, compared to the year ended December 31, 2017 as a result of increased focus on production after restructuring our SBA loan program in 2018. We continue to focus on originating high quality loans. In 2019, we originated $4.6 million of SBA loans compared to $7.8 million in 2018 and $4.8 million in 2017. In 2019 we originated $3.7 million in USDA loans compared to $814,000 in 2018 and zero in 2017. Gain on Sale of Securities, net. In the quarter ended September 30, 2019 we restructured our investment portfolio to improve the rate of return and reduce the weighted average maturity, interest rate risk and price risk on the portfolio. As a result of this restructuring we were able to recognize $171,000 in net gains on the securities sold during the year ended December 31, 2019. No gain on sale of securities was recognized in 2018 or 2017. Other. This category includes a variety of other income-producing activities, annuity broker fees, and SBA and USDA servicing fees. Other noninterest income decreased $32,000, or 6.2%, for the year ended December 31, 2019 compared to the year ended December 31, 2018 most significantly because of lower SBA servicing fees and lower annuity fees, as compared to the prior period. Other noninterest income was $487,000 for the year ended December 31, 2019 and $519,000 in each of the years ended December 31, 2018, and 2017. Noninterest Expense Generally, noninterest expense includes 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 expense, data processing expense, director and staff expense, marketing expense, and legal and professional fees. For the year ended December 31, 2019, noninterest expense totaled $31.1 million, an increase of $4.9 million, or 18.5%, compared to $26.2 million for the year ended December 31, 2018. For the year ended December 31, 2018, noninterest expense totaled $26.2 million, an increase of $3.8 million, or 16.9%, compared to $22.4 million for the year ended December 31, 2017. The following table presents, for the periods indicated, the major categories of noninterest expense: Salaries and Employee Benefits. Salaries and employee benefits are the largest component of noninterest expense and include payroll expense, incentive compensation costs, benefit plans, health insurance and payroll taxes. Salaries and employee benefits were $19.0 million for the year ended December 31, 2019, an increase of $3.0 million, or 18.3%, compared to $16.0 million for the year ended December 31, 2018. The increase was primarily due to hiring staff for our BaaS CCBX division, additional staff for our ongoing banking related growth initiatives, a full year of doing business as a public company and operating our Edmonds branch. Salaries and employee benefits were $16.0 million for the year ended December 31, 2018, an increase of $2.6 million, or 19.7%, compared to $13.4 million for 2017. The increase was primarily due to the continued organic growth initiatives, and include increases in sales staff, including hiring new lending teams, adding lenders, staff for the newly opened Edmonds branch, and additional back office staffing to support the incremental increases in banking teams, BaaS activities and for operation as a public company. As of December 31, 2019, we had 195 full-time equivalent employees, compared to 183 at December 31, 2018, and 156 at December 31, 2017. Occupancy Expenses. Occupancy expenses were $3.8 million for the year ended December 31, 2019, compared to $3.3 million for the year ended December 31, 2018. Occupancy expenses were $3.3 million for the year ended December 31, 2018, compared to $3.0 million for 2017. This category includes building, leasehold, furniture, fixtures and equipment depreciation totaling $1.2 million, $1.1 million, and $993,000 for years ended December 31, 2019, 2018, and 2017, respectively. The increase of $461,000, or 13.9%, in occupancy expenses for 2019 compared to 2018 was primarily due to the addition of our Edmonds branch in October 2018 and includes increases in rent expense, depreciation, property taxes and utilities as well as higher maintenance and repair costs overall. The increase of $277,000, or 9.1%, in occupancy expenses for the year ended December 31, 2018, compared to the prior year was largely due to a full year of occupancy expenses for the Woodinville location that was opened late in 2017. Data Processing. Data processing costs were $2.1 million for the year ended December 31, 2019, compared to $2.0 million for the year ended December 31, 2018. Data processing costs were $2.0 million for the year ended December 31, 2018, compared to $1.8 million for the year ended December 31, 2017. Data processing costs include all of our customer processing, computer processing, and network costs. In general, data processing costs increase as the Company and services provided grow. The increase for the year ended December 31, 2019 as compared to the year ended December 31, 2018 was offset due to a change in accounting related to certain point-of-sale transactions that reduced expenses by $211,000 for that account in the current period. In 2018, we saw increases in our loan and deposit bases as well as new products and branches, all of which impact data processing expense. We anticipate that our data processing costs will increase proportionately as we grow our customer base, CCBX division, deposits and loans and add new products. Legal and Professional Fees. Legal and professional costs were $1.1 million for the year ended December 31, 2019 compared to $677,000 for the year ended December 31, 2018. Legal and professional costs increased $322,000 in 2018 from $355,000 for the year ended December 31, 2017. The increase for both years ended December 31, 2019 and 2018 is largely the result of additional legal and consulting fees from negotiating BaaS agreements and increased legal and accounting expenses associated with becoming and being a publicly traded company. Director and Staff Expenses. Director and staff expenses includes compensation for director service, continuing education for employees and other director and staff related expenses. Director and staff expenses were $1.0 million for the year ended December 31, 2019 compared to $701,000 for the year ended December 31, 2018, an increase of $299,000 or 42.7%. Director and staff expenses were $701,000 for the year ended December 31, 2018 compared to $561,000 for the year ended December 31, 2017, an increase of $140,000 or 25.0%. In mid-2018 a change in the structure of director compensation as a result of increased responsibilities of becoming a publicly traded company contributed to the increase for each of the years ended December 31, 2019 and 2018. Other. This category includes software licenses and maintenance, dues and subscriptions, office supplies, mail services, telephone, examination fees, internal loan expenses, services charges from banks, operational losses, directors and officers insurance, donations, provision for unfunded commitments, and miscellaneous other expenses. Other noninterest expense increased to $2.4 million for the year ended December 31, 2019, compared to $2.0 million for the year ended December 31, 2018, an increase of $460,000, or 23.5%. The increase was primarily due to an increase in the unfunded commitment provision, increases in software licenses and maintenance combined with standard increases throughout the accounts in this category. Other noninterest expense increased to $2.0 million for the year ended December 31, 2018, compared to $1.8 million for the year ended December 31, 2017. The increase was primarily due to increases in office supplies, dues and subscription costs, and telephone expenses, all of which are related to increases in staffing, the addition of new banking teams and the new branch that was added in 2018. Income Tax Expense The amount of income tax expense we incur is impacted by the amounts of our pre-tax income, tax-exempt income and 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, deferred tax assets and liabilities are adjusted through the provision for income taxes. Valuation allowances are established when necessary to reduce our deferred tax assets to the amount expected to be realized. Year Ended December 31, 2019, Compared to Year Ended December 31, 2018. For the year ended December 31, 2019, income tax expense totaled $3.5 million, compared to $2.5 million for the year ended December 31, 2018. Our effective tax rates for each of the years ended December 31, 2019 and 2018, was 20.8%. Year Ended December 31, 2018, Compared to Year Ended December 31, 2017. For the year ended December 31, 2018, income tax expense totaled $2.5 million, compared to $4.7 million for the year ended December 31, 2017. In 2018, the Company saw a decrease in federal income tax expense as a result of the reduced tax rate under the Tax Cuts and Jobs Act. The income tax expense for 2017 included $1.3 million in additional expense that resulted from the revaluation of our deferred tax assets as a result of the reduction in the corporate income tax rate under the Tax Cuts and Jobs Act. Excluding the effect of the charge for revaluation of our deferred tax assets, our effective tax rates for the years ended December 31, 2018 and 2017, were 20.8% and 33.3%, respectively. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Operations-GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures.” Financial Condition Our total assets increased $176.4 million, or 18.5%, to $1.129 billion as of December 31, 2019, from $952.1 million as of December 31, 2018. The increase is primarily the result of $169.1 million in net loans receivable growth during the year ended December 31, 2019. Additionally, the Company implemented the new lease accounting standard, which brought operating leases onto the balance sheet on January 1, 2019, and increased assets by $8.5 million as of December 31, 2019. Our total assets increased $146.3 million, or 18.2%, to $952.1 million as of December 31, 2018, from $805.8 million as of December 31, 2017. Our asset growth in 2018 was primarily due to $111.1 million in loan growth and a $36.0 million increase in cash and cash equivalents, offset by a decrease of $414,000 in investment securities. Our asset growth was primarily funded by $100.3 million in deposit growth during 2018, plus the $33.2 million in equity from the capital raise completed on July 18, 2018. The initial public offering consisted of 2,577,500 shares of common stock, including the exercise of the over-allotment of 427,500 shares, for net proceeds of $33.2 million after deducting underwriting discounts, commissions, and estimated offering expenses. Loan Portfolio Our primary source of income is derived through interest earned on loans. A substantial portion of our loan portfolio consists of commercial real estate loans and commercial and industrial loans in the Puget Sound region. Our loan portfolio represents the highest yielding component of our earning assets. As of December 31, 2019, gross loans totaled $939.1 million, an increase of $171.2 million, or 22.3%, compared to $767.9 million as of December 31, 2018. As of December 31, 2018, gross loans totaled $767.9 million, an increase of $111.1 million, or 16.9%, compared to December 31, 2017. These increases were primarily due to our efforts to increase income by building a secure loan portfolio while maintaining strong credit quality. Loans as a percentage of deposits were 97.0% as of December 31, 2019, 95.6% as of December 31, 2018, and 94.3% as of December 31, 2017. We are focused on serving our communities and markets by growing loans locally and funding those loans with customer deposits. The following table summarizes our loan portfolio by type of loan as of the dates indicated: Commercial and Industrial Loans. Commercial and industrial loans are underwritten after evaluating and understanding the borrower’s ability to operate profitably and effectively. These loans are primarily made based on the borrower’s ability to service the debt from income. Most commercial and industrial loans are secured by the assets being financed or other business assets, such as accounts receivable, inventory or equipment, and we generally obtain personal guarantees on these loans. Commercial and industrial loans increased $21.0 million, or 23.2%, to $111.4 million as of December 31, 2019, from $90.4 million as of December 31, 2018. The $21.0 million increase is the result of $63.1 million in new loans, net of $42.1 million in principal reductions and payoffs. Commercial and industrial loans increased $1.7 million, or 1.9%, to $90.4 million as of December 31, 2018, from $88.7 million as of December 31, 2017. The $1.7 million increase is the result of more than $31.1 million in new loans, net of $29.4 million in principal reductions and payoffs. The 2019 increase was due, in part, to our diversification strategy, which includes sourcing loans from strong markets with good returns and risk characteristics to supplement growth in our existing markets. Construction, Land and Land Development Loans. Construction, land and land development loans are comprised of loans to fund construction, land acquisition and land development construction. The properties securing these loans are primarily located in the Puget Sound region and are comprised of both residential and commercial properties, including owner occupied properties and investor properties. Construction, land and land development loans increased $33.0 million, or 51.5%, to $97.0 million as of December 31, 2019, from $64.0 million as of December 31, 2018, primarily due to continued favorable economic conditions for building in our market area. Unfunded loan commitments for construction, land and land development loans were $63.7 million at December 31, 2019, which was comparable to the $63.4 million in unfunded commitments at December 31, 2018. Construction, land and land development loans increased $22.4 million, or 53.8%, to $64.0 million as of December 31, 2018, from $41.6 million as of December 31, 2017. The increase was primarily due to favorable economic conditions for building in our market area. Unfunded loan commitments for construction, land and land development loans increased to $63.4 million as of December 31, 2018. We had a number of construction loans that have been approved, primarily for residential projects, where the contractor/developer had not requested the funds, resulting in our unfunded construction and development commitments increasing to $63.4 million at December 31, 2018, from $30.8 million at December 31, 2017. Because of the strong residential real estate market in the Puget Sound region, we expect to see construction and development loans continue to pay off more quickly than we have experienced historically. Residential Real Estate Loans. We originate one-to-four family ARM loans for our own loan portfolio and operate as a mortgage broker for mortgage lenders. Loans that we originate as a broker are not funded by us and do not appear on our balance sheet. From time to time, we also purchase residential mortgages originated by other financial institutions to hold for investment with the intent to diversify our residential mortgage loan portfolio and increase our interest income. As of December 31, 2019, we held $28.6 million in purchased residential real estate mortgage loans. We also make one-to-four family loans to investors to finance their rental properties and to business owners to secure their business loans. As of December 31, 2019, residential real estate loans made to investors and business owners totaled $59.7 million. In addition, we originate home equity lines of credit and home equity term loans for our portfolio. Our residential loans increased $20.3 million, or 21.4%, to $115.0 million as of December 31, 2019, from $94.7 million as of December 31, 2018. Our residential loans increased $7.7 million, or 8.9%, to $94.7 million as of December 31, 2018, from $87.0 million as of December 31, 2017. The increases were primarily a result of our diversification strategy to supplement existing loan growth with purchased loans individually underwritten to our credit standards. Most of the one-to-four family loans that we purchase are from other lenders in the Puget Sound region or in California. Commercial Real Estate Loans. We make commercial mortgage loans collateralized by owner-occupied and non-owner-occupied real estate, as well as multi-family residential loans. The real estate securing our existing commercial real estate loans includes a wide variety of property types, such as manufacturing and processing facilities, business parks, warehouses, retail centers, convenience stores and gas stations, hotels and motels, office buildings, mixed-use residential and commercial, and other properties. Commercial real estate loans represented 65.2% of our loan portfolio at December 31, 2019, and are our largest source of revenue. Commercial real estate loans increased $97.4 million, or 18.9%, to $613.4 million as of December 31, 2019, from $516.0 million as of December 31, 2018. Commercial real estate loans increased $78.3 million, or 17.9%, to $516.0 million as of December 31, 2018, from $437.7 million as of December 31, 2017. These increases, which occurred across the various segments of our portfolio, were due to our commitment to grow this portfolio in the Puget Sound region. We actively seek commercial real estate loans in our markets and our lenders are experienced in competing for these loans. Consumer and Other Loans. Our consumer and other loans are comprised of personal lines of credit, automobile, boat, and recreational vehicle loans, and secured term loans. Consumer and other loans increased $630,000, or 17.6%, to $4.2 million as of December 31, 2019, from $3.6 million as of December 31, 2018. Consumer and other loans increased $1.5 million, or 71.4%, to $3.6 million as of December 31, 2018, from $2.1 million as of December 31, 2017. The increases in these loans were primarily a result of strong consumer confidence and economic strength in the Puget Sound region. The contractual maturity ranges of loans in our loan portfolio and the amount of such loans with fixed and floating interest rates in each maturity range as of date indicated are summarized in the following tables: The following table sets forth all loans at December 31, 2019, that are due after December 31, 2020, and have either fixed interest rates or floating or adjustable 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 applicable regulations. 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 loans are placed on nonaccrual status, all unpaid accrued interest is reversed from income and all interest accruals are stopped. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal balance. Loans are returned to accrual status if we believe that all remaining principal and interest is fully collectible and there has been at least six months of sustained repayment performance since the loan was placed on nonaccrual status. We define nonperforming loans as loans on nonaccrual status and accruing loans that are 90 days or more past due. We believe our conservative lending practices and active approach to managing 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 credit quality of our loan portfolio. We have established underwriting guidelines, and we also monitor our delinquency levels for any negative or adverse trends. We actively manage problem assets to reduce our risk for loss. We had $1.0 million in nonperforming assets, and no troubled debt restructurings (TDRs), as of December 31, 2019, compared to $1.8 million as of December 31, 2018. All of our nonperforming assets were nonperforming loans as of December 31, 2019 and 2018. The decrease in nonperforming assets was the result of the payoff of a TDR and nonperforming loan in 2019, partially offset by the addition of five smaller loans to nonperforming status. We had $1.8 million in nonperforming assets, including performing TDRs, as of December 31, 2018, compared to $2.1 million as of December 31, 2017. All of our nonperforming assets were nonperforming loans as of December 31, 2018, and 2017. The decrease in nonperforming assets was the result of the payoff of two of our nonperforming loans. The following table presents information regarding nonperforming assets at the dates indicated: Potential Problem Loans From a credit risk standpoint, we classify loans in one of five categories: pass, other loans especially mentioned, substandard, doubtful or loss. Within the pass category, we classify loans into one of the following five subcategories based on perceived credit risk, including repayment capacity and collateral security: minimal risk, low risk, modest risk, average risk and acceptable risk. The classifications of loans reflect a judgment about the risks of default and loss given default. We review the risk ratings of our credits on an annual basis, or more frequently if circumstances warrant. Risk ratings are adjusted to reflect the degree of risk and loss that is believed to be inherent in each credit as of each monthly reporting period. 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). Credits rated as other loans especially mentioned show clear signs of financial weaknesses or deterioration in creditworthiness; however, such concerns are not so pronounced that we generally expect to experience significant loss within the short-term. Such credits typically maintain the ability to perform within standard credit terms and credit exposure is not as prominent as credits with a lower rating. Credits rated as substandard are those in which the normal repayment of principal and interest may be, or has been, jeopardized by reason of adverse trends or developments of a financial, managerial, economic or political nature, or important weaknesses in the collateral for the loan. A protracted workout on these credits is a distinct possibility. Prompt corrective action is therefore required to reduce exposure and to assure that adequate remedial measures are taken by the borrower. Credit exposure becomes more likely in such credits and a serious evaluation of the secondary support to the credit is performed. Credits rated as doubtful have weaknesses of substandard assets that are sufficient to make collection or liquidation in full questionable and there is a high probability of loss based on currently existing facts, conditions and values. Credits rated as loss are charged-off. We have no expectation of the recovery of any payments in respect of credits rated as loss. The following table summarizes the internal ratings of our loans as of the dates indicated: 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. 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, and current economic factors. See “-Critical Accounting Policies-Allowance for Loan Losses.” In connection with the review of our loan portfolio, we consider risk elements applicable to particular loan types or categories in assessing the quality of individual loans. Some of the risk elements we consider include: • for commercial and industrial loans, the debt service coverage ratio (income from the business in excess of operating expenses compared to loan repayment requirements), the operating results of the commercial, professional or agricultural enterprise, the borrower’s business, professional and financial ability and expertise, the specific risks and volatility of income and operating results typical for businesses in that category and the value, nature and marketability of collateral; • for construction, land and land development loans, the perceived feasibility of the project including the ability to sell developed lots or improvements constructed for resale or the ability to lease property constructed for lease, the quality and nature of contracts for presale or prelease, if any, experience and ability of the developer and loan-to-value ratio. • for commercial real estate loans, the debt service coverage ratio, operating results of the owner in the case of owner-occupied properties, the loan-to-value ratio, the age and condition of the collateral and the volatility of income, property value and future operating results typical of properties of that type; • for residential real estate mortgage loans, the borrower’s ability to repay the loan, including a consideration of the debt-to-income ratio and employment and income stability, the loan-to-value ratio, and the age, condition and marketability of the collateral; and As of December 31, 2019, the allowance for loan losses totaled $11.5 million, or 1.22% of total loans. Our allowance for loan losses as of December 31, 2018, increased by $2.1 million, or 21.9%, compared to December 31, 2018, primarily due to organic growth in our loan portfolio. As of December 31, 2018, the allowance for loan losses totaled $9.4 million, or 1.23% of total loans. Our allowance for loan losses as of December 31, 2018, increased by $1.4 million, or 17.3%, compared to December 31, 2017, primarily due to the growth of our loan portfolio, including both organic and purchased loans. As of December 31, 2017, the allowance for loan losses totaled $8.0 million, or 1.22% of total loans. The following tables present, as of and for the periods indicated, an analysis of the allowance for loan losses and other related data: 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. If the Puget Sound region experiences an economic downturn, our asset quality could deteriorate or if we are successful in continuing to grow our loan portfolio, our allowance may become inadequate and material additional provisions for loan losses could be necessary. 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 allocation of the allowance for loan losses as shown in the table should neither be interpreted as an indication of future charge-offs, nor as an indication that charge-offs in future periods will necessarily occur in these amounts or in the indicated proportions. The total allowance is available to absorb losses from any loan category. Securities We use our securities portfolio primarily as a source of liquidity and collateral that can be readily sold or pledged for public deposits or other business purposes. At December 31, 2019, 76.3% of our investment portfolio consisted of U.S. Treasury securities. The remainder of our securities portfolio was invested in U.S. Government securities, U.S. Agency collateralized mortgage obligations and U.S. Agency residential mortgage-backed securities, and municipal bonds. Because we target a loan-to-deposit ratio in the range of 90% to 100%, we prioritize liquidity over the earnings of our securities portfolio. At December 31, 2019, our loan-to-deposit ratio was 97.0% and our securities portfolio represented less than 5% of assets. To the extent our securities represent more than 5% of assets, absent an immediate need for liquidity, we anticipate investing excess funds to provide a higher return. As of December 31, 2019, the carrying amount of our investment securities totaled $32.7 million, a decrease of $5.2 million, or 13.7%, compared to $37.9 million as of December 31, 2018. The decrease in the securities portfolio in 2019 was due to the restructuring of the investment portfolio to increase our overall rate of return, reduce weighted average maturity, and improve interest rate risk and pricing risk, which involved the sale of $30.0 million (par value) of existing available for sale securities and the purchase of $20.0 million (par value) of available for sale securities as well as an additional $10.0 million of one year certificates of deposits. Also contributing to the decrease was pay-downs on U.S. Agency residential mortgage-backed securities. Additionally, we purchased $3.2 million of a community reinvestment act qualified U.S. Agency residential mortgage-backed security. The fair value of available for sale securities improved during the year ended December 31, 2019. As of December 31, 2018, the carrying amount of our investment securities totaled $37.9 million, a decrease of $414,000, or 1.1%, compared to $38.3 million as of December 31, 2017. The decrease in the securities portfolio in 2018 was primarily the result of the decline in fair value and pay-downs on U.S. Agency residential mortgage-backed securities. Investment securities represented 2.9% and 4.0%, and 4.8% of total assets as of December 31, 2019, 2018 and 2017, respectively. Our investment portfolio consists of securities classified as available for sale and, to a lesser amount, held to maturity. The carrying values of our investment securities classified as available for sale are adjusted for unrealized gain or loss, and any gain or loss is reported on an after-tax basis as a component of other comprehensive income in shareholders’ equity. The following table summarizes the amortized cost and estimated fair value of our investment securities as of the dates shown: All of our U.S. Agency residential mortgage-backed securities and U.S. Agency collateralized mortgage obligations are U.S. Government agency securities. As of December 31, 2019, we did not hold any Fannie Mae or Freddie Mac preferred stock, collateralized debt obligations, collateralized loan obligations, structured investment vehicles, private label collateralized mortgage obligations, subprime, Alt-A or second lien elements in our investment portfolio. Our management evaluates securities for other-than-temporary impairment on at least a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. As of December 31, 2019, and December 31, 2018, we did not own securities of any one issuer, other than the U.S. Government and its agencies, for which aggregate adjusted cost exceeded 10.0% of consolidated shareholders’ equity. Restricted equity securities were $4.0 million as of December 31, 2019 and $3.8 million as of December 31, 2018. The increase was attributable to net additions of Federal Reserve, FHLB stock and Pacific Coast Banker's Bank stock. Federal Reserve and FHLB stock are carried at par and do not have a readily determinable fair value. Ownership of FHLB stock is restricted to the FHLB and member institutions, and can only be purchased and redeemed at par. As of December 31, 2019, we held $500,000 in corporate equity securities which was recorded in other investments on the balance sheet. This is a new investment for 2019, therefore there was no balance as of December 31, 2018. The Company elects to account for the investment under ASC 321 Investments - Equity Securities without Readily Determinable Value. The investment will be held at cost minus impairment, the measurement should be applied until the investment does not qualify for the measurement election (e.g., if the investment has a readily determinable fair value). The Company will reassess at each reporting period whether the equity investment without a readily determinable fair value qualifies to be measured at cost minus impairment. The following table sets forth the amortized cost of held to maturity securities and the fair value of available for sale securities, maturities and approximated weighted average yield based on estimated annual income divided by the average amortized cost of our securities portfolio as of the dates indicated. The contractual maturity of a mortgage-backed security is the date at which the last underlying mortgage matures. Deposits We offer a variety of deposit products that have a wide range of interest rates and terms, including demand, savings, money market and time accounts as well as BaaS brokered deposits. In addition, in 2019 we added reciprocal deposits to our product offering. This enables us to extend FDIC insurance to customers that have balances in excess of the FDIC insurance limit. This service trades our customer’s funds as CDs in increments under the FDIC insured amount to other participating financial institutions and in exchange we receive CD investments from participating financial institutions in a reciprocal agreement. We rely primarily on competitive pricing policies, convenient locations, electronic delivery channels (Internet and mobile), and personalized service to attract and retain our deposits. Total deposits as of December 31, 2019, were $968.0 million, an increase of $164.4 million, or 20.5%, compared to $803.6 million as of December 31, 2018. Total deposits as of December 31, 2018, were $803.6 million, an increase of $100.3 million, or 14.3%, compared to $703.3 million as of December 31, 2017. The increases were primarily in core deposits and are related to our successful execution of our strategy of deepening relationships with existing customers and actively seeking new customers. We define core deposits as all deposits except time deposits and wholesale-brokered deposits. Noninterest-bearing deposits as of December 31, 2019, were $371.2 million, an increase of $77.7 million, or 26.5%, compared to $293.5 million as of December 31, 2018. Noninterest-bearing deposits as of December 31, 2018, were $293.5 million, an increase of $51.2 million, or 21.1%, compared to $242.4 million as of December 31, 2017. The increases were due to the collaboration of our branch managers, business development officers and lenders to grow core deposits. As a team, we actively pursue the business of new customers. Total interest-bearing account balances, excluding time deposits, as of December 31, 2019, were $514.9 million, an increase of $101.8 million, or 24.6%, from $413.0 million as of December 31, 2018. Total interest-bearing account balances, excluding time deposits, as of December 31, 2018, were $413.0 million, an increase of $42.7 million, or 11.5%, from $370.3 million as of December 31, 2017. The increases were due to our team focusing on growing core deposits. Included in interest bearing account balances is $23.6 million and $10.5 million in BaaS brokered deposits, as of December 31, 2019 and 2018, respectively. The balance of BaaS brokered deposits at December 31, 2017 was zero. Total time deposit balances as of December 31, 2019, were $81.9 million, a decrease of $15.1 million, or 15.7%, from $97.0 million as of December 31, 2018. Total time deposit balances as of December 31, 2018, were $97.0 million, an increase of $6.4 million, or 7.1%, from $90.6 million as of December 31, 2017. The decrease in 2019 is due to the strong increase in core deposits, and thus not requiring the replacement of time deposits as they mature. Included in time deposits are $2.5 million in reciprocal deposits, which is a new product for the Bank this year. We have seen competitors increase rates on time deposits, and we have not globally matched their rates in response as we have been able to grow and retain less costly core deposits. The following table sets forth deposit balances at the dates indicated. The following table sets forth the Company’s time deposits of $100,000 or more by time remaining until maturity as of the dates indicated: Average deposits for the year ended December 31, 2019, were $887.8 million, an increase of $142.3 million, or 19.1%, compared to the year ended December 31, 2018. Average deposits for the year ended December 31, 2018, were $745.5 million, an increase of $80.8 million, or 12.2%, compared to the year ended December 31, 2017. The increases in average deposits were primarily due to our continued growth in our primary market areas and the increase in commercial lending relationships for which we also seek deposit balances and the results of business development efforts by our business development officers, branch managers and lenders. The average rate paid on total interest-bearing deposits was 1.03% for the year ended December 31, 2019, compared to 0.66% for the year ended December 31, 2018. The average rate paid on total interest-bearing deposits was 0.66% for the year ended December 31, 2018, compared to 0.50% for the year ended December 31, 2017. The increase in average rate paid is a result of a competitive market and four 0.25% rate increases throughout 2018 by the Federal Reserve. The following table presents the average balances and average rates paid on deposits for the periods indicated: The ratio of average noninterest-bearing deposits to average total deposits for the years ended December 31, 2019 and 2018, was 36.3% and 35.8%, respectively. Factors affecting the cost of funding interest-bearing assets include the volume of noninterest- and interest-bearing deposits, changes in market interest rates and economic conditions in the Puget Sound region and their impact on interest paid on deposits, as well as the ongoing execution of our growth strategies. Cost of total interest-bearing liabilities is calculated as total interest expense divided by average total interest-bearing deposits plus average total borrowings. Our cost of total interest-bearing liabilities was 1.13%, 0.80% and 0.64% for the years ended December 31, 2019, 2018 and 2017, respectively. The increase in our cost of deposits in 2019 and 2018 was primarily due to higher deposit rates throughout the market resulting from rate increases from the Federal Reserve throughout 2018. We actively manage our interest rates on deposits, however, rate changes from the Federal Reserve will impact our deposit costs. Borrowings We have the ability to utilize short-term to long-term borrowings to supplement deposits to fund our lending and investment activities, each of which is discussed below. Federal Home Loan Bank (FHLB) Advances. The FHLB allows us to borrow against our line of credit, which is collateralized by certain loans. As of December 31, 2019, 2018 and 2017, total borrowing capacity of $84.9 million, $79.3 million and $59.3 million, respectively, was available under this arrangement. As of December 31, 2019, FHLB advances totaled $10.0 million, compared to $20.0 million at December 31, 2018 and 2017. The following table presents the FHLB borrowing for the periods indicated: Junior Subordinated Debentures. In 2004, we issued $3.6 million in junior subordinated debentures to Coastal (WA) Statutory Trust (the Trust), of which we own all of the outstanding common securities. The Trust used the proceeds from the issuance of its underlying common securities and preferred securities to purchase the debentures issued by the Company. These debentures are the Trust’s only assets and the interest payments from the debentures finance the distributions paid on the preferred securities. The debentures bear interest at a rate per annum equal to the 3-month LIBOR plus 2.10%. The effective rate as of December 31, 2019, 2018 and 2017, was 3.99%, 4.88% and 3.69%, respectively. We generally have the right to defer payment of interest on the debentures at any time or from time to time for a period not exceeding five years provided that no extension period may extend beyond the stated maturity of the debentures. During any such extension period, distributions on the trust’s preferred securities will also be deferred, and our ability to pay dividends on our common stock will be restricted. The Trust’s preferred securities are mandatorily redeemable upon maturity of the debentures, or upon earlier redemption as provided in the indenture. If the debentures are redeemed prior to maturity, the redemption price will be the principal amount and any accrued but unpaid interest. We unconditionally guarantee payment of accrued and unpaid distributions required to be paid on the Trust Securities subject to certain exceptions, the redemption price with respect to any Trust securities called for redemption and amounts due if the Trust is liquidated or terminated. Subordinated Debt. In 2016, the Company issued a subordinated note to a commercial bank in the amount of $10.0 million. The note matures on August 1, 2026, and bears interest at the rate of 5.65% per year for five years and, thereafter, at a rate equal to The Wall Street Journal prime rate plus 2.50%. Principal payments of $500,000 per quarter commence November 1, 2021. We may redeem the subordinated note, in whole or in part, without premium or penalty after July 29, 2021, subject to any required regulatory approvals. Liquidity and Capital Resources Liquidity Management Liquidity refers to our capacity to meet our cash obligations at a reasonable cost. Our cash obligations require us to have cash flow that is adequate to fund loan growth and maintain on-balance sheet liquidity while meeting present and future obligations of deposit withdrawals, borrowing maturities and other contractual cash obligations. In managing our cash flows, management regularly confronts situations that can give rise to increased liquidity risk. These include funding mismatches, market constraints in accessing sources of funds and the ability to convert assets into cash. Changes in economic conditions or exposure to credit, market, and operational, legal and reputational risks also could affect the Bank’s liquidity risk profile and are considered in the assessment of liquidity management. We continually monitor our liquidity position to ensure that our assets and liabilities are managed in a manner to meet all reasonably foreseeable short-term, long-term and strategic liquidity demands. Management has established a comprehensive 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 that are commensurate with the complexity of our business activities; 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; contingency funding policies and 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 Bank’s liquidity risk management process. Our liquidity position is supported by management of our liquid assets and liabilities and access to alternative sources of funds. Our liquidity requirements are met primarily through our deposits, FHLB advances and the principal and interest payments we receive on loans and investment securities. Cash on hand, cash at third-party banks, investments available-for-sale and maturing or prepaying balances in our investment and loan portfolios are our most liquid assets. Other sources of liquidity that are routinely available to us include funds from retail, commercial, and wholesale deposits, advances from the FHLB and proceeds from the sale of loans. Less commonly used sources of funding include borrowings from the Federal Reserve discount window, draws on established federal funds lines from unaffiliated commercial banks and the issuance of debt or equity securities. We believe we have ample liquidity resources to fund future growth and meet other cash needs as necessary. The Company is a corporation separate and apart from our Bank and, therefore, must provide for its own liquidity, including liquidity required to meet its debt service requirements on its subordinated note and junior subordinated debentures. The Company’s main source of cash flow has been through equity and debt offerings. The Company has consistently retained a portion of the funds from equity and debt offerings so that is has sufficient funds for its operating and debt costs for the next two or three years. In addition, the Bank can declare and pay dividends to the Company to meet the Company’s debt and operating expenses. There are statutory and regulatory limitations that affect the ability of the Bank to pay dividends to the Company. We believe that these limitations will not impact the ability of the Bank to pay dividends to the Company to meet ongoing operating needs. For contingency purposes, the Company maintains a minimum level of cash to fund one year’s projected operating cash flow needs and the Bank targets a liquidity ratio of 4% or greater of assets. Both of these minimum liquidity levels are on-balance sheet sources. Per policy and the Bank’s liquidity contingency plan, in event of a liquidity emergency the Bank can utilize wholesale funds in an amount up to 30% of assets. Since the Bank uses only a small portion of its borrowing capacity, the Bank has access to funds if needed in a liquidity emergency. Capital Adequacy Capital management consists of providing equity and other instruments that qualify as regulatory capital to support current and future operations. Banking regulators view capital levels as important indicators of an institution’s financial soundness. As a general matter, FDIC-insured depository institutions and their holding companies are required to maintain minimum capital levels relative to the amount and types of assets they hold. We are subject to regulatory capital requirements at the bank level. The Company will become subject to regulatory capital requirements once its consolidated assets exceed a certain threshold. Federal legislation enacted in May 2018 and implemented by the Federal Reserve effective August 30, 2018, raised the threshold of the Federal Reserve’s “Small Bank Holding Company” exception to the application of consolidated capital requirements from $1 billion to $3 billion of consolidated assets. Consequently, bank holding companies of under $3 billion of consolidated assets are no longer subject to the consolidated requirements unless otherwise directed by the Federal Reserve Board. See “Item 1. Business-Regulation and Supervision-Bank Regulation and Supervision-Capital Adequacy” for additional discussion regarding the regulatory capital requirements applicable to the Bank. As of each of December 31, 2019 and 2018, the Bank was in compliance with all applicable regulatory capital requirements, and the Bank was classified as “well capitalized” for purposes of the Federal Reserve’s 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 expect 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 Company and the Bank’s regulatory capital ratios as of the dates presented, as well as the regulatory capital ratios that are required by Federal Reserve regulations to maintain “well-capitalized” status: Contractual Obligations The following table summarizes contractual obligations and other commitments to make future payments (other than non-time deposit obligations), which consist of future cash payments associated with our contractual obligations, as of December 31, 2019. For a discussion of our borrowings, see “-Financial Condition-Borrowings.” We believe that we will be able to meet our contractual obligations as they come due. Adequate cash levels are expected through profitability, repayments from loans and securities, deposit gathering activity, access to borrowing sources and periodic loan sales. Off-Balance Sheet Items In the normal course of business, we enter into various transactions, which, 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 standby and commercial 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 commitments associated with outstanding commitments to extend credit and standby and commercial letters of credit are summarized below. Since commitments associated with commitments to extend credit and letters of credit may expire unused, the amounts shown do not necessarily reflect the actual future cash funding requirements. The following table presents commitments associated with outstanding commitments to extend credit and standby and commercial letters of credit as of the periods indicated: Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have 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 upon, 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. Standby and commercial 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, we have rights to the underlying collateral, which can include commercial real estate, physical plant and property, inventory, receivables, cash and/or marketable securities. Our credit risk associated with issuing letters of credit is essentially the same as the risk involved in extending loan facilities to our customers. GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures Some of the financial measures included in this report are not measures of financial performance recognized by GAAP. Our management uses the non-GAAP financial measures set forth below in its analysis of our performance. • “Adjusted net income” is a non-GAAP measure defined as net income increased by the additional income tax expense that resulted from the revaluation of deferred tax assets as a result of the reduction in the corporate income tax rate under the recently enacted Tax Cuts and Jobs Act. The most directly comparable GAAP measure is net income. • “Adjusted earnings per share” is a non-GAAP measure defined as net income, plus additional income tax expense, divided by weighted average outstanding shares (diluted). The most directly comparable GAAP measure is earnings per share. • “Pre-tax, pre-provision ROAA” is a non-GAAP measure defined as net income increased by provision for income tax and provision for loan losses, divided by average assets. The most directly comparable GAAP measure is return on average assets. • “Adjusted effective tax rate” is a non-GAAP measure defined as provision for income taxes, less additional income tax expense, divided income before provision for income taxes. • “Adjusted return on average assets” is a non-GAAP measure defined as net income, plus additional income tax expense, divided by average assets. The most directly comparable GAAP measure is return on average assets. • “Adjusted return on average shareholders’ equity” is a non-GAAP measure defined as net income, plus additional income tax expense, divided by average shareholders’ equity. The most directly comparable GAAP measure is return on average shareholders’ equity. We believe that these non-GAAP financial measures provide information that is important to investors and that is useful in understanding our results of operations. Our management uses the non-GAAP financial measures set forth below in its analysis of our performance for 2017 to exclude the impact of a deferred tax asset revaluation due to the enactment of the Tax Cuts and Jobs Act. However, these non-GAAP financial measures are supplemental and are not a substitute for an analysis based on GAAP measures. As other companies may use different calculations for these measures, this presentation may not be comparable to other similarly titled measures by other companies. (1) Share and per share information has been adjusted to give effect to a one-for-five reverse stock split of our common shares completed effective May 4, 2018. Quantitative and Qualitative Disclosures about Market Risk As a financial institution, our primary component of market risk is interest rate volatility. Our asset liability and funds management policy provides management with the guidelines for effective funds management, and we have established a measurement system for monitoring our net interest rate sensitivity position. We have historically managed our sensitivity position within our established guidelines. Fluctuations in interest rates will ultimately impact both the level of income and expense recorded on most of our assets and liabilities, and the market value of all interest-earning assets and interest-bearing liabilities, other than those which have a short term to maturity. Interest rate risk is the potential for economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a decrease in current fair market values. Our objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximizing income. We manage our exposure to interest rates by structuring our balance sheet in the ordinary course of business. We do not enter into instruments such as leveraged derivatives, financial options, financial future contracts or forward delivery contracts for the purpose of reducing interest rate risk. Based upon the nature of our operations, we are not subject to foreign exchange or commodity price risk. We do not own any trading assets. Our exposure to interest rate risk is managed by the Asset Liability Committee (ALCO), of the Bank and reviewed by the Asset Liability and Investment Committee of our board of directors in accordance with policies approved by our board of directors. ALCO formulates strategies based on appropriate levels of interest rate risk. In determining the appropriate level of interest rate risk, ALCO considers the impact on earnings and capital on the current outlook on interest rates, potential changes in interest rates, regional economies, liquidity, business strategies and other factors. ALCO meets regularly to review, among other things, the sensitivity of assets and liabilities to interest rate changes, the book and market values of assets and liabilities, unrealized gains and losses, purchase and sale activities, commitments to originate loans and the maturities of investments and borrowings. Additionally, ALCO reviews liquidity, cash flows, maturities of deposits and consumer and commercial deposit activity. Management employs various methodologies to manage interest rate risk including an analysis of relationships between interest-earning assets and interest-bearing liabilities and interest rate simulations using a model. The Asset Liability and Investment Committee of our board of directors meets quarterly to review the Bank’s interest rate risk profile, liquidity position, including contingent liquidity, and investment portfolio. We use interest rate risk simulation models to test interest rate sensitivity of net interest income and fair value of equity, and the impact of changes in interest rates on other financial metrics. Contractual maturities and re-pricing opportunities of loans are incorporated in the model, as are prepayment assumptions, maturity data and call options within the investment portfolio. Average life of non-maturity deposit accounts are based on historical decay rates and assumptions and are incorporated into the model. The assumptions used are inherently uncertain and, as a result, the model cannot precisely measure future net interest income or precisely predict the impact of fluctuations in market interest rates on net interest income. Actual results will differ from the model’s simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and the application and timing of various management strategies. On a quarterly basis, we run multiple simulations under two different premises of which one is a static balance sheet and the other is a dynamic growth balance sheet. The static balance sheet approach produces results that show the interest risk currently inherent in our balance sheet at that point in time. The dynamic balance sheet includes our projected growth levels going forward and produces results that shows how net income, net interest income, and interest risk change based on our projected growth. These simulations test the impact on net interest income and fair value of equity from changes in market interest rates under various scenarios. Under the static and dynamic approaches, rates are shocked instantaneously and ramped over a 12-month horizon assuming parallel yield curve shifts. Parallel shock scenarios assume instantaneous parallel movements in the yield curve compared to a flat yield curve scenario. Non-parallel simulations are also conducted and involve analysis of interest income and expense under various changes in the shape of the yield curve including a forward curve, flat curve, steepening curve, and an inverted curve. Our internal policy regarding internal rate risk simulations currently specifies that for instantaneous parallel shifts of the yield curve, estimated net income at risk for the subsequent one- and two-year period should not decline by more than 10% for a 100 basis point shift, 15% for a 200 basis point shift, 20% for a 300 basis point shift, and 25% for a 400 basis point shift. The following tables summarize the simulated change in net interest income over a 12-month horizon as of the dates indicated: The results illustrate that the Bank is asset sensitive and generally performs better in an increasing interest rate environment. The results are primarily due to behavior of demand, money market and savings deposits during such rate fluctuations. We have found that, historically, interest rates on these deposits change more slowly than changes in the discount and federal funds rates. This assumption is incorporated into the simulation model. The assumptions incorporated into the model are inherently uncertain and, as a result, the model cannot precisely measure future net interest income or precisely predict the impact of fluctuations in market interest rates on net interest income. Actual results will differ from the model’s simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and the application and timing of various strategies. Impact of Inflation Our consolidated financial statements and related notes to those financial statements 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.
-0.022076
-0.021598
0
<s>[INST] We are a bank holding company that operates through our wholly owned subsidiary, Coastal Community Bank, or the Bank. We are headquartered in Everett, Washington, which by population is the largest city in, and the county seat of, Snohomish County. We focus on providing a wide range of banking products and services to consumers and small to medium sized businesses in the broader Puget Sound region in the state of Washington. We currently operate 14 fullservice banking locations, 11 of which are located in Snohomish County, where we are the largest community bank by deposit market share, and three of which are located in neighboring counties (one in King County and two in Island County). As of December 31, 2019, we had total assets of $1.129 billion, total gross loans of $939.1 million, total deposits of $968.0 million and total shareholders’ equity of $124.2 million. The following discussion and analysis presents our financial condition and results of operations on a consolidated basis. However, because we conduct all of our material business operations through the Bank, the discussion and analysis relate to activities primarily conducted by the Bank. As a bank holding company that operates through one segment, community banking, we generate most of our revenue from interest on loans and investments. Our primary source of funding for our loans is commercial and retail deposits. We place secondary reliance on wholesale funding, primarily borrowings from the Federal Home Loan Bank (FHLB). Our largest expenses are salaries and related employee benefits, occupancy, interest on deposits and borrowings, data processing, and provision for loan losses. Our principal lending products are commercial real estate loans, commercial and industrial loans, residential real estate loans, construction, land and land development loans, and to a lesser extent consumer loans. Key Factors Affecting our Business Average Balances and Interest Rates Our operating results depend primarily on our net interest income, which is the largest contributor to our net income and is the difference between the interest and fees earned on interestearning assets (such as loans and securities) and the interest expense incurred in connection with interestbearing liabilities (such as deposits and borrowings). Net interest income is primarily a function of the average balances of interestearning assets and interestbearing liabilities and the yields and costs with respect to these assets and liabilities. Average balances are influenced by internal considerations such as the types of products we offer and the amount of risk that we are willing to assume as well as external influences such as economic conditions, competition for loans and deposits, and interest rates. The yields generated by our loans and securities are typically affected by shortterm and longterm interest rates and, in the case of loans, competition for similar products in our market area. Interest rates are often impacted by the actions of the Federal Reserve. The cost of our deposits and shortterm borrowings is primarily based on shortterm interest rates, which are largely driven by competition and by the actions of the Federal Reserve. The level of net interest income is influenced by movements in interest rates and the pace at which such movements occur, as well as the relationship between short and longterm interest rates. Credit Quality We have well established loan policies and underwriting practices that have resulted in low levels of chargeoffs and nonperforming assets. Through our thorough underwriting process, we strive to originate quality loans that will maintain and enhance the overall credit quality of our loan portfolio, and through our careful monitoring of our loan portfolio and prompt attention to delinquencies, we seek to minimize the impact of problem loans. However, credit trends in the markets in which we operate are largely impacted by economic conditions beyond our control and can adversely impact our financial condition. Operating Efficiency The largest component of noninterest expense is salaries and employee benefits. Other significant operating expenses include occupancy expense, data processing expense, director and staff expense, marketing expense, and legal and professional fees. Our operating efficiency, as measured by our efficiency ratio, has gradually improved primarily because the growth of our deposits and loans has enabled our net interest income and noninterest income to outpace our expenses. When we open new branches or make substantial investments to increase our operating capacity, our operating efficiency decreases until we generate enough growth to offset the increased costs however, prior to making such investments, we focus on how best and most [/INST] Negative. </s>
2,020
14,176
1,748,621
Alberton Acquisition Corp
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 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 incorporated on February 16, 2018 under the laws of British Virgin Islands 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 businesses or entities. The Company’s efforts to identify a prospective target business are not limited to a particular industry or geographic location. 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 and operating costs and have had no operations other than identifying and evaluating suitable acquisition transaction candidates. We have relied upon the sale of our securities and loans from our Sponsor to fund our operations. On October 26, 2018, we consummated our IPO of 10,000,000 units. Each unit consists of one Ordinary Share, one redeemable warrant to purchase one-half of one Ordinary Share and one right to receive 1/10 of an Ordinary Share upon the consummation of our initial business combination. The units were sold at an offering price of $10.00 per unit, generating gross proceeds of $100,000,000. The Company granted the underwriters a 45-day option to purchase up to 1,500,000 additional units to cover over-allotments. On October 26, 2018, simultaneously with the consummation of the IPO, we consummated a private placement with our Sponsor of 300,000 private units at a price of $10.00 per private unit, generating total proceeds of $3,000,000. On November 20, 2018, the underwriters exercised the over-allotment option in part and purchased 1,487,992 over-allotment option units at an offering price of $10.00 per unit, generating gross proceeds of $14,879,920. On November 20, 2018, simultaneously with the sale of the over-allotment units, the Company consummated the private sale of an additional 29,760 private units to our Sponsor, generating gross proceeds of $297,600. On November 20, 2018, the underwriters waived its right to exercise the reminder of the over-allotment option. In connection with such wavier, an aggregate of 3,002 founder shares held by our initial shareholders were forfeited. As of December 31, 2018, a total of $114,879,920 of the net proceeds from the IPO (including the partial exercise of the over-allotment option) and the private placements were deposited in a trust account established for the benefit of the Company’s public shareholders. Our management has broad discretion with respect to the specific application of the net proceeds of IPO and the private placements, 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 October 26, 2018 was related to the Company’s formation, the IPO and general and administrative activities. 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 initial business combination. We expect to generate small amounts of non-operating income in the form of interest income on cash and cash equivalents. 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 $341,708. During the year ended December 31, 2018, we incurred $102,685 of formation and operating costs (not charged against shareholders’ equity), consisting mostly of general and administrative expenses, and we recorded $444,156 of interest income from investments in our Trust Account and $62 of interest income from deposits in our corporate bank account. Liquidity and Capital Resources As of December 31, 2018, the Company had cash outside the Trust Account of $452,409 available for working capital needs. All remaining cash was held in the Trust Account and is generally unavailable for our use, prior to an initial Business Combination, and is restricted for use either in a Business Combination or to redeem ordinary shares. As of December 31, 2018, none of the amount on deposit in the Trust Account was available to be withdrawn as described above. Through December 31, 2018, the Company’s liquidity needs were satisfied through receipt of $19,550 from the sale of the insider shares, $300,000 loaned by the Sponsor to the Company under a certain unsecured promissory note, advances from our Sponsor and an affiliate of our sponsor in an aggregate amount of $71,256 which were repaid after the IPO (as described in Note 5), and the net proceeds from the IPO and private placement held outside the trust account. On July 6, 2018, the Sponsor loaned the Company $300,000 pursuant to a non-interest bearing promissory note, which will be repaid promptly after the date on which the Company consummates a Business Combination. Until consummation of its Business Combination, the Company will be using the funds not held in the Trust Account, and any additional funding that may be loaned to us by our Sponsor, for identifying and evaluating prospective acquisition 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 acquire and structuring, negotiating and consummating the Business Combination. If the Company’s estimates of the costs of undertaking in-depth due diligence and negotiating Business Combination is less than the actual amount necessary to do so, the Company may have insufficient funds available to operate its business prior to the Business Combination and will need to raise additional capital. In this event, our officers, directors or their affiliates may, but are not obligated to, loan us funds as may be required. If we consummate an initial business combination, we would repay such loaned amounts. 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. Up to $1,500,000 of such working capital loans may be convertible into units of the post business combination entity at a price of $10.00 per unit at the option of the lender. The terms of such loans by our initial shareholders, officers and directors, if any, have not been determined and no written agreements exist with respect to such loans. 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 Management’s discussion and analysis of our results of operations and liquidity and capital resources are based on our audited financial information. We describe our significant accounting policies in Note 2 - Significant Accounting Policies, of the Notes to Financial Statements included in this report. Our audited financial statements have been prepared in accordance with U.S. GAAP. Certain of our accounting policies require that management apply significant judgments in defining the appropriate assumptions integral to financial estimates. On an ongoing basis, management reviews the accounting policies, assumptions, estimates and judgments to ensure that our financial statements are presented fairly and in accordance with U.S. GAAP. Judgments are based on historical experience, terms of existing contracts, industry trends and information available from outside sources, as appropriate. However, by their nature, judgments are subject to an inherent degree of uncertainty, and, therefore, actual results could differ from our estimates.
-0.009068
-0.00896
0
<s>[INST] Overview We were incorporated on February 16, 2018 under the laws of British Virgin Islands 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 businesses or entities. The Company’s efforts to identify a prospective target business are not limited to a particular industry or geographic location. 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 and operating costs and have had no operations other than identifying and evaluating suitable acquisition transaction candidates. We have relied upon the sale of our securities and loans from our Sponsor to fund our operations. On October 26, 2018, we consummated our IPO of 10,000,000 units. Each unit consists of one Ordinary Share, one redeemable warrant to purchase onehalf of one Ordinary Share and one right to receive 1/10 of an Ordinary Share upon the consummation of our initial business combination. The units were sold at an offering price of $10.00 per unit, generating gross proceeds of $100,000,000. The Company granted the underwriters a 45day option to purchase up to 1,500,000 additional units to cover overallotments. On October 26, 2018, simultaneously with the consummation of the IPO, we consummated a private placement with our Sponsor of 300,000 private units at a price of $10.00 per private unit, generating total proceeds of $3,000,000. On November 20, 2018, the underwriters exercised the overallotment option in part and purchased 1,487,992 overallotment option units at an offering price of $10.00 per unit, generating gross proceeds of $14,879,920. On November 20, 2018, simultaneously with the sale of the overallotment units, the Company consummated the private sale of an additional 29,760 private units to our Sponsor, generating gross proceeds of $297,600. On November 20, 2018, the underwriters waived its right to exercise the reminder of the overallotment option. In connection with such wavier, an aggregate of 3,002 founder shares held by our initial shareholders were forfeited. As of December 31, 2018, a total of $114,879,920 of the net proceeds from the IPO (including the partial exercise of the overallotment option) and the private placements were deposited in a trust account established for the benefit of the Company’s public shareholders. Our management has broad discretion with respect to the specific application of the net proceeds of IPO and the private placements, 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 October 26, 2018 was related to the Company’s formation, the IPO and general and administrative activities. 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 initial business combination. We expect to generate small amounts of nonoperating income in the form of interest income on cash and cash equivalents. 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 $341,708. During the year ended December 31, 2018, we incurred $102,685 of formation and operating costs (not charged against shareholders’ equity), consisting mostly of general and administrative expenses, and we recorded $444,156 of interest income from investments in our Trust Account and $62 of interest income from deposits in our [/INST] Negative. </s>
2,019
1,498
1,748,621
Alberton Acquisition Corp
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 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. We were incorporated on February 16, 2018 under the laws of British Virgin Islands 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 businesses or entities. The Company’s efforts to identify a prospective target business are not limited to a particular industry or geographic location. 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 and operating costs and have had no operations other than identifying and evaluating suitable acquisition transaction candidates. We have relied upon the sale of our securities and loans from Hong Ye Hong Kong Shareholding Co., Limited (our “Sponsor”) to fund our operations. On October 26, 2018, we consummated our initial public offering of 10,000,000 units. Each unit consists of one ordinary share, one redeemable warrant to purchase one-half of one ordinary share and one right to receive 1/10 of an ordinary share upon the consummation of our initial business combination. The units were sold at an offering price of $10.00 per unit, generating gross proceeds of $100,000,000. On October 26, 2018, simultaneously with the consummation of the initial public offering, we consummated a private placement with our Sponsor of 300,000 private units at a price of $10.00 per private unit, generating total proceeds of $3,000,000. On November 20, 2018, the underwriters exercised the over-allotment option in part and purchased 1,487,992 over-allotment option units at an offering price of $10.00 per unit, generating gross proceeds of $14,879,920. On November 20, 2018, simultaneously with the sale of the over-allotment units, the Company consummated the private sale of an additional 29,760 private units to our Sponsor, generating gross proceeds of $297,600. On November 20, 2018, the underwriters waived their right to exercise the reminder of the over-allotment option. In connection with such waiver, an aggregate of 3,002 founder shares held by our initial shareholders were forfeited. A total of $114,879,920 of the net proceeds from the initial public offering (including the partial exercise of the over-allotment option) and the private placements were deposited in a trust account established for the benefit of the Company’s public shareholders. Our management has broad discretion with respect to the specific application of the net proceeds of initial public offering and the private placements, although substantially all of the net proceeds are intended to be applied generally towards consummating a business combination. Recent Developments We initially had until October 25, 2019 to consummate a business combination. However, as we anticipated that we may not be able to consummate a business combination by October 25, 2019, we extended the period of time to consummate a business combination by two extensions, each consisting of additional three months, (for a total of 18 months to complete a business combination) until April 27, 2020. On September 18, 2019, we issued an unsecured promissory note in the amount of $1,148,800 (the “GN Note 1”) to Global Nature Investment Holdings Limited (“Global Nature”) to fund a three-month extension payment and, accordingly, $1,148,799 was deposited into the trust account. GN Note 1 was issued in connection with a non-binding letter of intent entered into by and between Global Nature and us on September 13, 2019, to consummate a potential business combination with Global Nature (the “LOI”). The GN Note 1 is non-interest bearing and is payable on the date on which we consummate our initial business combination with Global Nature or another qualified target company (a “Qualified Business Combination” and such date, the “Maturity Date”), subject to certain mandatory repayment arrangement set forth in the GN Note 1. The principal balance may be prepaid at any time without penalty. Pursuant to the GN Note 1, in the event that the Global Nature notifies us in written that it does not wish to proceed with the Qualified Business Combination (the “Withdrawal Request”), we shall only be obligated to repay the Note, as follows: (i) the full principal amount of the GN Note 1 within 5 business days of such Withdrawal Request if such Withdrawal Request is given on or before September 24, 2019; (ii) 50% of the principal amount of the GN Note 1 within 5 business days of such Withdrawal Request if the Withdrawal Request is given from after September 24, 2019 and on or before October 15, 2019 or the date the subscription amount of this GN Note 1 is transferred into the trust account (whichever is later); (iii) 50% of the principal amount of the GN Note 1 as soon as possible with best efforts but no later than 5 business days after Alberton’s business combination if the Withdrawal Request is given from after October 15, 2019 or the date the subscription amount of this Note is transferred into the trust account (whichever is later); or (iv) the full principal amount of the Note as soon as possible with best efforts but no later than 5 business days after Alberton’s business combination or the date of expiry of the term of Alberton (whichever is earlier), if the parties have not entered into a definitive agreement with regard to the Qualified Business Combination within 45 days from the date of the GN Note 1 as a result of the disagreement on the valuation of the Qualified Business Combination. On March 12, 2020, we received the Withdrawal Request from Global Nature that it did not wish to proceed with the Qualified Business Combination. The parties are in discussion of the repayment of the GN Note 1 which shall be repaid as soon as possible with best efforts but no later than 5 business days after our business combination or the date of expiry of the term of us (whichever is earlier). On December 3, 2019, we, upon receipt of the principal, issued an unsecured promissory note in the aggregate principal amount of $500,000 (the “GN Note 2”, together with GN Note 1, the “GN Notes”) to Global Nature, its registered assignees or successor in interest as working capital. The GN Note 2 is non-interest bearing and is payable on the earlier date of (i) that we consummate a Qualified Business Combination, and (ii) expiry of the term of us. The principal balance may be prepaid prior to the Maturity Date without penalty. Pursuant to the GN Note 2, in the event that (i) the parties do not agree with the valuation of the Qualified Business Combination; (ii) a definitive agreement with regard to the Qualified Business Combination with the Payee is not entered into within 45 days from the date of this GN Note 2; or (iii) the Qualified Business Combination is not consummated for any reason prior to the date of expiry of the term of us, we shall repay the principal amount of the GN Note 2 no later than 5 business days after our initial business combination or the date of expiry of the term of Alberton, whichever is earlier. As a result that the parties did not enter into a definitive agreement within 45 days from the GN Note 2, such note becomes payable no later than 5 business days after our initial business combination or the date of expiry of the term of us. On December 3, 2019, the Company issued an unsecured promissory note (“GN Note 2”) in the aggregate principal amount of $500,000 to Global Nature. The GN Note 2 was issued in order to fund our working capital needs. On January 23, 2020, we deposited $1,148,800 into the trust account to extend the time available for us to complete a business combination from January 24, 2020 to April 27, 2020. The extension deposit was partially funded from a $780,000 loan provided by the Sponsor and partially from a $368,800 from our working capital. In connection with the loan provided by the Sponsor, we issued a promissory note (the “Sponsor Note”) to the Sponsor in the aggregate principal amount of $780,000. The Sponsor Note is non-interest bearing and is payable on the date on which we consummate our initial business combination. The sponsor, however, has the right to convert the Sponsor Note, in whole or in part, into our private units, as described in the public offering prospectus we filed with the Securities and Exchange Commission on October 24, 2018, file No. 333-227652. As of the date of this report, we have not entered into any definitive agreements, for the purpose of acquiring, engaging in a share exchange, share reconstruction and amalgamation with, purchasing all or substantially all of the assets of, entering into contractual arrangements with, or engaging in any other similar business combination with one or more businesses or entities. Our board has decided to seek shareholders’ approval to amend our current charter to extend the time we need to consummate an initial business combination after April 27, 2020 and provide public shareholder the opportunity to redeem their public shares in connection with such amendment and extension. Results of Operations Our entire activity from inception up to October 26, 2018 was related to the Company’s formation, the initial public offering and general and administrative activities. Since 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 generate non-operating income in the form of interest income on investments. 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 $2,090,361, consisting of $2,572,276 of interest income from investments in our trust account and $2,193 of interest income from deposits in our corporate bank account, offset by $484,108 of operating costs, consisting mostly of general and administrative expenses. For the year ended December 31, 2018, we had a net income of $341,708, consisting of $444,218 of interest income from investments in our trust account and $175 from the reversal of a trust fee, offset by $102,685 of operating costs, consisting mostly of general and administrative expenses. Liquidity and Capital Resources For the year ended December 31, 2019, cash used in operating activities was $475,255. As of December 31, 2019, we had cash outside the trust account of $477,154 available for working capital needs. All remaining cash is held in the trust account and is generally unavailable for our use, prior to an initial business combination, and is restricted for use either in a business combination or to redeem ordinary shares. As of December 31, 2019, none of the amount on deposit in the trust account was available to be withdrawn as described above. Until consummation of the business combination, we will be using the funds not held in the trust account, and any additional funding that may be loaned to us by our Sponsor, for identifying and evaluating prospective acquisition 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 acquire and structuring, negotiating and consummating the business combination. If our estimates of the costs of undertaking in-depth due diligence and negotiating business combination are less than the actual amount necessary to do so, we may have insufficient funds available to operate its business prior to the business combination and will need to raise additional capital. In this event, our officers, directors or their affiliates may, but are not obligated to, loan us funds as may be required. If we consummate an initial business combination, we would repay such loaned amounts out of the proceeds of the trust account released to us upon consummation of the business combination, or, at the lender’s discretion, up to $1,500,000 of such loans may be convertible into units of the post business combination entity at a price of $10.00 per unit. 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. The terms of such loans by our initial shareholders, officers and directors, if any, have not been determined and no written agreements exist with respect to such loans. 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. Going Concern 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 27, 2020. 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 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 the Sponsor a monthly fee of $1,000 for general and administrative services including office space, utilities and secretarial support. We began incurring these fees on August 1, 2018 and will continue to incur these fees monthly until the earlier of the completion of the business combination or our liquidation. The underwriters are entitled to a deferred underwriting discounts and commissions equal to 3.5% of the gross proceeds of the initial public offering. Upon completion of the business combination, $4,020,797 (with consideration of the underwriters’ exercise of their over-allotment option on November 20, 2018) will be paid to the underwriters from the funds held in the trust account. No discounts or commissions will be paid with respect to the purchase of the private units. Critical Accounting Policies The preparation of the 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 not identified any critical accounting policies. Recent accounting standards 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.
0.056427
0.056522
0
<s>[INST] We were incorporated on February 16, 2018 under the laws of British Virgin Islands 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 businesses or entities. The Company’s efforts to identify a prospective target business are not limited to a particular industry or geographic location. 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 and operating costs and have had no operations other than identifying and evaluating suitable acquisition transaction candidates. We have relied upon the sale of our securities and loans from Hong Ye Hong Kong Shareholding Co., Limited (our “Sponsor”) to fund our operations. On October 26, 2018, we consummated our initial public offering of 10,000,000 units. Each unit consists of one ordinary share, one redeemable warrant to purchase onehalf of one ordinary share and one right to receive 1/10 of an ordinary share upon the consummation of our initial business combination. The units were sold at an offering price of $10.00 per unit, generating gross proceeds of $100,000,000. On October 26, 2018, simultaneously with the consummation of the initial public offering, we consummated a private placement with our Sponsor of 300,000 private units at a price of $10.00 per private unit, generating total proceeds of $3,000,000. On November 20, 2018, the underwriters exercised the overallotment option in part and purchased 1,487,992 overallotment option units at an offering price of $10.00 per unit, generating gross proceeds of $14,879,920. On November 20, 2018, simultaneously with the sale of the overallotment units, the Company consummated the private sale of an additional 29,760 private units to our Sponsor, generating gross proceeds of $297,600. On November 20, 2018, the underwriters waived their right to exercise the reminder of the overallotment option. In connection with such waiver, an aggregate of 3,002 founder shares held by our initial shareholders were forfeited. A total of $114,879,920 of the net proceeds from the initial public offering (including the partial exercise of the overallotment option) and the private placements were deposited in a trust account established for the benefit of the Company’s public shareholders. Our management has broad discretion with respect to the specific application of the net proceeds of initial public offering and the private placements, although substantially all of the net proceeds are intended to be applied generally towards consummating a business combination. Recent Developments We initially had until October 25, 2019 to consummate a business combination. However, as we anticipated that we may not be able to consummate a business combination by October 25, 2019, we extended the period of time to consummate a business combination by two extensions, each consisting of additional three months, (for a total of 18 months to complete a business combination) until April 27, 2020. On September 18, 2019, we issued an unsecured promissory note in the amount of $1,148,800 (the “GN Note 1”) to Global Nature Investment Holdings Limited (“Global Nature”) to fund a threemonth extension payment and, accordingly, $1,148,799 was deposited into the trust account. GN Note 1 was issued in connection with a nonbinding letter of intent entered into by and between Global Nature and us on September 13, 2019, to consummate a potential business combination with Global Nature (the “LOI”). The GN Note 1 is noninterest bearing and is payable on the date on which we consummate our initial business combination with Global Nature or another qualified target company (a “Qualified Business Combination” and such date, the “Maturity Date”), subject to certain mand [/INST] Positive. </s>
2,020
2,674
1,418,100
Avaya Holdings Corp.
2018-12-21
2018-09-30
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” should be read in conjunction with the Consolidated Financial Statements and related notes thereto included in Part II, Item 8 of this Annual Report on Form 10-K. The matters discussed in "Management’s Discussion and Analysis of Financial Condition and Results of Operations” contain certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve significant risks and uncertainties. See the "Cautionary Note Regarding Forward-looking Statements" above and Part 1, Item 1A, "Risk Factors" in this Annual Report on Form 10-K for additional information regarding forward-looking statements and the factors that could cause actual results to differ materially from those anticipated in the forward-looking statements. Overview Avaya is a global leader in digital communications products, solutions and services for businesses of all sizes. We enable organizations around the globe to succeed by creating intelligent communications experiences for customers and employees. Avaya builds open, converged and innovative solutions to enhance and simplify communications and collaboration in the cloud, on-premises or a hybrid of both. Our global, experienced team of professionals delivers award-winning services from initial planning and design, to seamless implementation and integration, to ongoing managed operations, optimization, training and support. As of September 30, 2018, we had a presence in approximately 180 countries worldwide and during the past three fiscal years we served more than 90% of the Fortune 100 organizations. Our business has two operating segments: Products & Solutions and Services. Products & Solutions Products & Solutions encompasses our unified communications and contact center platforms, applications and devices. Unified Communications: Avaya unifies communications, helping companies increase employee productivity, improve customer service and reduce costs. Avaya embeds communications directly into the applications, browsers and devices employees use every day to create a single, powerful gateway for voice, video, messaging, conferencing and collaboration. We give people a more natural, efficient, and flexible way to connect, engage, respond, and share - where and how they want - for better business results. Avaya offers an open, extensible development platform, so that customers and third parties can easily create custom applications and automated workflows for their unique needs, integrating Avaya’s capabilities into the customer's existing infrastructure and business applications. Contact Center: Avaya’s industry-leading omnichannel contact center solutions enable customers to build a customized portfolio of applications, driving stronger customer engagement and higher customer lifetime value. Our reliable, secure and scalable communications solutions include voice, email, chat, social media, video, performance management and ease of third-party integration that can improve customer service and help companies compete more effectively. Avaya also focuses on ensuring an outstanding experience for mobile callers, because we integrate transformative technologies, including Artificial Intelligence ("AI"), big data analytics, and cybersecurity into our contact center solutions. As organizations use these solutions to gain a deeper understanding of their customer needs, we believe that their teams become more efficient and effective and their customer loyalty grows. Both segments are supported by our portfolio of innovative business phones and multimedia devices, which is one of the broadest in the industry. Avaya brings consumer technology to the employee desktop in a way that can help our customers enhance customer service, internal and external collaboration, and employee productivity. Customers experience seamless audio and video capabilities for both Avaya and approved third-party Unified Communications (or "UC") platforms via open Session Initiation Protocol ("SIP") devices. SIP is used for signaling and controlling multi-media communication sessions in applications of Internet telephony for voice and video calls, along with integration with numerous apps that help connect and accelerate business. Developers can easily customize capabilities for their specific needs with our client Software Development Kit ("SDK"). Services Avaya Services consists of three business areas: Global Support Services, Enterprise Cloud and Managed Services and Professional Services. Together, these comprehensive services enable clients to leverage communications technology to help them maximize their business results. Our global, experienced team of experts delivers award-winning services from initial planning and design, to seamless implementation and integration, to ongoing managed operations, optimization, training and support. We help our customers use communications to minimize the risk of outages, enable employee productivity and deliver a differentiated customer experience. Our services teams also help our clients transition at their desired pace to next generation communications technology solutions, either via the cloud, on-premises, or a hybrid of both. Customers can choose various levels of support for their communications solutions, including deployment, training, monitoring, troubleshooting and optimization, and more. Our proactive, preventative system performance monitoring can quickly identify and resolve issues. Remote diagnostics and resolutions rapidly fix existing problems and avoid potential issues, helping our customers to save time and reducing the risk of an outage. • Global Support Services feature offerings that address the risk of system outages and also help businesses protect their technology investments. We help our customers maintain their competitiveness through proactive problem prevention, rapid resolution and continual solution optimization. The majority of our revenue in this business is recurring in nature. • Enterprise Cloud and Managed Services enables customers to take advantage of our technology via the cloud, on-premises, or a hybrid of both, depending on the solution and the needs of the customer. The majority of our revenue in this business is recurring in nature and based on multi-year services contracts. • Professional Services enable businesses worldwide to take full advantage of their solution investments to drive measurable business results. Our expert consultants and experienced engineers work with clients as a strategic partner along each step of the solution lifecycle to deliver services that drive business transformation and expand ongoing value. The majority of our revenue in this business is one-time in nature. Effective September 30, 2018, the Company changed the name of its Global Communications Solutions (“GCS”) and Avaya Global Services (“AGS”) segments to "Products & Solutions" and "Services," respectively. These were name changes only and did not have an impact on the operating results of each segment. Avaya also previously had a Networking business, which was sold on July 14, 2017. Recent Developments Spoken Acquisition On March 9, 2018, the Company acquired Intellisist, Inc. (“Spoken”), a United States-based private technology company, which provides cloud-based Contact Center as a Service ("CCaaS") solutions and customer experience management and automation applications. The total purchase price was $172 million, consisting of $157 million in cash, $14 million in contingent consideration and a $1 million settlement of Spoken’s net payable to the Company. Prior to the acquisition, the Company and Spoken had been working in a co-development partnership for more than a year pursuant to which the Company had recorded a net receivable from Spoken for services provided. Spoken became a wholly-owned subsidiary of the Company on March 9, 2018. Spoken’s revenue and operating loss included in the Company’s results for the period from the transaction date through September 30, 2018 (Successor) was $8 million and $31 million, respectively, including $7 million of compensation expense for the accelerated vesting of certain Spoken stock option awards and $7 million of amortization for acquired technology intangible assets. Emergence from Bankruptcy On January 19, 2017 (the "Petition Date"), Avaya Holdings Corp., together with certain of its affiliates (collectively, the "Debtors"), filed voluntary petitions for relief (the "Bankruptcy Filing") under Chapter 11 of the United States Bankruptcy Code (the "Bankruptcy Code") in the United States Bankruptcy Court for the Southern District of New York (the "Bankruptcy Court"). On November 28, 2017, the Bankruptcy Court entered an order confirming the Second Amended Joint Plan of Reorganization filed by the Debtors on October 24, 2017 (the "Plan of Reorganization"). On December 15, 2017 (the "Emergence Date"), the Plan of Reorganization became effective and the Debtors emerged from bankruptcy. In accordance with the Plan of Reorganization, the following significant transactions occurred on the Emergence Date: • The Company paid in full amounts outstanding under the debtor-in-possession credit agreement (the "DIP Credit Agreement"); • The Debtors' obligations under stock certificates, equity interests, and/or any other instrument or document directly or indirectly evidencing or creating any indebtedness or obligation of, or ownership interest in, the Debtors or giving rise to any claim or equity interest were canceled, except as provided under the Plan of Reorganization and as noted below; • The Company's certificate of incorporation was amended and restated to authorize the issuance of 605.0 million shares of stock, consisting of 55.0 million shares of preferred stock, par value $0.01 per share, and 550.0 million shares of common stock, par value $0.01 per share; • The Company entered into a term loan credit agreement (the "Term Loan Credit Agreement") with a principal amount of $2,925 million and a $300 million asset-based revolving credit facility (the "ABL Credit Agreement"); • The Company issued 99.3 million shares of common stock to the holders of the Predecessor's first lien obligations that were extinguished in the bankruptcy. In addition, these holders received $2,061 million in cash; • The Company issued 4.4 million shares of common stock to the holders of the Predecessor's second lien obligations that were extinguished in the bankruptcy. In addition, these holders received warrants to purchase 5.6 million shares of common stock at an exercise price of $25.55 per warrant (the "Emergence Date Warrants"); • The Company issued 6.1 million shares of common stock to the Pension Benefit Guaranty Corporation ("PBGC"). In addition, the PBGC received $340 million in cash; and • The Debtors established a liquidating trust in the amount of $58 million for the benefit of general unsecured creditors. In addition, the Company issued 0.2 million additional shares of common stock for the benefit of its former general unsecured creditors. The general unsecured creditors will receive a total of $58 million in cash and these shares of common stock. Any excess cash and/or common stock not distributed to the general unsecured creditors will be distributed to the holders of the Predecessor first lien obligations. Beginning on the Emergence Date, the Company applied fresh start accounting, which resulted in a new basis of accounting and the Company becoming a new entity for financial reporting purposes. As a result of the application of fresh start accounting and the effects of the implementation of the Plan of Reorganization, the consolidated financial statements after December 15, 2017 are not comparable with the consolidated financial statements on or prior to that date. Refer to Note 5, "Fresh Start Accounting," to our Consolidated Financial Statements for further details. Factors and Trends Affecting Our Results of Operations There are a number of trends and uncertainties affecting our business. For example, we are dependent on general economic conditions and the willingness of our customers to invest in technology. In addition, instability in the geopolitical environment of our customers, instability in the global credit markets and other disruptions put pressure on the global economy causing uncertainties. We are also affected by the impact of foreign currency exchange rates on our business. We believe these uncertainties have impacted our customers’ willingness to spend on IT and the manner in which they procure such technologies and services. This includes delays or rejection of capital projects, including the implementation of our products and services. In addition, as further explained below, we believe there is a growing market trend around cloud consumption preferences with more customers exploring operating expense and subscription-based models as opposed to capital expenditure (“CapEx”) models for procuring technology. As a result of a growing market trend preferring cloud consumption, more customers are exploring subscription and pay-per-use based models, rather than CapEx models, for procuring technology. The shift to subscription and pay-per-use models enables customers to manage costs and efficiencies by paying a subscription or a per minute or per message fee for business communications services rather than purchasing the underlying products and services, infrastructure and personnel, which are owned and managed by the equipment vendor or a cloud and managed services provider. We believe the market trend toward these flexible consumption models will continue as we see an increasing number of opportunities and requests for proposals based on subscription and pay-per-use models. This trend has driven an increase in the proportion of total Company revenues attributable to software and services. In addition, we believe customers are moving away from owned and operated infrastructure, preferring cloud offerings and virtualized server defined networks, which reduce our associated maintenance support opportunities. We continue to evolve into a software and services business and focus our go-to-market efforts by introducing new solutions and innovations, particularly on workflow automation, multi-channel customer engagement and cloud-enabled communications applications. The Company is focused on growing products and services with a recurring revenue stream. Recurring revenue includes products and services that are delivered pursuant to multi-period contracts including revenue recurring from sales of software, maintenance, and Cloud and Avaya private cloud services, which was recently renamed Enterprise Cloud and Managed Services. Despite the benefits of a robust indirect channel, which include expanding our sales reach, our channel partners have direct contact with our customers that may foster independent relationships between them and a loss of certain services agreements for us. We have been able to offset these impacts by focusing on utilizing partners in a sales agent relationship, whereby partners perform selling activities but the contract remains with Avaya. We are also offering higher-value services in support of our software offerings, such as professional services and cloud-managed services, which are not traditionally provided by our channel partners. The Company has maintained its focus on profitability levels and investing in future results. As the Company continues its transformation to a software and service-led organization, it has implemented programs designed to streamline its operations, generate cost savings and eliminate overlapping processes and resources. These cost savings programs include: (1) reducing headcount, (2) eliminating real estate costs associated with unused or under-utilized facilities and (3) implementing gross margin improvement and other cost reduction initiatives. The Company continues to evaluate opportunities to streamline its operations and identify cost savings globally and may take additional restructuring actions in the future. The costs of those actions could be material. Financial Results Summary Our financial results for the period from October 1, 2017 through December 15, 2017 and for fiscal 2017 and 2016 are referred to as those of the “Predecessor” period. Our financial results for the period from December 16, 2017 through September 30, 2018 are referred to as those of the “Successor” period. Our results of operations as reported in our Consolidated Financial Statements for these periods are prepared in accordance with GAAP. Although GAAP requires that we report on our results for the period from October 1, 2017 through December 15, 2017 and the period from December 16, 2017 through September 30, 2018 separately, management views the Company’s operating results for the fiscal year ended September 30, 2018 by combining the results of the applicable Predecessor and Successor periods because such presentation provides the most meaningful comparison of our results to prior periods. The Company cannot adequately benchmark the operating results of the period from December 16, 2017 through September 30, 2018 against any of the previous periods reported in its Consolidated Financial Statements without combining it with the period from October 1, 2017 through December 15, 2017 and does not believe that reviewing the results of this period in isolation would be useful in identifying any trends in or reaching any conclusions regarding the Company’s overall operating performance. Management believes that the key performance metrics such as revenue, gross margin and operating (loss) income for the Successor period when combined with the Predecessor period provides more meaningful comparisons to other periods and are useful in identifying current business trends. Accordingly, in addition to presenting our results of operations as reported in our Consolidated Financial Statements in accordance with GAAP, the table and discussion below also presents the combined results for the fiscal year ended September 30, 2018. The combined results for the fiscal year ended September 30, 2018, which we refer to herein as results for "fiscal 2018," represent the sum of the reported amounts for the Predecessor period from October 1, 2017 through December 15, 2017 and the Successor period from December 16, 2017 through September 30, 2018. These combined results are not considered to be prepared in accordance with GAAP and have not been prepared as pro forma results under applicable regulations. The combined operating results may not reflect the actual results we would have achieved absent our emergence from bankruptcy and may not be indicative of future results. The following table displays our consolidated net income (loss) for the periods indicated: The following table displays the impact of the fair value adjustments resulting from fresh start accounting (See Note 5, "Fresh Start Accounting," to our Consolidated Financial Statements), excluding those related to the amortization of intangible assets, on the Company's operating loss for the period indicated: Fiscal Year Ended September 30, 2018 Combined Results Compared with Fiscal Year Ended September 30, 2017 Revenue Revenue for fiscal 2018 was $2,851 million compared to $3,272 million for fiscal 2017. The decrease was primarily the result of the recognition of deferred revenue at fair value upon emergence from bankruptcy, which resulted in lower revenue in subsequent periods; the sale of the Networking business in July 2017; and lower demand for the Company's unified communications products and maintenance services mainly due to extended procurement cycles resulting from the Bankruptcy Filing. The lower demand for our products in prior periods also contributed, in part, to lower maintenance services revenue for fiscal 2018. The decrease was partially offset by higher contact center professional services sales; the favorable impact of foreign currency exchange rates; and incremental revenue from the Spoken acquisition. The following table displays revenue and the percentage of revenue to total sales by operating segment for the periods indicated: (1) Not meaningful Products & Solutions revenue for fiscal 2018 was $1,305 million compared to $1,297 million for fiscal 2017. The increase was primarily attributable to the favorable impact of foreign currency exchange rates and incremental revenue from the Spoken acquisition, partially offset by lower unified communications revenue. Networking revenue for fiscal 2017 was $140 million. The Networking business was sold to Extreme in July 2017. Services revenue for fiscal 2018 was $1,752 million compared to $1,835 million for fiscal 2017. The decrease was primarily due to lower maintenance services revenue and the sale of the Networking business, partially offset by the favorable impact of foreign currency exchange rates and higher contact center professional services sales. Unallocated amounts for fiscal 2018 represent the fair value adjustment to deferred revenue recognized upon emergence from bankruptcy and excluded from segment revenue. The following table displays revenue and the percentage of revenue to total sales by location for the periods indicated: Revenue in the U.S. for fiscal 2018 was $1,515 million compared to $1,798 million for fiscal 2017. The decrease in U.S. revenue was primarily attributable to the recognition of deferred revenue at fair value upon emergence from bankruptcy, which results in lower revenue in subsequent periods; the impact of the sale of the Networking business in July 2017; a decrease in maintenance services revenue; and lower sales of unified communications and contact center products, partially offset by incremental revenue from the Spoken acquisition. Revenue in Europe, Middle East and Africa ("EMEA") for fiscal 2018 was $769 million compared to $834 million for fiscal 2017. The decrease in EMEA revenue was primarily attributable to the impact of the sale of the Networking business and the recognition of deferred revenue at fair value upon emergence from bankruptcy, partially offset by an increase in demand for our unified communications products and the favorable impact of foreign currency exchange rates. Revenue in Asia Pacific ("APAC") for fiscal 2018 was $313 million compared to $334 million for fiscal 2017. The decrease in APAC revenue was primarily attributable to the impact of the sale of the Networking business and the recognition of deferred revenue at fair value upon emergence from bankruptcy, partially offset by higher sales of unified communications products and the favorable impact of foreign currency exchange rates. Revenue in Americas International for fiscal 2018 was $254 million compared to $306 million for fiscal 2017. The decrease in Americas International revenue was primarily attributable to the sale of the Networking business; the recognition of deferred revenue at fair value upon emergence from bankruptcy; and lower sales of unified communications products, partially offset by the favorable impact of foreign currency exchange rates. We sell our products both directly to end users and through an indirect sales channel. The following table provides a comparison of each for the periods indicated: Gross Profit The following table sets forth gross profit and gross margin by operating segment for the periods indicated: (1) Not meaningful Gross profit for fiscal 2018 was $1,505 million compared to $2,008 million for fiscal 2017. The decrease was primarily attributable to the impact of applying fresh start accounting upon emergence from bankruptcy, including the effect of the recognition of deferred revenue at fair value, which resulted in lower revenue in subsequent periods, and the amortization of technology intangibles with higher asset values; the sale of the Networking business in July 2017; a decrease in sales of maintenance services; incremental amortization of technology intangibles acquired from the Spoken acquisition; and lower sales of unified communications products, partially offset by an increase in professional services and cloud services gross profit and the favorable impact of foreign currency exchange rates. Products & Solutions gross profit for fiscal 2018 was $865 million compared to $890 million for fiscal 2017. The decrease was attributable to lower sales of unified communications products, partially offset by the favorable impact of foreign currency exchange rates. Networking gross profit for fiscal 2017 was $48 million. The Networking business was sold to Extreme in July 2017. Services gross profit for fiscal 2018 was $1,039 million compared to $1,091 million for fiscal 2017. The decrease in Services gross profit was due to a decrease in sales of maintenance services and the sale of the Networking business, partially offset by an increase in professional services and cloud services gross profit and the favorable impact of foreign currency exchange rates. Unallocated amounts for fiscal 2018 include the fair value adjustments recognized upon emergence from bankruptcy and excluded from segment gross profit; the effect of the amortization of technology intangibles; and costs that are not core to the measurement of segment performance, but rather are controlled at the corporate level. Unallocated amounts for fiscal 2017 included the effect of the amortization of technology intangibles and costs that are not core to the measurement of segment performance, but rather controlled at the corporate level. Operating Expenses The following table sets forth operating expenses and the percentage of operating expenses to total revenue for the periods indicated: Selling, general and administrative expenses for fiscal 2018 were $1,152 million compared to $1,261 million for fiscal 2017. The decrease was primarily attributable to advisory fees incurred in the prior year period to assist in the assessment of strategic and financial alternatives to improve the Company's capital structure; expenses associated with the Networking business that was sold in July 2017; costs incurred in connection with certain legal matters; and the impact of fresh start accounting, partially offset by the unfavorable impact of foreign currency exchange rates and Spoken acquisition-related costs. The impact of applying fresh start accounting resulted in additional depreciation expense as property, plant and equipment was recorded at fair value, resulting in higher asset values; and lower sales commission expense due to the recognition of deferred revenue at fair value, which resulted in lower revenue and sales commission expense in subsequent periods. Research and development expenses for fiscal 2018 were $210 million compared to $225 million for fiscal 2017. The decrease was primarily attributable to expenses associated with the Networking business that was sold in July 2017, partially offset by higher depreciation expense due to the impact of applying fresh start accounting as described above; the unfavorable impact of foreign currency exchange rates; and research and development costs associated with the Spoken acquisition in March 2018. Amortization of intangible assets for fiscal 2018 was $137 million compared to $204 million for fiscal 2017. The carrying value of intangible assets was adjusted upon the application of fresh start accounting resulting in higher asset values and longer remaining useful lives. Impairment of indefinite-lived intangible assets for fiscal 2017 was $65 million. Due to the Company filing for bankruptcy and also experiencing a decline in revenues, a revision of its five year forecast was completed in the quarter ended June 30, 2017. Due to the decline in revenue in the five year forecast, the Company tested its intangible assets with indefinite lives and other long-lived assets for impairment. The Company estimated the fair values of its indefinite-lived intangible assets using the royalty savings method, which values an asset by estimating the royalties saved through ownership of the asset. As a result of the impairment test, the Company estimated the fair value of its trademarks and trade names to be $190 million as compared to a carrying amount of $255 million and recorded the impairment charge of $65 million. There was no such impairment in fiscal 2018. Goodwill impairment for fiscal 2017 was $52 million. As a result of the sale of certain assets and liabilities of the Company's Networking business to Extreme in July 2017, it was determined that the fair value of the Networking services component was less than its carrying value. As a result, the Company recorded a goodwill impairment charge of $52 million. No goodwill impairments have been recognized in fiscal 2018. Restructuring charges, net, for fiscal 2018 were $95 million compared to $30 million for fiscal 2017. Restructuring charges recorded during fiscal 2018 included employee separation costs of $83 million primarily associated with employee severance actions in EMEA and the U.S. and lease obligations of $12 million primarily in the U.S. and EMEA. Restructuring charges recorded during fiscal 2017 included employee separation costs of $21 million primarily associated with employee severance actions in the U.S. and EMEA and lease obligations of $9 million, primarily in EMEA. Operating (Loss) Income Operating loss for fiscal 2018 was $89 million compared to operating income of $171 million for fiscal 2017. Our operating results for fiscal 2018 as compared to fiscal 2017 reflect, among other things: • the impact of applying fresh start accounting upon emergence from bankruptcy on December 15, 2017; • impairment charges for indefinite-lived intangible assets and goodwill recognized during fiscal 2017; • higher restructuring charges for fiscal 2018, primarily related to employee separation charges and lease termination agreements associated with vacated facilities particularly in Europe and the U.S.; • lower advisory fees incurred to assist in the assessment of strategic and financial alternatives to improve the Company’s capital structure during fiscal 2018 of $62 million; • costs incurred in connection with certain legal matters of $37 million for fiscal 2018; • operating results from the Networking business for fiscal 2017; and • operating results from the Spoken acquisition completed in March 2018. Interest Expense Interest expense for fiscal 2018 was $183 million compared to $246 million for fiscal 2017. Fiscal 2017 included non-cash interest expense of $61 million related to the accelerated amortization of debt issuance costs and accretion of debt discount. Our Bankruptcy Filing, which constituted an event of default under our Predecessor first lien obligations and Predecessor second lien obligations, accelerated the Company's payment obligations under those instruments. Consequently, all debt outstanding under our Predecessor first lien obligations and Predecessor second lien obligations were classified as Liabilities subject to compromise, and related unamortized deferred financing costs and debt discounts in the amount of $61 million were expensed during fiscal 2017. Effective January 19, 2017, the Company ceased recording interest expense on outstanding pre-petition debt classified as Liabilities subject to compromise. Contractual interest expense represented amounts due under the contractual terms of outstanding debt, including debt classified as Liabilities subject to compromise. For the period from October 1, 2017 through December 15, 2017 and the period from January 19, 2017 through September 30, 2017, contractual interest expense of $94 million and $316 million, respectively, was not recorded as interest expense, as it was not an allowed claim under the Bankruptcy Filing. Contractual interest expense recorded for fiscal 2018 and 2017 was $175 million and $185 million, respectively, a decrease of $10 million. Other Income (Expense), Net Other income, net for fiscal 2018 was $33 million as compared to other expense, net of $25 million for fiscal 2017. Other income, net for fiscal 2018 included net foreign currency gains of $28 million, principally due to the strengthening of the U.S. dollar compared to certain foreign exchange rates on U.S. dollar denominated receivables maintained in non-U.S. locations, mainly Argentina, India and Mexico; income from a transition services agreement entered into in connection with the sale of the Networking business to Extreme (the "TSA") of $8 million; interest income of $7 million; other pension and post-retirement benefit credits of $5 million; and other, net of $2 million, partially offset by a loss due to the change in fair value of the Emergence Date Warrants of $17 million. Other expense, net for fiscal 2017 included other pension and post-retirement benefit costs of $34 million and other, net of $2 million, partially offset by interest income of $4 million; income from the TSA with Extreme of $3 million; a gain on the sale of the Networking business of $2 million; and net foreign currency gains of $2 million. As a result of adopting Financial Accounting Standards Board ("FASB") Accounting Standards Update ("ASU") No. 2017-07, "Improving the Presentation of Net Periodic Pension Cost and Net Periodic Post-retirement Benefit Cost," the Company reclassified $34 million of other pension and post-retirement benefit costs to Other expense, net for fiscal 2017. For fiscal 2018, the Company recorded $5 million of other pension and post-retirement benefit credits in Other income, net. Reorganization Items, Net Reorganization items, net for fiscal 2018 and 2017 were $3,416 million and $(98) million, respectively. Reorganization items, net for fiscal 2018 primarily consists of the net gain from the consummation of the Plan of Reorganization and the related settlement of liabilities. Reorganization items, net for fiscal 2018 and 2017 also include amounts incurred subsequent to the Bankruptcy Filing as a direct result of the Bankruptcy Filing and are comprised of professional service fees and contract rejection fees. See Note 4, "Emergence from Voluntary Reorganization under Chapter 11 Proceedings," and Note 5, "Fresh Start Accounting," for additional information. Benefit from (Provision for) Income Taxes The benefit from income taxes was $87 million for fiscal 2018 compared with a benefit from income taxes of $16 million for fiscal 2017. The Company’s effective income tax rate for fiscal 2018 differed from the U.S. federal tax rate primarily due to: (1) the effect of tax rate differentials on foreign income/loss, (2) losses generated within certain foreign jurisdictions for which no benefit was recorded because it is more likely than not that the tax benefits would not be realized, (3) non-U.S. withholding taxes on foreign earnings, (4) current period changes to unrecognized tax positions, (5) U.S. state and local income taxes, (6) the impact of the Tax Cuts and Jobs Act, (7) the impact of reorganization and fresh start adjustments, and (8) the utilization and recognition of previously unrecognized tax net operating losses, and the reversal of deferred tax liabilities, associated with the centralization of the management and ownership of certain intellectual property. The Company’s effective income tax rate for fiscal 2017 differed from the U.S. federal tax rate primarily due to: (1) the effect of tax rate differentials on foreign income/loss, (2) changes in the valuation allowance established against the Company’s deferred tax assets, (3) tax positions taken during the year offset by reductions for unrecognized tax benefits resulting from the lapse of statute of limitations and the completion of income tax examinations, (4) the non-deductible portion of goodwill impairment, (5) the non-deductible portion of the loss on the sale of Networking business assets, (6) the non-deductible portion of reorganization items, (7) the effect of enacted changes in tax laws, and (8) the recognition of income tax benefits as a result of net gains in other comprehensive income. Net Income (Loss) Net income was $3,264 million for fiscal 2018 compared to a net loss of $182 million for fiscal 2017, primarily due to the reorganization gain of $3,416 million resulting from our emergence from bankruptcy and the items discussed above. Fiscal Year Ended September 30, 2017 Results Compared with Fiscal Year Ended September 30, 2016 Revenue Revenue for fiscal 2017 and 2016 was $3,272 million and $3,702 million, respectively, a decrease of $430 million or 12%. The following table displays revenue and the percentage of revenue to total sales by operating segment: (1) Networking business was sold on July 14, 2017; therefore, the Company recognized no revenue after the date of sale. Products & Solutions revenue for fiscal 2017 and 2016 was $1,297 million and $1,536 million, respectively, a decrease of $239 million or 16%. The decrease was primarily attributable to uncertainties that had an impact on our customers’ buying decisions as we saw ongoing procurement slowdowns and extended procurement cycles resulting from the Bankruptcy Filing. As a result, there was a lower demand for endpoints, gateways, Nortel and Tenovis products, SME Telephony products and servers. Networking revenue for fiscal 2017 and 2016 was $140 million and $219 million, respectively, a decrease of $79 million or 36%. The decrease in Networking revenue was primarily attributable to the sale of certain assets and liabilities of the Company’s Networking segment in July 2017 to Extreme. Prior to the sale, there was a lower demand for our products in the U.S., partially offset by greater demand for our products in EMEA. Services revenue for fiscal 2017 and 2016 was $1,835 million and $1,947 million, respectively, a decrease of $112 million or 6%. The decrease was primarily due to lower maintenance services revenues as a result of the lower product sales discussed above and lower professional services revenue. The following table displays revenue and the percentage of revenue to total sales by location: Revenue in the U.S. for fiscal 2017 and 2016 was $1,798 million and $2,072 million, respectively, a decrease of $274 million or 13%. This decrease was primarily attributable to lower sales of unified communications products, including endpoints, SME Telephony, and gateways; networking products; and contact center products, in addition to decreased global shared services revenue. Revenue in EMEA for fiscal 2017 and 2016 was $834 million and $880 million, respectively, a decrease of $46 million or 5%. The decrease in EMEA revenue was primarily attributable to lower sales of unified communication and networking products, and an unfavorable impact of foreign currency. Revenue in APAC for fiscal 2017 and 2016 was $334 million and $416 million, respectively, a decrease of $82 million or 20%. The decrease in APAC revenue was primarily attributable to lower sales of unified communications, principally endpoints, gateways, Aura CM, video and SME Telephony, and contact center products. Revenue in Americas International for fiscal 2017 and 2016 was $306 million and $334 million, respectively, a decrease of $28 million or 8%. The decrease in Americas International revenue was primarily attributable to lower sales of endpoints and gateways, and contact center and networking products, partially offset by increased demand for APCS and the favorable impact of foreign currency. We sell our products directly to end users and through an indirect sales channel. The following table provides a comparison of each for the periods indicated: Gross Profit The following table sets forth gross profit and gross margin by operating segment: (1) Not meaningful Gross profit for fiscal 2017 and 2016 was $2,008 million and $2,258 million, respectively, a decrease of $250 million or 11%. The decrease was attributable to the decrease in sales volume, partially offset by the success of our gross margin improvement initiatives and favorable pricing. Our gross margin improvement initiatives included exiting facilities, reducing the workforce, productivity improvements and obtaining better pricing from our contract manufacturers and transportation vendors. Gross margin increased to 61.4% for fiscal 2017 from 61.0% for fiscal 2016 primarily as a result of our gross margin improvement initiatives, favorable pricing and higher software sales as a percentage of revenues, which have higher margins. Products & Solutions gross profit for fiscal 2017 and 2016 was $890 million and $1,047 million, respectively, a decrease of $157 million or 15%. The decrease was primarily attributable to lower sales volume, partially offset by the success of our gross margin improvement initiatives and favorable pricing. Products & Solutions gross margin increased to 68.6% for fiscal 2017 compared to 68.2% for fiscal 2016 primarily as a result of favorable pricing. Networking gross profit for fiscal 2017 and 2016 was $48 million and $80 million, respectively, a decrease of $32 million or 40%. Networking gross margin decreased to 34.3% for fiscal 2017 from 36.5% for fiscal 2016. The decrease in Networking gross profit was primarily attributable to lower sales volume as a result of the sale of the Company’s Networking business to Extreme. Services gross profit for fiscal 2017 and 2016 was $1,091 million and $1,160 million, respectively, a decrease of $69 million or 6%. The decrease was due to lower revenue. Services gross margin decreased to 59.5% for fiscal 2017 from 59.6% for fiscal 2016. Unallocated amounts for fiscal 2017 and 2016 included the effect of the amortization of technology intangibles and costs that are not core to the measurement of segment performance, but rather are controlled at the corporate level. Operating Expenses The following table sets forth operating expenses and the percentage of operating expenses to total revenue: Selling, general and administrative expenses for fiscal 2017 and 2016 were $1,261 million and $1,401 million, respectively, a decrease of $140 million. The decrease was primarily attributable to lower costs incurred in connection with certain legal matters period over period, lower payroll and payroll related expenses realized from the success of cost savings initiatives executed in prior periods, lower selling expenses and the favorable impact of foreign currency, partially offset by advisory fees incurred to assist in the assessment of strategic and financial alternatives to improve the Company’s capital structure. Our cost savings initiatives included reductions to the workforce, exiting and consolidating facilities and relocating positions to lower-cost geographies. Research and development expenses for fiscal 2017 and 2016 were $225 million and $273 million, respectively, a decrease of $48 million. The decrease was primarily due to lower payroll and payroll related expenses realized as a result of cost savings initiatives executed in prior periods. Impairment of indefinite-lived intangible assets in fiscal 2017 was $65 million. Due to the Company filing for bankruptcy and also experiencing a decline in revenues, a revision of its five year forecast was completed in the quarter ended June 30, 2017. Due to the decline in revenue in the five year forecast, the Company tested its intangible assets with indefinite lives and other long-lived assets for impairment. The Company estimated the fair values of its indefinite-lived intangible assets using the royalty savings method, which values an asset by estimating the royalties saved through ownership of the asset. As a result of the impairment test, the Company estimated the fair value of its trademarks and trade names to be $190 million as compared to a carrying amount of $255 million and recorded an impairment charge of $65 million. Impairment of indefinite-lived intangible assets in fiscal 2016 was $100 million and related to the Company’s trademarks and trade names. The reduced valuation reflected additional market risks and lower sales forecasts for the Company, which was consistent with the lack of customers’ willingness to spend on products, specifically relating to unified communications, such as endpoints, gateways, Nortel and Tenovis products, servers and SME Telephony products. Goodwill impairment in fiscal 2017 was $52 million. As a result of the sale of certain assets and liabilities of the Company’s Networking business to Extreme in July 2017, it was determined that the fair value of the Networking services component was less than its carrying value. As a result, the Company recorded a goodwill impairment charge of $52 million. Goodwill impairment in fiscal 2016 was $442 million. At July 1, 2016, the Company performed step one of the goodwill impairment test for all of its reporting units, which indicated the estimated fair value of the Unified Communication reporting unit was less than the carrying amount of its net assets (including goodwill). Therefore, the Company performed step two of its annual goodwill impairment test and determined that the carrying amount of the reporting unit’s goodwill exceeded its implied fair value resulting in an impairment to goodwill of $442 million. The impairment was primarily the result of the continued customer cutbacks in investments in unified communication products. The reduced valuation of the reporting unit reflected additional market risks and lower sales forecasts for the reporting unit, which was consistent with the lack of customers’ willingness to spend on unified communication products such as endpoints, gateways, Nortel and Tenovis products, servers and SME Telephony products. At July 1, 2016, the Company determined that the respective carrying amounts of the Company’s other reporting units did not exceed their estimated fair values and therefore no impairment of the goodwill for these reporting units existed. Restructuring charges, net, for fiscal 2017 and 2016 were $30 million and $105 million, respectively, a decrease of $75 million. Restructuring charges recorded during fiscal 2017 include employee separation costs of $21 million primarily associated with employee severance actions in the U.S. and EMEA and lease obligations of $9 million primarily in EMEA. Restructuring charges recorded during fiscal 2016 include employee separation costs of $101 million primarily associated with employee severance actions in EMEA and Canada, and a voluntary plan initiated in the U.S., as well as lease obligations of $4 million. Operating Income (Loss) Fiscal 2017 had operating income of $171 million compared to an operating loss of $289 million for fiscal 2016. Operating income (loss) for fiscal 2017 and 2016 includes impairments of goodwill and indefinite-lived intangible assets of $117 million and $542 million, depreciation and amortization of $326 million and $374 million and share-based compensation of $11 million and $16 million, respectively. Interest Expense Interest expense for fiscal 2017 and 2016 was $246 million and $471 million, respectively, and includes non-cash interest expense of $61 million and $20 million, respectively. Non-cash interest expense is comprised of amortization of debt issuance costs and accretion of debt discounts. The increase in non-cash interest is a result of accelerated amortization of debt issuance costs and accretion of debt discounts due to our Bankruptcy Filing. The Bankruptcy Filing constituted an event of default under the Company's Predecessor first lien and second lien obligations that accelerated its payment obligations. Consequently, all debt outstanding under the Company's Predecessor first lien and second lien obligations was classified as Liabilities subject to compromise and the related unamortized deferred financing costs and debt discounts of $61 million were expensed during fiscal 2017. Effective January 19, 2017, the Company ceased recording interest expense on outstanding pre-petition debt classified as Liabilities subject to compromise. Contractual interest expense represented amounts due under the contractual terms of outstanding debt, including debt subject to compromise. For the period from January 19, 2017 through September 30, 2017, contractual interest expense related to debt classified as Liabilities subject to compromise of $316 million was not recorded as interest expense, as it was not an allowed claim under the Bankruptcy Filing. Cash interest expense for fiscal 2017 and 2016 was $185 million and $451 million, respectively, a decrease of $266 million. Other Income (Expense), Net Other expense, net for fiscal 2017 was $25 million compared with other income, net of $41 million for fiscal 2016. Other expense, net for fiscal 2017 included other pension and post-retirement benefit costs of 34 million; and other expense, net of $2 million, partially offset by interest income of $4 million; income from the TSA with Extreme of $3 million; a gain on the sale of certain assets and liabilities of the Networking business of $2 million; and net foreign currency transaction gains of $2 million. Other income, net for fiscal 2016 includes $73 million from changes in the fair value of the Predecessor Series B preferred stock embedded derivative; net foreign currency transaction gains of $10 million; and interest income of $1 million, partially offset by other pension and post-retirement benefit costs of $27 million; loss on an equity investment of $11 million; and other expense, net of $5 million. Reorganization Items, Net Reorganization items, net for fiscal 2017 was $98 million. Reorganization items, net for fiscal 2017 included amounts incurred subsequent to the Bankruptcy Filing as a direct result of the Bankruptcy Filing and was comprised of professional service fees, contract rejection fees and DIP Credit Agreement financing costs. Benefit from (Provision for) Income Taxes The benefit from income taxes was $16 million for fiscal 2017 compared with a provision for income taxes of $11 million for fiscal 2016. The Company’s effective income tax rate for fiscal 2017 differed from the U.S. federal tax rate primarily due to (1) the effect of tax rate differentials on foreign income/loss, (2) changes in the valuation allowance established against the Company’s deferred tax assets, (3) tax positions taken during the year offset by reductions for unrecognized tax benefits resulting from the lapse of statute of limitations and the completion of income tax examinations, (4) the non-deductible portion of goodwill impairment, (5) the non-deductible portion of the loss on the sale of Networking business assets, (6) the non-deductible portion of reorganization items, (7) the effect of enacted changes in tax laws, and (8) the recognition of income tax benefits as a result of net gains in other comprehensive income. The Company’s effective income tax rate for fiscal 2016 differed from the U.S. federal tax rate primarily due to (1) the effect of tax rate differentials on foreign income/loss, (2) changes in the valuation allowance established against the Company’s deferred tax assets, (3) tax positions taken during the year offset by reductions for unrecognized tax benefits resulting from the lapse of statute of limitations, (4) the non-deductible portion of goodwill impairment, (5) the effect of enacted changes in tax laws, and (6) a $5 million income tax provision related to the change in the indefinite reinvestment assertion. At September 30, 2017, the Company’s book basis exceeded the tax basis it had in certain foreign subsidiaries, creating an outside basis difference for which the Company provided a deferred tax liability. During fiscal 2016, the Company could no longer assert that it had the intent to indefinitely reinvest the portion of the outside basis difference related to items other than the earnings and profits of the foreign subsidiaries. Accordingly, the Company was required to adjust its deferred tax liability for the effects of this change in assertion, which increased the fiscal 2016 provision for income taxes of continuing operations by $5 million. Liquidity and Capital Resources We expect our existing cash balance, cash generated by operations and borrowings available under our ABL Credit Agreement to be our primary sources of short-term liquidity. Based on our current level of operations, we believe these sources will be adequate to meet our liquidity needs for at least the next twelve months. Our ability to meet our cash requirements will depend on our ability to generate cash in the future, which is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. Cash Flow Activity The following table provides a summary of the statements of cash flows for the periods indicated: Operating Activities Cash (used for) provided by operating activities was $(212) million, $291 million and $113 million for fiscal 2018, 2017 and 2016, respectively. The change between fiscal 2018 and 2017 was primarily due to payments related to the Company's reorganization and emergence from bankruptcy, which included payments to the PBGC ($340 million), general unsecured creditor claims ($58 million) and the APP pension trust ($49 million); lower cash earnings; and higher interest and pension and other post-retirement benefits due to the cessation of such payments upon declaration of bankruptcy in January 2017. These higher payments were partially offset by lower income tax payments; lower advisory fees to assist in the assessment of strategic and financial alternatives to improve the Company's capital structure; an increase in deferred revenue as a result of advance payments for products and services; and the timing of customer payments. The change between fiscal 2017 and 2016 was primarily due to lower interest and pension and other post-retirement benefits payments as a result of filing bankruptcy; lower payments under the Company's restructuring programs; and the timing of vendor and customer payments. Investing Activities Cash used for investing activities for fiscal 2018, 2017 and 2016 was $126 million, $70 million and $100 million, respectively. During fiscal 2018, cash used for investing activities included the acquisition of Spoken for $157 million and capital expenditures of $74 million, partially offset by the release of restricted cash of $86 million related to the Company's emergence from bankruptcy and the release of an escrow related to the sale of the Networking business; and $17 million of proceeds received from sale-leaseback transactions, mainly the sale of equipment used in the performance of services under the Company's agreement with HP Enterprise Services, LLC ("HP"). During fiscal 2017, cash used for investing activities included an increase in restricted cash of $80 million, primarily related to cash collateralized letters of credit issued under the Predecessor Company's DIP Credit Agreement; capital expenditures of $57 million; and acquisitions of businesses, net of cash acquired of $4 million, partially offset by $70 million of proceeds from the sale of the Networking business. During fiscal 2016, cash used for investing activities included capital expenditures of $94 million; and acquisitions of businesses, net of cash acquired of $20 million, partially offset by $14 million of proceeds for the sale of equipment used in the performance of services under our agreement with HP. Financing Activities Cash provided by financing activities for fiscal 2018, 2017 and 2016 was $171 million, $314 million and $9 million, respectively. Cash provided by financing activities for fiscal 2018 included: • proceeds of $2,896 million from the Term Loan Credit Agreement entered into on the Emergence Date; • proceeds of $350 million from the issuance of 2.25% Convertible Notes; and • proceeds from the issuance of call spread warrants (the "Call Spread Warrants") of $58 million; partially offset by: • repayment of the Company's Term Loan Credit Agreement of $2,918 million as part of the refinancing discussed below, net of proceeds received under the refinancing of $2,911 million; • repayments to the Predecessor Company first lien debt holders of $2,061 million; • repayment of the Predecessor Company DIP Credit Agreement of $725 million; • adequate protection payments related to the bankruptcy of $111 million; • payment of debt issuance costs of $107 million; • the purchase of a bond hedge of $84 million; • scheduled debt repayments under the Term Loan Credit Agreement of $22 million; and • repayments in connection with financing the use of equipment for the performance of services under our agreement with HP of $13 million. Cash provided by financing activities for fiscal 2017 included: • proceeds from the Predecessor Company DIP Credit Agreement of $712 million, partially offset by: • scheduled debt repayments of $223 million, inclusive of adequate protection payments; • repayments in excess of borrowings under the Predecessor Company revolving credit facilities of $150 million; and • repayments under our agreement with HP of $19 million. Cash provided by financing activities for fiscal 2016 included: • borrowings in excess of repayments under the Predecessor Company revolving credit facilities of $57 million, partially offset by: • scheduled debt repayments of $25 million; and • repayments under our agreement with HP of $19 million. Term Loan Credit Agreement Refinancing On June 18, 2018, the Company amended the Term Loan Credit Agreement to reduce interest rates and to reduce the London Inter-bank Offered Rate ("LIBOR") floor that existed under the original agreement from 1.00% to 0.00%. After the amendment, the Term Loan Credit Agreement (a) in the case of alternative base rate ("ABR") Loans, bears interest at a rate per annum equal to 3.25% plus the highest of (i) the Federal Funds Rate plus 0.50%, (ii) the U.S. prime rate as publicly announced in the Wall Street Journal and (iii) the LIBOR Rate for an interest period of one month and (b) in the case of LIBOR Loans, bears interest at a rate per annum equal to 4.25% plus the applicable LIBOR rate, subject to a 0.00% floor. Prior to the amendment, the Term Loan Credit Agreement, in the case of ABR Loans, bore interest at a rate per annum equal to 3.75% plus the highest of (i) the Federal Funds Rate plus 0.50%, (ii) the U.S. prime rate as publicly announced in the Wall Street Journal and (iii) the LIBOR Rate for an interest period of one month and in the case of LIBOR Loans, bore interest at a rate per annum equal to 4.75% plus the applicable LIBOR rate, subject to a 1.00% floor. As a result of the amendment, outstanding loan balances under the original Term Loan Credit Agreement were paid in full and new debt was issued for the same outstanding principal amount. Interest Rate Contracts On May 16, 2018, the Company entered into interest rate swap agreements with six counterparties, which fixed a portion of the variable interest due under its Term Loan Credit Agreement. Under the terms of the interest rate swap agreements, which mature on December 15, 2022, the Company pays a fixed rate of 2.935% and receives a variable rate of interest based on one-month LIBOR. As of September 30, 2018, the total notional amount of the six interest rate swap agreements was $1,800 million. Convertible Notes On June 11, 2018, the Company issued its 2.25% Convertible Notes in an aggregate principal of $350 million (including the underwriters’ exercise in full of an over-allotment option of $50 million), which mature on June 15, 2023 (the “Convertible Notes”). The Convertible Notes were issued under an indenture, by and between the Company and the Bank of New York Mellon Trust Company N.A., as Trustee. The Company received net proceeds from the offering of $314 million after giving effect to debt issuance costs, including the underwriting discount, the net cash used to purchase a bond hedge and the proceeds from the issuance of warrants, which are discussed below. Bond Hedge and Call Spread Warrants In connection with the issuance of the Convertible Notes, the Company also entered into privately negotiated transactions to purchase hedge instruments (“Bond Hedge”), covering 12.6 million shares of its common stock at a cost of $84 million. The Bond Hedge is subject to anti-dilution provisions substantially similar to those of the Convertible Notes, has a strike price of $27.76 per share, is exercisable by the Company upon any conversion under the Convertible Notes, and expires on June 15, 2023. The Company also sold warrants for the purchase of up to 12.6 million shares of its common stock for aggregate proceeds of $58 million (“Call Spread Warrants”). The Call Spread Warrants have a strike price of $37.3625 per share and are subject to customary anti-dilution provisions. The Call Spread Warrants will expire in ratable portions on a series of expiration dates commencing on September 15, 2023. The Bond Hedge and Call Spread Warrants are intended to reduce the potential dilution with respect to the Company’s common stock and/or reduce the Company’s exposure to potential cash payments that the Company may be required to make upon conversion of the Convertible Notes by, in effect, increasing the conversion price, from the Company’s economic standpoint, to $37.3625 per share. However, the Call Spread Warrants could have a dilutive effect with respect to the Company's common stock or, if the Company so elects, obligate the Company to make cash payments to the extent that the market price of common stock exceeds $37.3625 per share on any date upon which the Call Spread Warrants are exercised. As of September 30, 2018, the Company was not in default under any of its debt agreements. See Note 11, “Financing Arrangements,” and Note 12, "Derivative Instruments and Hedging Activities," to our Consolidated Financial Statements for further details about our financing arrangements, including summaries of the Term Loan Credit Agreement, ABL Credit Agreement and Convertible Notes. Contractual Obligations and Sources of Liquidity Contractual Obligations The following table summarizes the Company's contractual obligations as of September 30, 2018: (1) The contractual obligations for debt represent principal payments only. (2) The interest payments due on debt include the impact of the Company's interest rate swap agreements. The interest payments for the unhedged portion of the Company's Term Loan Credit Agreement were calculated by applying an applicable margin to a projected LIBOR rate. The interest payments for the Company's Convertible 2.25% senior notes were based on the contractual 2.25% coupon rate. An estimated unused facility fee was calculated for the ABL Credit Agreement using the contract rate. (3) During the normal course of business, in order to manage manufacturing lead times and to help assure adequate component supply, the Company enters into agreements with contract manufacturers and suppliers that allow them to produce and procure inventory based upon forecasted requirements. If the Company does not meet the specified minimum purchase commitments under these agreements, it could be required to purchase the inventory. (4) Other purchase obligations represent an estimate of contractual obligations in the ordinary course of business, other than commitments with contract manufacturers and suppliers, for which the Company had not received the goods or services as of September 30, 2018. Although contractual obligations are considered enforceable and legally binding, the terms generally allow the Company the option to cancel, reschedule and adjust its requirements based on the Company's business needs prior to the delivery of goods or performance of services. (5) Contractual obligations for operating leases include future minimum lease payments, net of remaining sublease income of $10 million. (6) The payments due for capital lease obligations do not include $2 million in future payments for interest. (7) The Company sponsors non-contributory defined pension and post-retirement plans covering certain employees and retirees. The Company's general funding policy with respect to qualified pension plans is to contribute amounts at least sufficient to satisfy the minimum amount required by applicable law and regulations, or to directly pay benefits where appropriate. Most post-retirement medical benefits are not pre-funded. Consequently, the Company makes payments as these retiree medical benefits are disbursed. Upon emergence, the APPSE was transferred to the PBGC and the Avaya Supplemental Pension Plan was terminated. The amounts presented represent estimated minimum funding requirements through fiscal 2028. As of September 30, 2018, the Company's unrecognized tax benefits ("UTBs") associated with uncertain tax positions were $174 million and interest and penalties related to these amounts were an additional $19 million. Those UTBs are not reflected in the table above due to the uncertainty of the timing of payments. Future Cash Requirements Our primary future cash requirements will be to fund debt service, restructuring payments, capital expenditures, and benefit obligations. In addition, we may use cash in the future to make strategic acquisitions. Specifically, we expect our primary cash requirements for fiscal 2019 to be as follows: • Debt service-We expect to make payments of approximately $245 million during fiscal 2019 in principal and interest associated with the Term Loan Credit Agreement, and interest and fees associated with our ABL Credit Agreement and 2.25% Convertible Notes due 2023. In the ordinary course of business, we may from time to time borrow and repay amounts under our ABL Credit Agreement. • Restructuring payments-We expect to make payments of approximately $45 million to $50 million during fiscal 2019 for employee separation costs and lease termination obligations associated with restructuring actions we have taken through September 30, 2018. The Company continues to evaluate opportunities to streamline its operations and identify additional cost savings globally. • Capital expenditures-We expect to spend approximately $75 million to $85 million for capital expenditures and capitalized software development costs during fiscal 2019. • Benefit obligations-We estimate we will make payments under our pension and post-retirement benefit obligations totaling $65 million during fiscal 2019. These payments include: $26 million to satisfy the minimum statutory funding requirements of our U.S. qualified pension plans; $25 million for our non-U.S. benefit plans, which are predominantly not pre-funded; and $14 million for represented retiree post-retirement benefits. See discussion in Note 15, “Benefit Obligations,” to our Consolidated Financial Statements for further details. In addition to the matters identified above, in the ordinary course of business, the Company is involved in litigation, claims, government inquiries, investigations and proceedings, including but not limited to those identified in Note 22, "Commitments and Contingencies," to our Consolidated Financial Statements, relating to intellectual property, commercial, employment, environmental and regulatory matters, which may require us to make cash payments. These and other legal matters could have a material adverse effect on the manner in which the Company does business and the Company's financial position, results of operations, cash flows and liquidity. During the period from December 16, 2017 through September 30, 2018 (Successor), the period from October 1, 2017 through December 15, 2017 (Predecessor), and fiscal 2017 and 2016 (Predecessor), the Company recognized $0 million, $37 million, $64 million and $106 million, respectively, of costs incurred in connection with the resolution of certain legal matters. We and our subsidiaries and affiliates may from time to time seek to retire or purchase our outstanding equity (common stock and warrants) and/or debt (including publicly issued debt) through cash purchases and/or exchanges, in open market purchases, privately negotiated transactions, tender offers or otherwise. Such repurchases or exchanges, if any, will depend on prevailing market conditions, liquidity requirements, contractual restrictions and other factors. Future Sources of Liquidity We expect our cash balance, cash generated by operations and borrowings available under our ABL Credit Agreement to be our primary sources of short-term liquidity. As of September 30, 2018 (Successor) and September 30, 2017 (Predecessor), our cash and cash equivalent balances held outside the U.S. were $169 million and $246 million, respectively. As of September 30, 2018 (Successor), cash and cash equivalents held outside the U.S. in excess of in-country needs and, which could not be distributed to the U.S. without restriction, were not material. Under the terms of the ABL Credit Agreement, the Company can issue letters of credit up to $150 million. At September 30, 2018 (Successor), the Company had issued and outstanding letters of credit and guarantees of $46 million. The aggregate additional principal amount that may be borrowed under the ABL Credit Agreement, based on the borrowing base less $46 million of outstanding letters of credit and guarantees, was $153 million at September 30, 2018 (Successor). We believe that our existing cash and cash equivalents of $700 million as of September 30, 2018 (Successor), future cash provided by operating activities and borrowings available under the ABL Credit Agreement will be sufficient to meet our future cash requirements for at least the next twelve months. Our ability to meet these requirements will depend on our ability to generate cash in the future, which is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. Off-Balance Sheet Arrangements See discussion in Note 22, “Commitments and Contingencies,” to our Consolidated Financial Statements for further details. Debt Ratings On the Emergence Date, the Company obtained ratings from Moody’s Investors Service (“Moody’s”), Standard and Poor's ("S&P") and Fitch Ratings Inc. (“Fitch”). Moody’s issued a corporate family rating of “B2” with a stable outlook and a rating of the 7-year $2,925 million Term Loan Credit Agreement of “B2”. S&P issued a definitive corporate credit rating of "B" with a stable outlook and a rating of the Term Loan Credit Agreement of "B". Fitch issued a Long-Term Issuer Default Rating of “B” with a stable outlook and a rating of the Term Loan Credit Agreement of “B+”. On June 1 , 2018, Fitch affirmed the Long-term Issuer Default Rating of “B” and upgraded the rating of the Term Loan Credit Agreement to “BB-“. Our ability to obtain additional external financing and the related cost of borrowing may be affected by our ratings, which are periodically reviewed by the major credit rating agencies. The ratings are subject to change or withdrawal at any time by the respective credit rating agencies. Commitments and Contingencies We are party to several types of agreements, including surety bonds, purchase commitments, product financing arrangements and performance guarantees, which are fully discussed in Note 22, “Commitments and Contingencies,” to our Consolidated Financial Statements. EBITDA and Adjusted EBITDA EBITDA is defined as net income (loss) before income taxes, interest expense, interest income and depreciation and amortization and excludes the results of discontinued operations. EBITDA provides us with a measure of operating performance that excludes certain non-operating and/or non-cash expenses, which can differ significantly from company to company depending on capital structure, the tax jurisdictions in which companies operate and capital investments. Adjusted EBITDA is EBITDA as further adjusted by the items noted in the reconciliation table below. We believe Adjusted EBITDA provides a measure of our financial performance based on operational factors that management can impact in the short-term, such as our pricing strategies, volume, costs and expenses of the organization, and therefore presents our financial performance in a way that can be more easily compared to prior quarters or fiscal years. In addition, Adjusted EBITDA serves as a basis for determining certain management and employee compensation. We also present EBITDA and Adjusted EBITDA because we believe analysts and investors utilize these measures in analyzing our results. Under the Company's debt agreements, the ability to engage in activities such as incurring additional indebtedness, making investments and paying dividends is tied in part to ratios based on a measure of Adjusted EBITDA. EBITDA and Adjusted EBITDA have limitations as analytical tools. EBITDA measures do not represent net income (loss) or cash flow from operations as those terms are defined by GAAP and do not necessarily indicate whether cash flows will be sufficient to fund cash needs. While EBITDA measures are frequently used as measures of operations and the ability to meet debt service requirements, these terms are not necessarily comparable to other similarly titled captions of other companies due to the potential inconsistencies in the method of calculation. Further, Adjusted EBITDA excludes the impact of earnings or charges resulting from matters that we consider not to be indicative of our ongoing operations but could be substantial. In particular, our formulation of Adjusted EBITDA adjusts for certain amounts that are included in calculating net income (loss) as set forth in the following table including, but not limited to, restructuring charges, impairment charges, certain fees payable to our Predecessor private equity sponsors and other advisors, resolution of certain legal matters and a portion of our pension costs and post-retirement benefits costs, which represents the amortization of pension service costs and actuarial gain (loss) associated with these benefits. However, these are expenses that may recur, may vary and/or may be difficult to predict. The unaudited reconciliation of net income (loss), which is a GAAP measure, to EBITDA and Adjusted EBITDA, which are non-GAAP measures, is presented below for the periods indicated: (a) Effective January 19, 2017, the Company ceased recording interest expense on outstanding pre-petition debt classified as liabilities subject to compromise. Contractual interest expense represents amounts due under the contractual terms of outstanding debt, including debt subject to compromise. For the periods from October 1, 2017 through December 15, 2017 and January 19, 2017 through September 30, 2017, contractual interest expense related to debt subject to compromise of $94 million and $316 million, respectively, had not been recorded as interest expense, as it was not an allowed claim under the Bankruptcy Filing. (b) The impact of fresh start accounting adjustments in connection with the Company's emergence from bankruptcy. (c) Advisory fees represent costs incurred to assist in the assessment of strategic and financial alternatives to improve the Company's capital structure. Also included in advisory fees for the prior year periods were sponsors’ fees, which represented monitoring fees payable to affiliates of two private equity firms, Silver Lake Partners (“Silver Lake”) and TPG Capital (“TPG”, together with Silver Lake, the “Sponsors”) that each had an ownership interest in the Predecessor Company and their designees pursuant to a management services agreement. Effective as of emergence from bankruptcy, the Company ceased being an affiliate of the Sponsors and the management services agreement and related monitoring fees no longer exist. (d) In fiscal 2018, acquisition-related costs include investment banking, legal and other costs related to the acquisition of Spoken, including the accelerated vesting of certain Spoken stock options in connection with the acquisition. (e) Third-party sales transformation costs are consulting fees incurred in support of the Company’s sales initiatives and the realignment of its sales organization. (f) Costs in connection with the resolution of certain legal matters include reserves and settlements, as well as associated legal costs. (g) Represents the gain on changes in the fair value of certain embedded derivative features of the Predecessor Company’s Series B preferred stock. Under GAAP, these embedded features must be recognized at fair value at each balance sheet date with the changes in the fair value recognized in operations. The Predecessor Company's Series B preferred stock was canceled upon the Company's emergence from bankruptcy. (h) Represents third-party fees incurred in connection with the Company’s registration statement filed with the SEC on Form S-1, Amendment No. 8, which was subsequently withdrawn on January 23, 2017. (i) Represents that portion of our pension and post-retirement benefit costs which represent the amortization of prior service costs and net actuarial gain (loss) associated with these benefits. Critical Accounting Policies and Estimates The preparation of financial statements and related disclosures in conformity with GAAP requires the Company's management to make judgments, assumptions and estimates that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and revenue and expenses during the periods reported. Management bases its estimates on historical experience and on various other assumptions it believes to be reasonable under the circumstances. Actual results may differ from these estimates and such differences may be material. Note 2, "Summary of Significant Accounting Policies," to our Consolidated Financial Statements describes the significant accounting policies and methods used in the preparation of the Company's Consolidated Financial Statements. Management considers the following policies critical because they are important to the portrayal of the Company's financial condition and operating results and they require management to make judgments and estimates about inherently uncertain matters. Acquisitions and Fresh Start Accounting The Company accounts for business combinations using the acquisition method, which requires an allocation of the purchase price of an acquired entity to the assets acquired and liabilities assumed based on their estimated fair values at the date of acquisition. Goodwill represents the excess of the purchase price over the net tangible and intangible assets acquired. The estimated useful lives of acquired intangible and long-lived assets are based on many factors including assumptions regarding the effects of obsolescence, demand, competition and other economic factors, expectations regarding the future use of the asset, and the Company's historical experience with similar assets. The assumptions used to determine the estimated useful lives could change due to numerous factors including product demand, market conditions, technological developments, economic conditions and competition. Upon emergence from bankruptcy on December 15, 2017, the Company applied fresh start accounting, which required all assets and liabilities to be remeasured at fair value as of the Emergence Date. See Note 5, "Fresh Start Accounting," to our Consolidated Financial Statements for additional information. Revenue Recognition The Company derives revenue primarily from the sale of products and services for communications systems and applications. The Company’s indirect sales to channel partners are generally recognized at the time of shipment if all contractual obligations have been satisfied. The Company accrues a provision for estimated sales returns and other allowances, including promotional marketing programs and other incentives as a reduction of revenue at time of sale. When estimating returns, the Company considers customary inventory levels held by third-party distributors. The Company enters into multiple deliverable arrangements, which may include various combinations of products, software and services. Most product and service deliverables qualify as separate units of accounting and can be sold on a standalone basis. A deliverable constitutes a separate unit of accounting when it has standalone value and, where return rights exist, delivery or performance of the undelivered items is considered probable and substantially within the Company’s control. When the Company sells products with implementation services, they are generally combined as one or more units of accounting, depending on the nature of the services and the customer’s acceptance requirements. The Company’s products may have both software and non-software components that function together to deliver the products’ essential functionality. For these multiple deliverable arrangements, the Company allocates revenue to the deliverables based on their relative selling prices. To the extent that a deliverable is subject to specific guidance on whether and/or how to allocate the consideration in a multiple element arrangement, that deliverable is accounted for in accordance with such specific guidance. The Company limits the amount of revenue recognition for delivered items to the amount that is not contingent on the future delivery of products or services or meeting other future performance obligations. The Company allocates revenue based on a selling price hierarchy of vendor-specific objective evidence, third-party evidence, and then estimated selling price. Vendor-specific objective evidence is based on the price charged when the deliverable is sold separately. Third-party evidence is based on largely interchangeable competitor products or services in standalone sales to similarly situated customers. As the Company is unable to reliably determine what competitor products’ selling prices are on a standalone basis, the Company is not typically able to determine third-party evidence. Estimated selling price is based on the Company’s best estimates of what the selling prices of deliverables would be if they were sold regularly on a standalone basis. Estimated selling price is established considering multiple factors including, but not limited to, pricing practices in different geographies and through different sales channels, major product and services groups, and customer classifications. Standalone or subsequent sales of software or software-related items are recognized in accordance with the software revenue recognition guidance. For multiple deliverable arrangements that only include software items, the Company generally uses the residual method to allocate the arrangement consideration. Under the residual method, the amount of consideration allocated to the delivered items equals the total arrangement consideration, less the fair value of the undelivered items. Where vendor-specific objective evidence of fair value for the undelivered items cannot be determined, the Company generally defers revenue until all items are delivered and services have been performed, or until such evidence of fair value can be determined for the undelivered items. The Company will adopt FASB Accounting Standards Update ("ASU") No. 2014-09, “Revenue from Contracts with Customers (Topic 606),” effective October 1, 2018. The standard supersedes most existing revenue recognition guidance and will have an impact on the Company’s revenue recognition accounting policies. Refer to Note 3, “Recent Accounting Pronouncements,” to our Consolidated Financial Statements for additional information. Goodwill and Indefinite-lived Intangible Assets Goodwill and indefinite-lived intangible assets are not amortized but are subject to annual testing for impairment each July 1st, or more frequently if events occur or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Goodwill is tested for impairment at the reporting unit level, which is one level below the Company's operating segments. The assessment of goodwill impairment is conducted by estimating and comparing the fair value of each of the Company’s reporting units to its carrying amount. If the carrying value of a reporting unit exceeds its fair value, the Company recognizes an impairment loss equal to the amount of the excess. Application of the impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units and the determination of the fair value of each reporting unit. The Company estimates the fair value of each reporting unit using a weighting of fair values derived from an income approach and a market approach. Under the income approach, the fair value of a reporting unit is based on the future cash flows expected from that reporting unit. Future cash flows are based on forward-looking information regarding market share and costs for each reporting unit and are discounted using an appropriate discount rate in a discounted cash flows model. The discounted cash flows model relies on assumptions regarding revenue growth rates, gross profit, projected working capital needs, selling, general and administrative expenses, research and development expenses, business restructuring costs, capital expenditures, income tax rates, discount rates and terminal growth rates. The discount rate the Company uses represents the estimated weighted average cost of capital, which reflects the overall level of inherent risk involved in its reporting unit operations and the rate of return an outside investor would expect to earn. To estimate cash flows beyond the final year of its model, the Company uses a terminal value approach. Under this approach, the Company applies a perpetuity growth assumption to determine the terminal value. The Company incorporates the present value of the resulting terminal value into its estimate of fair value. Forecasted cash flows for each reporting unit consider current economic conditions and trends, estimated future operating results, the Company’s view of growth rates and anticipated future economic conditions. Revenue growth rates inherent in this forecast are based on input from internal and external market intelligence research sources that compare factors such as growth in global economies, regional trends in the telecommunications industry and product evolution from a technological segment basis. Macroeconomic factors such as changes in economies, product evolutions, industry consolidations and other changes beyond the Company’s control could have a positive or negative impact on achieving its targets. The market approach estimates the fair value of a reporting unit by applying multiples of operating performance measures to the reporting unit's operating performance (the "Guideline Public Company Method"). These multiples are derived from comparable publicly-traded companies with similar investment characteristics to the reporting unit. The key estimates and assumptions that are used to determine the fair value under this market approach include current and forward 12-month operating performance results, as applicable, and the selection of the relevant multiples to be applied. Changes in these estimates and assumptions could materially affect the determination of fair value and the goodwill impairment test result for each reporting unit. At July 1, 2018, the level of excess fair value over carrying value exceeds 10% for each of the Company's five reporting units, except for the Global Support Services ("GSS") reporting unit which has an excess fair value over carrying value of 7%. The goodwill assigned to GSS is $1,448 million. An increase in the discount rate of 1.1% used in the most recent goodwill impairment testing calculation would result in an estimated fair value below the carrying value for this reporting unit. During the fourth quarter of 2018, we closely monitored the key variables and other market factors and determined that we were not required to perform an interim impairment test. To the extent that changes in business conditions occur or other management decisions are made that result in adjusted management projections, it may be necessary to record impairment charges in the future. See Note 7, "Goodwill," to our Consolidated Financial Statements for details of the Company's goodwill balance and the goodwill impairment reviews performed in fiscal 2018 (Successor) and fiscal 2017 and 2016 (Predecessor). Income Taxes Income taxes are accounted for under the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the Consolidated Statements of Operations in the period that includes the enactment date. A valuation allowance is recorded to reduce the carrying amounts of deferred tax assets if it is more likely than not that such assets will not be realized. Additionally, the accounting for income taxes requires the Company to evaluate and make an assertion as to whether undistributed foreign earnings will be indefinitely reinvested or repatriated. FASB ASC subtopic 740-10, “Income Taxes-Overall” (“ASC 740-10”) prescribes a comprehensive model for the financial statement recognition, measurement, classification, and disclosure of uncertain tax positions. ASC 740-10 contains a two-step approach to recognizing and measuring uncertain tax positions. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit based on the technical merits of the position. The second step is to measure the tax benefit as the largest amount that is more than 50% likely of being realized upon settlement. Significant judgment is required in evaluating uncertain tax positions and determining the provision for income taxes. Although the Company believes its reserves are reasonable, no assurance can be given that the final tax outcome of these matters will not be different from that which is reflected in the historical income tax provision and accruals. The Company adjusts its estimated liability for uncertain tax positions periodically due to new information discovered from ongoing examinations by, and settlements with various taxing authorities, as well as changes in tax laws, regulations and interpretations. The Company’s policy is to recognize, when applicable, interest and penalties on uncertain tax positions as part of income tax expense. As part of the Company’s accounting for business combinations, some of the purchase price is allocated to goodwill and intangible assets. Impairment expenses associated with goodwill are generally not tax deductible and will result in an increased effective income tax rate in the fiscal period any impairment is recorded. The income tax benefit from future releases of the acquisition date valuation allowances or income tax contingencies, if any, are reflected in the income tax provision in the Consolidated Statements of Operations, rather than as an adjustment to the purchase price allocation. Pension and Post-retirement Benefit Obligations The Company sponsors non-contributory defined benefit pension plans covering a portion of its U.S. employees and retirees, and post-retirement benefit plans covering a portion of its U.S. employees and retirees that include healthcare benefits and life insurance coverage. Certain non-U.S. operations have various retirement benefit programs covering substantially all of their employees. The Company’s pension and post-retirement benefit costs are developed from actuarial valuations. Inherent in these valuations are key assumptions, including the discount rate, expected long-term rate of return on plan assets, rate of compensation increase and healthcare cost trend rate. Material changes in pension and post-retirement benefit costs may occur in the future due to changes in these assumptions, changes in the number of plan participants, changes in the level of benefits provided, changes in asset levels and changes in legislation. The discount rate is subject to change each year, consistent with changes in rates of return on high-quality fixed-income investments currently available and expected to be available during the expected benefit payment period. The Company selects the assumed discount rate for its U.S. pension and post-retirement plans by applying the rates from the Aon AA Only and Aon AA Above Median yield curves to the expected benefit payment streams and develops a rate at which it is believed the benefit obligations could be effectively settled. The Company follows a similar process for its non-U.S. pension plans by applying the Aon Euro AA corporate bond yield curve. The market-related value of the Company’s plan assets as of the measurement date is developed using a five-year smoothing technique. First, a preliminary market-related value is calculated by adjusting the market-related value at the beginning of the year for payments to and from plan assets and the expected return on assets during the year. The expected return on assets represents the expected long-term rate of return on plan assets adjusted up to plus or minus 2% based on the actual ten-year average rate of return on plan assets. A final market-related value is determined as the preliminary market-related value, plus 20% of the difference between the actual return and expected return for each of the past five years. Salary growth and healthcare cost trend assumptions are based on the Company's historical experience and future outlook. While the Company believes that the assumptions used in these calculations are reasonable, differences in actual experience or changes in assumptions could materially affect the expense and liabilities related to the Company's defined benefit plans. For the U.S. pension, non-U.S. pension and post-retirement plans combined, a hypothetical 25 basis point increase or decrease in the discount rate would affect expense for the period from December 16, 2017 through September 30, 2018 by $2 million or $(3) million, respectively. A hypothetical 25 basis point increase or decrease in the discount rate would change the projected benefit obligation as of September 30, 2018 by $(56) million or $58 million, respectively. A hypothetical 25 basis point change in the expected long-term rate of return would affect expense for the period from December 16, 2017 through September 30, 2018 by approximately $2 million.
0.000624
0.000946
0
<s>[INST] This “Management’s Discussion and Analysis of Financial Condition and Results of Operations” should be read in conjunction with the Consolidated Financial Statements and related notes thereto included in Part II, Item 8 of this Annual Report on Form 10K. The matters discussed in "Management’s Discussion and Analysis of Financial Condition and Results of Operations” contain certain forwardlooking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forwardlooking statements involve significant risks and uncertainties. See the "Cautionary Note Regarding Forwardlooking Statements" above and Part 1, Item 1A, "Risk Factors" in this Annual Report on Form 10K for additional information regarding forwardlooking statements and the factors that could cause actual results to differ materially from those anticipated in the forwardlooking statements. Overview Avaya is a global leader in digital communications products, solutions and services for businesses of all sizes. We enable organizations around the globe to succeed by creating intelligent communications experiences for customers and employees. Avaya builds open, converged and innovative solutions to enhance and simplify communications and collaboration in the cloud, onpremises or a hybrid of both. Our global, experienced team of professionals delivers awardwinning services from initial planning and design, to seamless implementation and integration, to ongoing managed operations, optimization, training and support. As of September 30, 2018, we had a presence in approximately 180 countries worldwide and during the past three fiscal years we served more than 90% of the Fortune 100 organizations. Our business has two operating segments: Products & Solutions and Services. Products & Solutions Products & Solutions encompasses our unified communications and contact center platforms, applications and devices. Unified Communications: Avaya unifies communications, helping companies increase employee productivity, improve customer service and reduce costs. Avaya embeds communications directly into the applications, browsers and devices employees use every day to create a single, powerful gateway for voice, video, messaging, conferencing and collaboration. We give people a more natural, efficient, and flexible way to connect, engage, respond, and share where and how they want for better business results. Avaya offers an open, extensible development platform, so that customers and third parties can easily create custom applications and automated workflows for their unique needs, integrating Avaya’s capabilities into the customer's existing infrastructure and business applications. Contact Center: Avaya’s industryleading omnichannel contact center solutions enable customers to build a customized portfolio of applications, driving stronger customer engagement and higher customer lifetime value. Our reliable, secure and scalable communications solutions include voice, email, chat, social media, video, performance management and ease of thirdparty integration that can improve customer service and help companies compete more effectively. Avaya also focuses on ensuring an outstanding experience for mobile callers, because we integrate transformative technologies, including Artificial Intelligence ("AI"), big data analytics, and cybersecurity into our contact center solutions. As organizations use these solutions to gain a deeper understanding of their customer needs, we believe that their teams become more efficient and effective and their customer loyalty grows. Both segments are supported by our portfolio of innovative business phones and multimedia devices, which is one of the broadest in the industry. Avaya brings consumer technology to the employee desktop in a way that can help our customers enhance customer service, internal and external collaboration, and employee productivity. Customers experience seamless audio and video capabilities for both Avaya and approved thirdparty Unified Communications (or "UC") platforms via open Session Initiation Protocol ("SIP") devices. SIP is used for signaling and controlling multimedia communication sessions in applications of Internet telephony for voice and video calls, along with integration with numerous apps that help connect and accelerate business. Developers can easily customize capabilities for their specific needs with our client Software Development Kit ("SDK"). Services Avaya Services consists of three business areas: Global Support Services, Enterprise Cloud and Managed Services and Professional Services. Together, these comprehensive services enable clients to leverage communications technology to help them maximize their business results. Our global, experienced team of experts delivers awardwinning services from initial planning and design, to seamless implementation and integration, to ongoing managed operations, optimization, training and support. We help our customers use communications to minimize the risk of outages, enable employee productivity and [/INST] Positive. </s>
2,018
14,340
1,418,100
Avaya Holdings Corp.
2019-11-29
2019-09-30
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 Consolidated Financial Statements and related notes thereto included in Part II, Item 8 of this Annual Report on Form 10-K. The matters discussed in "Management’s Discussion and Analysis of Financial Condition and Results of Operations" contain certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve significant risks and uncertainties. See the "Cautionary Note Regarding Forward-looking Statements" above and Part 1, Item 1A, "Risk Factors" in this Annual Report on Form 10-K for additional information regarding forward-looking statements and the factors that could cause actual results to differ materially from those anticipated in the forward-looking statements. Overview Avaya is a global leader in digital communications products, solutions and services for businesses of all sizes. We enable organizations around the globe to succeed by creating intelligent communications experiences for customers and employees. Avaya builds open, converged and innovative solutions to enhance and simplify communications and collaboration in the cloud, on-premises or a hybrid of both. Our global, experienced team of professionals delivers award-winning services from initial planning and design, to seamless implementation and integration, to ongoing managed operations, optimization, training and support. Our business has two operating segments: Products & Solutions and Services. Products & Solutions Products & Solutions encompasses our unified communications and contact center platforms, applications and devices. Unified Communications ("UC"): Avaya's unified communications solutions enable organizations to reimagine what teaming can mean and help companies increase employee productivity, improve customer service and reduce costs. With Avaya's UC solutions, organizations can provide their workers with a single app for all-channel calling, messaging, meetings and team collaboration with the same ease of use they receive from consumer apps. Avaya embeds communications directly into the applications, browsers and devices employees use every day giving people a more natural, efficient and flexible way to connect, engage, respond and share - where and how they want - for better business results. Avaya offers an open, extensible development platform, so that customers and third parties can easily create custom applications and automated workflows for their unique needs, integrating Avaya’s capabilities into the customer's existing infrastructure and business applications. Our solutions enable a seamless communications experience that fits into how employees work instead of changing how they work. Avaya continues to evolve its UC solutions for cloud deployment, as some customers prefer to consume this service via the cloud. Contact Center ("CC"): Avaya’s industry-leading digital contact center solutions enable customers to build a customized portfolio of applications, driving stronger customer engagement and higher customer lifetime value. Our reliable, secure and scalable communications solutions include voice, email, chat, social media, video, performance management and ease of third-party integration that can improve customer service and help companies compete more effectively. Like the UC business, Avaya is evolving the CC solution set for cloud development. Avaya also focuses on ensuring an outstanding experience for mobile callers by integrating transformative technologies, including Artificial Intelligence ("AI"), mobility, big data analytics, and cybersecurity into our contact center solutions. As organizations use these solutions to gain a deeper understanding of their customer needs, we believe that their teams become more efficient and effective and their customer loyalty grows. Both UC and CC are supported by our portfolio of innovative business phones and multimedia devices, which is one of the broadest in the industry. Avaya brings consumer technology to employee mobile devices and the desktop in a way that can help our customers enhance customer service, internal and external collaboration, and employee productivity. Customers experience seamless audio and video capabilities for both Avaya and approved third-party UC platforms via open Session Initiation Protocol ("SIP") devices. SIP is used for signaling and controlling multi-media communication sessions in applications of Internet telephony for voice and video calls, along with integration with numerous apps that help connect and accelerate business. Developers can easily customize capabilities for their specific needs with our client Software Development Kit ("SDK"). Services Services consists of three business areas: Global Support Services, Enterprise Cloud and Managed Services and Professional Services. • Global Support Services features offerings that address the risk of system outages and also help businesses protect their technology investments. We help our customers maintain their competitiveness through proactive problem prevention, rapid resolution and continual solution optimization. The majority of our revenue in this business is recurring in nature. • Enterprise Cloud and Managed Services enables customers to take advantage of our technology via the cloud, on-premises, or a hybrid of both, depending on the solution and the needs of the customer. The majority of our revenue in this business is recurring in nature and based on multi-year services contracts. • Professional Services enables businesses worldwide to take full advantage of their solution investments to drive measurable business results. Our expert consultants and experienced engineers work with clients as a strategic partner along each step of the solution lifecycle to deliver services that drive business transformation and expand ongoing value. The majority of our revenue in this business is one-time in nature. Together, these comprehensive services enable clients to leverage communications technology to help them maximize their business results. Our global team of professionals delivers services from initial planning and design, to seamless implementation and integration, to ongoing managed operations, optimization, training and support. We help our customers use communications to minimize the risk of outages, enable employee productivity and deliver a differentiated customer experience. Our services teams also help our clients transition at their desired pace to next generation communications technology solutions, either via the cloud, on-premises, or a hybrid of both. Customers can choose various levels of support for their communications solutions, including deployment, training, monitoring, troubleshooting and optimization, and more. Our proactive, preventative system performance monitoring can quickly identify and resolve issues. Remote diagnostics and resolutions rapidly fix existing problems and avoid potential issues, helping our customers to save time and reducing the risk of an outage. Recent Developments Strategic Partnership with RingCentral On October 3, 2019, the Company entered into certain agreements regarding a strategic partnership with RingCentral, Inc. (“RingCentral”), a leading provider of global enterprise cloud communications, collaboration and contact center solutions, to accelerate the Company's transition to the cloud. Through this partnership, the Company will introduce Avaya Cloud Office by RingCentral (“Avaya Cloud Office” or “ACO”), a new global unified communications as a service (“UCaaS”) solution. Avaya Cloud Office will expand the Company's industry-leading portfolio to offer a full suite of UC, CC, UCaaS and contact center as a service ("CCaaS") solutions to a global customer base, which includes more than 100,000 customers, over 100 million UC lines and 5 million CC users in approximately 175 countries. Avaya Cloud Office provides the Company with an opportunity to unlock value from a largely unmonetized base of our business as it brings compelling value to our customers and partners. ACO combines RingCentral’s leading UCaaS platform with Avaya technology, services and migration capabilities to create a highly differentiated UCaaS offering. Under the partnership, the Company is required to market and sell ACO as its exclusive UCaaS solution (subject to certain exceptions). Avaya now has a full suite of public, private and hybrid cloud solutions for its global UC and CC customers and partners. ACO is expected to launch in the second quarter of fiscal 2020. On October 25, 2019, the Company and RingCentral received notice from the U.S. Federal Trade Commission that it had granted early termination, effective immediately, of the applicable waiting period under the Hart-Scott-Rodino Antitrust Act of 1976 ("HSR Act") for the transaction, and the transaction closed on October 31, 2019. As consideration for the strategic partnership, RingCentral contributed $500 million to the Company, comprised of a $125 million preferred equity investment and an advance of $375 million for future payments and certain licensing rights. The Company is currently in the process of evaluating the impact of the arrangement on its Consolidated Financial Statements. See Note 26, “Subsequent Events,” to our Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for additional information about the transaction. Factors and Trends Affecting Our Results of Operations There are a number of trends and uncertainties affecting our business. Most importantly, we are dependent on general economic conditions and the willingness of our customers to invest in technology. Instability in the geopolitical environment of our customers, instability in the global credit markets and other similar disruptions put pressure on the global economy causing uncertainties. Our business is also affected by changes in foreign currency exchange rates. We believe these uncertainties have impacted our customers’ willingness to spend on IT and the manner in which they procure such technologies and services. This includes delays or rejection of capital projects, including the implementation of our products and services. As a result of a growing market trend preferring cloud consumption, more customers are exploring subscription and pay-per-use based models, rather than CapEx models, for procuring technology. The shift to subscription and pay-per-use models enables customers to manage costs and efficiencies by paying a subscription or a per minute or per message fee for business communications services rather than purchasing the underlying products and services, infrastructure and personnel, which are owned and managed by the equipment vendor or a cloud and managed services provider. We believe the market trend toward these flexible consumption models will continue as we see an increasing number of opportunities and requests for proposals based on subscription and pay-per-use models. This trend has driven an increase in the proportion of total Company revenues attributable to software and services. In addition, we believe customers are moving away from owned and operated infrastructure, preferring cloud offerings and virtualized server defined networks, which reduce our associated maintenance support opportunities. We continue to evolve into a software and services business and focus our go-to-market efforts by introducing new solutions and innovations, particularly on workflow automation, multi-channel customer engagement and cloud-enabled communications applications. The Company is focused on growing products and services with a recurring revenue stream. Recurring revenue includes products and services that are delivered pursuant to multi-period contracts including revenue recurring from sales of software, maintenance, Cloud, and Enterprise Cloud and Managed Services. The Company has maintained its focus on profitability levels and investing in future results. As the Company continues its transformation to a software and service-led organization, it has implemented programs designed to streamline its operations, generate cost savings and eliminate overlapping processes and resources. These cost savings programs include: (1) reducing headcount, (2) eliminating real estate costs associated with unused or under-utilized facilities and (3) implementing gross margin improvement and other cost reduction initiatives. The Company continues to evaluate opportunities to streamline its operations and identify cost savings globally and may take additional restructuring actions in the future. The costs of those actions could be material. Financial Results Summary On January 19, 2017 (the "Petition Date"), Avaya Holdings Corp., together with certain of its affiliates (collectively, the "Debtors"), filed voluntary petitions for relief (the "Bankruptcy Filing") under Chapter 11 of the United States Bankruptcy Code (the "Bankruptcy Code") in the United States Bankruptcy Court for the Southern District of New York (the "Bankruptcy Court"). On November 28, 2017, the Bankruptcy Court entered an order confirming the Second Amended Joint Plan of Reorganization filed by the Debtors on October 24, 2017 (the "Plan of Reorganization"). On December 15, 2017 (the "Emergence Date"), the Plan of Reorganization became effective and the Debtors emerged from bankruptcy. Beginning on the Emergence Date, the Company applied fresh start accounting, which resulted in a new basis of accounting and the Company becoming a new entity for financial reporting purposes. As a result of the application of fresh start accounting and the effects of the implementation of the Plan of Reorganization, the Consolidated Financial Statements after December 15, 2017 are not comparable with the Consolidated Financial Statements on or prior to that date. Refer to Note 5, "Fresh Start Accounting," to our Consolidated Financial Statements for further details. As a result, our financial results for the period from October 1, 2017 through December 15, 2017 are referred to as those of the "Predecessor" period. Our financial results for fiscal 2019 and the period from December 16, 2017 through September 30, 2018 are referred to as those of the "Successor" period. Our results of operations as reported in our Consolidated Financial Statements are in accordance with GAAP and therefore reported separately for each of these periods. Although GAAP requires that we report on our results for the period from October 1, 2017 through December 15, 2017 and the period from December 16, 2017 through September 30, 2018 separately, management views and assesses the Company’s operating results for fiscal 2018 by combining the results of the applicable Predecessor and Successor periods because such presentation provides the most meaningful comparison of our results to the current period. The Company cannot adequately compare the operating results of the period from December 16, 2017 through September 30, 2018 against the subsequent period reported in its Consolidated Financial Statements without combining it with the period from October 1, 2017 through December 15, 2017 and does not believe that reviewing the results of each of these periods in isolation would be useful in identifying any trends in or reaching any conclusions regarding the Company’s overall operating performance. Management believes that the key performance metrics such as revenue, gross margin and operating (loss) income for the Successor period when combined with the Predecessor period provides more meaningful comparisons to other periods and are useful in identifying current business trends. Accordingly, in addition to presenting our results of operations as reported in our Consolidated Financial Statements in accordance with GAAP, the table and discussion below also present the combined results for fiscal 2018. The combined results for fiscal 2018, which we refer to herein as results for "fiscal 2018," represent the sum of the reported amounts for the Predecessor period from October 1, 2017 through December 15, 2017 and the Successor period from December 16, 2017 through September 30, 2018. These combined results are not considered to be prepared in accordance with GAAP and have not been prepared as pro forma results under applicable regulations. The combined operating results may not reflect the actual results we would have achieved absent our emergence from bankruptcy and may not be indicative of future results. New Revenue Recognition Standard In May 2014, the Financial Accounting Standards Board "FASB" issued Accounting Standards Update "ASU" No. 2014-09, "Revenue from Contracts with Customers ("ASU 2014-09")." This standard superseded most of the previous revenue recognition guidance under GAAP and is intended to improve and converge with international standards the financial reporting requirements for revenue recognition. The core principle of the new guidance is that an entity should recognize revenue to depict the transfer of control 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. New disclosures about the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers are also required. Subsequently, the FASB issued several standards that clarified certain aspects of ASU 2014-09 but did not significantly change the original standard. The Company adopted ASU 2014-09 and its related amendments (collectively "ASC 606") as of October 1, 2018 using the modified retrospective transition method. Refer to Note 3, "Recent Accounting Pronouncements" and Note 6, "Revenue Recognition" to our Consolidated Financial Statements for disclosures related to the adoption of ASC 606 and an updated accounting policy related to revenue recognition and contract costs. With the adoption of ASC 606, sales that include professional services, are generally recognized as the services are performed as opposed to upon completion and acceptance of the promised services. Additionally, when such arrangements also include products, certain products revenue is recognized when the products are delivered as opposed to upon completion and acceptance of the related services. Revenue recognition related to stand-alone product shipments, maintenance services, and certain cloud offerings remains substantially unchanged. In addition to the impacts on revenue recognition, the standard requires incremental contract acquisition costs (primarily sales commissions) to be capitalized and amortized over the term of the related performance obligation as opposed to expensed as incurred. The actual impacts are dependent upon contract-specific terms. At the beginning of fiscal 2019, the Company’s management proactively aligned its internal key performance indicators and its incentive compensation plans to drive performance under ASC 606. Due to these operational changes, the Company’s results for fiscal 2019 if prepared on an ASC 605 as opposed to an ASC 606 basis (see Note 6, “Revenue Recognition,” to our Consolidated Financial Statements) would not be directly comparable to the Company’s results for fiscal 2018, which are also on an ASC 605 basis. In addition to the impact on revenue, these operational changes also had a corresponding impact on the Company’s cash flow performance, as revenue recognition now precedes customer billing and cash collection in many cases. The Company anticipates that the differences resulting from these operational changes will normalize as services engagements reach completion milestones in subsequent reporting periods. Fiscal Year Ended September 30, 2019 Results Compared with Fiscal Year Ended September 30, 2018 Combined The section below provides a comparative discussion of our consolidated results of operations between fiscal 2019 and 2018. See Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K for the fiscal year ended September 30, 2018 for comparative discussion of our consolidated results of operations between fiscal 2018 (combined) and 2017. The following table displays our consolidated net (loss) income for the periods indicated: The following table displays the impact of the fair value adjustments resulting from the Company's application of fresh start accounting upon emergence from bankruptcy, excluding those related to the amortization of intangible assets, on the Company's operating loss for the period indicated: Revenue Revenue for fiscal 2019 was $2,887 million compared to $2,851 million for fiscal 2018. The increase was primarily driven by a lower impact of applying fresh start accounting upon emergence from bankruptcy, which resulted in the recognition of deferred revenue at fair value and lower revenue in subsequent periods and the favorable impact of adopting ASC 606 ($173 million). The increase was partially offset by lower demand for the Company’s unified communications and contact center products; lower professional services revenue mainly driven by the operational changes implemented in the current year to drive performance under ASC 606; a decline in maintenance services revenue primarily due to declines in Products & Solutions revenue in prior periods partially offset by an improvement in maintenance contract renewal rates; and the unfavorable impact of foreign currency exchange rates. The following table displays revenue and the percentage of revenue to total sales by operating segment for the periods indicated: (1) Not meaningful Products & Solutions revenue for fiscal 2019 was $1,228 million compared to $1,305 million for fiscal 2018. The decrease was primarily attributable to lower unified communications and contact center revenue and the unfavorable impact of foreign currency exchange rates, partially offset by the favorable impact of adopting ASC 606 ($97 million). Services revenue for fiscal 2019 was $1,680 million compared to $1,752 million for fiscal 2018. The decrease was primarily due to lower professional services revenue mainly driven by the operational changes implemented in the current year to drive performance under ASC 606; a decline in maintenance services revenue primarily due to declines in Products & Solutions revenue in prior periods partially offset by an improvement in maintenance contract renewal rates; and the unfavorable impact of foreign currency exchange rates, partially offset by the favorable impact of adopting ASC 606 ($76 million). Unallocated amounts for fiscal 2019 and 2018 represent the fair value adjustment to deferred revenue recognized upon emergence from bankruptcy and excluded from segment revenue. The following table displays revenue and the percentage of revenue to total sales by location for the periods indicated: Revenue in the U.S. for fiscal 2019 was $1,553 million compared to $1,515 million for fiscal 2018. The increase in U.S. revenue was the result of a lower impact of applying fresh start accounting upon emergence from bankruptcy and the favorable impact of adopting ASC 606 ($89 million). The increase was partially offset by lower demand for the Company's unified communications and contact center products and a decline in professional and maintenance services revenue. Revenue in Europe, Middle East and Africa ("EMEA") for fiscal 2019 was $753 million compared to $769 million for fiscal 2018. The decrease in EMEA revenue was primarily attributable to lower demand for our unified communications products; lower professional services revenue; and the unfavorable impact of foreign currency exchange rates, partially offset by a lower impact of fresh start accounting and the favorable impact of adopting ASC 606 ($31 million). Revenue in Asia Pacific ("APAC") for fiscal 2019 was $327 million compared to $313 million for fiscal 2018. The increase in APAC revenue was primarily attributable to the favorable impact of adopting ASC 606 ($21 million); a lower impact of fresh start accounting; and higher maintenance services revenue, partially offset by lower demand for our unified communications and contact center products; lower professional services revenue; and the unfavorable impact of foreign currency exchange rates. Revenue in Americas International for fiscal 2019 was $254 million and flat with the prior year period. In Americas International, the favorable impact of adopting ASC 606 ($32 million) and a lower impact of fresh start accounting was offset by lower professional services revenue; lower demand for our unified communications and contact center products; and the unfavorable impact of foreign currency exchange rates. Gross Profit The following table sets forth gross profit and gross margin by operating segment for the periods indicated: (1) Not meaningful Gross profit for fiscal 2019 was $1,575 million compared to $1,505 million for fiscal 2018. The increase was primarily driven by the increase in revenue described above, partially offset by amortization of technology intangibles with higher asset values due to the application of fresh start accounting upon emergence from bankruptcy and the unfavorable impact of costs recognized on an accelerated basis under ASC 606 ($44 million). Products & Solutions gross profit for fiscal 2019 was $791 million compared to $865 million for fiscal 2018. The decrease was mainly attributable to the decline in revenue described above. Products & Solutions gross margin decreased from 66.3% to 64.4% in fiscal 2019 mainly driven by unfavorable product mix. Services gross profit for fiscal 2019 was $996 million compared to $1,039 million for fiscal 2018. The decrease was mainly due to the decline in revenue described above. Services gross margin remained flat at 59.3% in both fiscal 2019 and 2018. Unallocated amounts for fiscal 2019 and 2018 include the fair value adjustments recognized upon emergence from bankruptcy and excluded from segment gross profit; the effect of the amortization of technology intangibles; and costs that are not core to the measurement of segment performance, but rather are controlled at the corporate level. Operating Expenses The following table sets forth operating expenses and the percentage of operating expenses to total revenue for the periods indicated: Selling, general and administrative expenses for fiscal 2019 were $1,001 million compared to $1,152 million for fiscal 2018. The decrease was primarily attributable to lower sales commissions and accrued incentive compensation due to the Company's revenue performance; costs incurred in the prior year in connection with certain legal matters and advisory fees to assist in the assessment of strategic and financial alternatives to improve the Company's capital structure; and the favorable impact of foreign currency exchange rates. The decrease was partially offset by an increase in non-cash share-based compensation due to a longer amortization period (twelve full months) for Successor Company stock awards included in the current year. Share-based compensation expense related to cancelled Predecessor Company stock awards was recorded within Reorganization items, net during the period from October 1, 2017 through December 15, 2017 (Predecessor). Research and development expenses for fiscal 2019 were $204 million compared to $210 million for fiscal 2018. The decrease was primarily attributable to lower depreciation expense in the current period due to the impact of applying fresh start accounting in fiscal 2018 and the favorable impact of foreign currency exchange rates, partially offset by incremental expenses associated with the Spoken acquisition. Amortization of intangible assets for fiscal 2019 was $162 million compared to $137 million for fiscal 2018. The carrying value of intangible assets was adjusted upon the application of fresh start accounting, which resulted in higher asset values and an increase in amortization during the current year period. Impairment charges for fiscal 2019 were $659 million. During the third quarter of fiscal 2019, the Company performed an interim impairment test of its goodwill and indefinite-lived intangible assets due to a sustained decrease in the Company’s stock price and lower than planned financial results which led to revisions to the Company's long-term forecast during the third quarter. The results of the Company’s interim goodwill impairment test as of June 30, 2019 indicated that the estimated fair values of the Company’s Unified Communications (“UC”), Global Support Services (“GSS”), Avaya Professional Services (“APS”) and Enterprise Cloud and Managed Solutions (“ECMS”) reporting units were greater than their carrying amounts, however, the carrying amount of the Company’s Contact Center (“CC”) reporting unit within the Products & Solutions segment exceeded its estimated fair value primarily due to a reduction in the Company's long-term forecast. As a result, the Company recorded a goodwill impairment charge of $657 million, representing the amount by which the carrying amount of the CC reporting unit exceeded its fair value. As of June 30, 2019, the remaining carrying amount of goodwill for the CC reporting unit was $197 million. The results of the indefinite-lived intangible asset impairment test indicated that no impairment existed. Subsequently, the Company performed its annual goodwill and indefinite-lived intangible assets impairment test as of July 1, 2019 and determined that no impairment existed. As of July 1, 2019, after giving effect to the impairment charges, the fair value of the UC, APS and ECMS reporting units exceeded their carrying amounts by more than 10%, however, the GSS reporting unit had an excess fair value over its carrying value of 7% and the CC reporting unit was at fair value due to the impairment charges described above. The goodwill assigned to GSS and CC as of July 1, 2019 was $1,446 million and $197 million, respectively. An increase in the GSS discount rate of 65 basis points or a decrease in the GSS long-term growth rate of 95 basis points used in the interim goodwill impairment test as of June 30, 2019 would result in an estimated fair value below its carrying value. During fiscal 2019, the Company also elected to abandon an in-process research and development project acquired with Spoken since it no longer aligned with the Company’s technology roadmap. As a result, the Company recorded an impairment charge of $2 million to write down the full carrying amount of the acquired in-process research and development project. To the extent that business conditions deteriorate further or if changes in key assumptions and estimates differ significantly from management’s expectations, it may be necessary to record additional impairment charges in the future. No impairment charges were recorded during fiscal 2018. Restructuring charges, net, for fiscal 2019 were $22 million compared to $95 million for fiscal 2018. Restructuring charges during fiscal 2019 consisted of employee separation costs of $19 million primarily associated with employee severance actions in the U.S., EMEA and Canada and lease obligations of $3 million primarily in the U.S. Restructuring charges during fiscal 2018 included employee separation costs of $83 million primarily associated with employee severance actions in EMEA and the U.S. and lease obligations of $12 million, primarily in the U.S. and EMEA. Operating Loss Operating loss for fiscal 2019 was $473 million compared to $89 million for fiscal 2018. Our operating results for fiscal 2019 as compared to fiscal 2018 reflect, among other things: • higher revenue and gross profit for fiscal 2019, as described above; • impairment charges of $659 million for fiscal 2019; • costs incurred in connection with certain legal matters of $37 million for fiscal 2018; • lower restructuring charges for fiscal 2019; • lower advisory fees incurred to assist in the assessment of strategic and financial alternatives to improve the Company's capital structure of $10 million; • higher amortization of intangible assets due to the application of fresh start accounting upon emergence from bankruptcy; • the favorable impact of adopting ASC 606 on October 1, 2018; and • lower accrued incentive compensation and sales commissions in fiscal 2019. Interest Expense Interest expense for fiscal 2019 was $237 million compared to $183 million for fiscal 2018. For the period from October 1, 2017 through December 15, 2017, contractual interest expense of $94 million was not recorded, as it was not an allowed claim under the Company's bankruptcy filing. The decline in interest expense, when including the contractual interest expense of $94 million not recorded in fiscal 2018, was driven by lower average debt balances outstanding in fiscal 2019 as a result of the Company's Plan of Reorganization upon emergence from bankruptcy, partially offset by interest expense associated with the Convertible Notes issued in June 2018. Other Income, Net Other income, net for fiscal 2019 was $41 million as compared to $33 million for fiscal 2018. Other income, net for fiscal 2019 consisted of a change in fair value of the Emergence Date Warrants of $29 million; interest income of $14 million; and other pension and post-retirement benefit credits of $7 million, partially offset by net foreign currency losses of $8 million and other, net of $1 million. Other income, net for fiscal 2018 included net foreign currency gains of $28 million, principally due to the strengthening of the U.S. dollar compared to certain foreign exchange rates on U.S. dollar denominated receivables maintained in non-U.S. locations, mainly Argentina, India and Mexico; income from a transition services agreement entered into in connection with the sale of the Networking business to Extreme (the "TSA") of $8 million; interest income of $7 million; other pension and post-retirement benefit credits of $5 million; and other, net of $2 million, partially offset by a change in fair value of the Emergence Date Warrants of $17 million. Reorganization Items, Net Reorganization items, net for fiscal 2018 were $3,416 million and primarily consists of the net gain from the consummation of the Plan of Reorganization and the related settlement of liabilities. Reorganization items, net also represent amounts incurred subsequent to the Bankruptcy Filing as a direct result of the Bankruptcy Filing and are comprised of professional service fees and contract rejection fees. (Provision for) Benefit from Income Taxes The provision for income taxes was $2 million for fiscal 2019 compared with a benefit from income taxes of $87 million for fiscal 2018. The Company's effective income tax rate for fiscal 2019 differed from the U.S. federal tax rate primarily due to: (1) income and losses taxed at different foreign tax rates, (2) losses generated within certain foreign jurisdictions for which no benefit was recorded because it is more likely than not that the tax benefits would not be realized, (3) non-U.S. withholding taxes on foreign earnings, (4) current period changes to unrecognized tax positions, (5) U.S. state and local income taxes, (6) the impact of the Tax Cuts and Jobs Act (the "Act"), (7) the goodwill impairment charges recorded in fiscal 2019, (8) current period elections taken in submitted tax filings, and (9) foreign tax credits. The Company’s effective income tax rate for the period from December 16, 2017 through September 30, 2018 (Successor) differed from the U.S. federal tax rate primarily due to: (1) income and losses taxed at different foreign tax rates, (2) losses generated within certain foreign jurisdictions for which no benefit was recorded because it is more likely than not that the tax benefits would not be realized, (3) non-U.S. withholding taxes on foreign earnings, (4) current period changes to unrecognized tax positions, (5) U.S. state and local income taxes, (6) an increase in estimated current year tax loss, which is eliminated as part of the attribute reduction related to the cancellation of indebtedness income ("CODI"), and (7) the impact of the Act, which only affects the period from December 16, 2017 through September 30, 2018 (Successor). The Company's effective income tax rate for the period from October 1, 2017 through December 15, 2017 (Predecessor) differed from the U.S. federal tax rate primarily due to: (1) income and losses taxed at different foreign tax rates, (2) losses generated within certain foreign jurisdictions for which no benefit was recorded because it is more likely than not that the tax benefits would not be realized, (3) non-U.S. withholding taxes on foreign earnings, (4) current period changes to unrecognized tax positions, (5) U.S. state and local taxes, and (6) the impact of reorganization and fresh start adjustments. Net (Loss) Income Net loss was $671 million for fiscal 2019 compared to a net income of $3,264 million for fiscal 2018 as a result of the items discussed above. Liquidity and Capital Resources We expect our existing cash balance, cash generated by operations, borrowings available under our ABL Credit Agreement and cash received in connection with the Company's strategic partnership with RingCentral, which closed on October 31, 2019, to be our primary sources of short-term liquidity. Refer to "Recent Developments - Strategic Partnership with RingCentral" and Note 26, "Subsequent Events," included in Part II, Item 8 of this Annual Report on Form 10-K for additional information regarding the strategic partnership with RingCentral. Our ability to meet our cash requirements will depend on our ability to generate cash in the future, which is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. Based on our current level of operations, we believe these sources will be adequate to meet our liquidity needs for at least the next twelve months. Cash Flow Activity The following table provides a summary of the statements of cash flows for the periods indicated: Operating Activities Cash provided by operating activities was $241 million for fiscal 2019, compared to cash used for operating activities of $212 million for fiscal 2018. The change between fiscal 2019 and 2018 was primarily due to payments made during fiscal 2018 related to the Company's reorganization and emergence from bankruptcy, which included payments to the Pension Benefit Guaranty Corporation ($340 million), general unsecured creditor claims ($58 million) and the Avaya Pension Plan trust ($49 million); the timing of vendor and customer payments; lower restructuring payments; lower pension and other post-retirement benefits; and lower advisory fees to assist in the assessment of strategic and financial alternatives to improve the Company's capital structure. These lower payments were partially offset by higher interest payments in fiscal 2019 due to the cessation of such payments in January 2017 during the bankruptcy process; lower cash earnings; higher income tax payments; and increases in inventory. Investing Activities Cash used for investing activities for fiscal 2019 and 2018 was $124 million and $212 million, respectively. The decrease was primarily due to cash paid for the Spoken acquisition of $157 million in the prior year period and $17 million of proceeds received in the prior year period from sale-leaseback transactions, mainly related to the sale of equipment used in the performance of services under the Company's agreement with HP Enterprise Services, LLC ("HP"). These decreases were partially offset by higher capital expenditures for IT-related projects and the Company's investment in a unified communications as a service (“UCaaS”) provider catering to public sector security requirements. Financing Activities Cash used for financing activities for fiscal 2019 was $61 million, compared to cash provided by financing activities of $171 million for fiscal 2018. Cash used for financing activities for fiscal 2019 included: • scheduled debt repayments under the Term Loan Credit Agreement of $29 million; • repayments in connection with financing the use of equipment for the performance of services under our agreement with HP of $12 million; • payment of contingent consideration related to the Spoken acquisition of $9 million; and • other financing activities, net of $11 million. Cash provided by financing activities for fiscal 2018 included: • proceeds of $2,896 million from the Term Loan Credit Agreement entered into on the Emergence Date; • proceeds of $350 million from the issuance of 2.25% Convertible Notes; and • proceeds from the issuance of call spread warrants (the "Call Spread Warrants") of $58 million; • partially offset by: • repayment of the Company's Term Loan Credit Agreement of $2,918 million as part of its refinancing in the prior year, net of proceeds received under the refinancing of $2,911 million; • repayments to the Predecessor Company first lien debt holders of $2,061 million; • repayment of the Predecessor Company DIP Credit Agreement of $725 million; • adequate protection payments related to the bankruptcy of $111 million; • payment of debt issuance costs of $107 million; • the purchase of a bond hedge of $84 million; • scheduled debt repayments under the Term Loan Credit Agreement of $22 million; • repayments in connection with financing the use of equipment for the performance of services under our agreement with HP of $13 million; and • other financing activities, net of $3 million. As of September 30, 2019, the Company was in compliance with all covenants and other requirements under its debt agreements. See Note 12, "Financing Arrangements," and Note 13, "Derivative Instruments and Hedging Activities," to our Consolidated Financial Statements for further details about our financing arrangements and hedging activities, including summaries of the Company's Term Loan Credit Agreement, ABL Credit Agreement, Convertible Notes and interest swap agreements. Contractual Obligations and Sources of Liquidity Contractual Obligations The following table summarizes the Company's contractual obligations as of September 30, 2019: (1) Represents principal payments only. (2) The interest payments due on debt give effect to the impact of the Company's interest rate swap agreements. The interest payments for the unhedged portion of the Company's Term Loan Credit Agreement were calculated by applying an applicable margin to a projected LIBOR rate. The interest payments for the Company's 2.25% convertible senior notes were based on the contractual 2.25% coupon rate. An estimated unused facility fee was calculated for the ABL Credit Agreement using the contract rate. (3) During the normal course of business, in order to manage manufacturing lead times and to help assure adequate component supply, the Company enters into agreements with contract manufacturers and suppliers that allow them to produce and procure inventory based upon forecasted requirements. If the Company does not meet the specified minimum purchase commitments under these agreements, it could be required to purchase the inventory. (4) Other purchase obligations represent an estimate of contractual obligations in the ordinary course of business, other than commitments with contract manufacturers and suppliers, for which the Company had not received the goods or services as of September 30, 2019. Although contractual obligations are considered enforceable and legally binding, the terms generally allow the Company the option to cancel, reschedule and adjust its requirements based on the Company's business needs prior to the delivery of goods or performance of services. (5) Contractual obligations for operating leases include future minimum lease payments, net of remaining sublease income of $3 million. (6) The payments due for capital lease obligations do not include $1 million in future payments for interest. (7) The Company sponsors non-contributory defined pension and post-retirement plans covering certain employees and retirees. The Company's general funding policy with respect to qualified pension plans is to contribute amounts at least sufficient to satisfy the minimum amount required by applicable law and regulations, or to directly pay benefits where appropriate. Most post-retirement medical benefits are not pre-funded. Consequently, the Company makes payments as these retiree medical benefits are disbursed. The amounts presented represent estimated minimum funding requirements through fiscal 2029. As of September 30, 2019, the Company's unrecognized tax benefits ("UTBs") associated with uncertain tax positions were $147 million and interest and penalties related to these amounts were an additional $22 million. Those UTBs are not reflected in the table above due to the uncertainty of the timing of payments. Future Cash Requirements Our primary future cash requirements will be to fund operations, debt service, restructuring payments, capital expenditures, benefit obligations and share repurchases. In addition, we may use cash in the future to make strategic acquisitions. Specifically, we expect our primary cash requirements for fiscal 2020 to be as follows: • Debt service-We expect to make payments of approximately $447 million during fiscal 2020 in principal and interest associated with the Term Loan Credit Agreement, and interest and fees associated with our ABL Credit Agreement and 2.25% Convertible Notes, inclusive of a debt principal paydown of $250 million made by the Company in November 2019. In the ordinary course of business, we may from time to time borrow and repay amounts under our ABL Credit Agreement. • Share repurchases-On October 1, 2019, the Board of Directors of the Company approved a stock repurchase program authorizing the Company to repurchase the Company’s Common Stock for an aggregate expenditure of up to $500 million. • Restructuring payments-We expect to make payments of approximately $25 million to $30 million during fiscal 2020 for employee separation costs and lease termination obligations associated with restructuring actions we have taken through September 30, 2019. The Company continues to evaluate opportunities to streamline its operations and identify additional cost savings globally. • Capital expenditures-We expect to spend approximately $115 million to $125 million for capital expenditures and capitalized software development costs during fiscal 2020. Environmental costs and accruals are presently not material to our operations, cash flows or financial position, and we do not currently anticipate material capital expenditures for environmental control facilities. • Benefit obligations-We estimate we will make payments under our pension and post-retirement benefit obligations totaling $51 million during fiscal 2020. These payments include $15 million to satisfy the minimum statutory funding requirements of our U.S. qualified pension plans; $23 million for our non-U.S. benefit plans, which are predominantly not pre-funded; and $13 million for represented retiree post-retirement benefits. See discussion in Note 16, "Benefit Obligations," to our Consolidated Financial Statements for further details. In addition to the matters identified above, in the ordinary course of business, the Company is involved in litigation, claims, government inquiries, investigations and proceedings, including but not limited to those identified in Note 23, "Commitments and Contingencies," to our Consolidated Financial Statements, relating to intellectual property, commercial, employment, environmental and regulatory matters, which may require us to make cash payments. These and other legal matters could have a material adverse effect on the manner in which the Company does business and the Company's financial position, results of operations, cash flows and liquidity. During fiscal 2019 (Successor) and the period from December 16, 2017 through September 30, 2018 (Successor), there were no costs incurred in connection with the resolution of legal matters other than those incurred in the ordinary course of business. During the period from October 1, 2017 through December 15, 2017 (Predecessor) and fiscal 2017 (Predecessor), costs incurred in connection with the resolution of certain legal matters were $37 million and $64 million, respectively. We and our subsidiaries and affiliates may from time to time seek to retire or purchase our outstanding equity (common stock and warrants) and/or debt (including publicly issued debt) through cash purchases and/or exchanges, in open market purchases, privately negotiated transactions, tender offers or otherwise. Such repurchases or exchanges, if any, will depend on prevailing market conditions, liquidity requirements, contractual restrictions and other factors. Future Sources of Liquidity We expect our cash balance, cash generated by operations, borrowings available under our ABL Credit Agreement and cash received in connection with the Company's strategic partnership with RingCentral to be our primary sources of short-term liquidity. As of September 30, 2019 and 2018, our cash and cash equivalent balances held outside the U.S. were $176 million and $169 million, respectively. As of September 30, 2019, the Company’s cash and cash equivalents held outside the U.S. are not required to be repatriated to fund the Company’s operations based on our expected future sources of liquidity. Under the terms of the ABL Credit Agreement, the Company can issue letters of credit up to $150 million. At September 30, 2019, the Company had issued and outstanding letters of credit and guarantees of $44 million under the ABL Credit Agreement and had no other borrowings outstanding under the ABL. The aggregate additional principal amount that may be borrowed under the ABL Credit Agreement, based on the borrowing base less $44 million of outstanding letters of credit and guarantees, was $142 million at September 30, 2019. We believe that our existing cash and cash equivalents of $752 million as of September 30, 2019, future cash provided by operating activities, borrowings available under the ABL Credit Agreement and cash received in connection with the Company's strategic partnership with RingCentral will be sufficient to meet our future cash requirements for at least the next twelve months. Our ability to meet these requirements will depend on our ability to generate cash in the future, which is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. Off-Balance Sheet Arrangements See discussion in Note 23, "Commitments and Contingencies," to our Consolidated Financial Statements for further details. Debt Ratings Our ability to obtain additional external financing and the related cost of borrowing may be affected by our ratings, which are periodically reviewed by the major credit rating agencies. The ratings are subject to change or withdrawal at any time by the respective credit rating agencies. As of September 30, 2019, the Company's debt ratings were as follows: • Moody’s Investors Service issued a corporate family rating of "B2" with a stable outlook and a rating of the 7-year $2,925 million Term Loan Credit Agreement of "B2"; • Standard and Poor's issued a definitive corporate credit rating of "B" with a stable outlook and a rating of the Term Loan Credit Agreement of "B"; and • Fitch Ratings Inc. issued a Long-Term Issuer Default Rating of "B" with a stable outlook and a rating of the Term Loan Credit Agreement of "BB-". Commitments and Contingencies We are party to several types of agreements, including surety bonds, purchase commitments, product financing arrangements and performance guarantees, which are fully discussed in Note 23, "Commitments and Contingencies," to our Consolidated Financial Statements. EBITDA and Adjusted EBITDA EBITDA is defined as net (loss) income before income taxes, interest expense, interest income and depreciation and amortization and excludes the results of discontinued operations. EBITDA provides us with a measure of operating performance that excludes certain non-operating and/or non-cash expenses, which can differ significantly from company to company depending on capital structure, the tax jurisdictions in which companies operate and capital investments. Adjusted EBITDA is EBITDA as further adjusted by the items noted in the reconciliation table below. We believe Adjusted EBITDA provides a measure of our financial performance based on operational factors that management can impact in the short-term, such as our pricing strategies, volume, costs and expenses of the organization, and therefore presents our financial performance in a way that can be more easily compared to prior quarters or fiscal years. In addition, Adjusted EBITDA serves as a basis for determining certain management and employee compensation. We also present EBITDA and Adjusted EBITDA because we believe analysts and investors utilize these measures in analyzing our results. Under the Company's debt agreements, the ability to engage in activities such as incurring additional indebtedness, making investments and paying dividends is tied in part to ratios based on a measure of Adjusted EBITDA. EBITDA and Adjusted EBITDA have limitations as analytical tools. EBITDA measures do not represent net (loss) income or cash flow from operations as those terms are defined by GAAP and do not necessarily indicate whether cash flows will be sufficient to fund cash needs. While EBITDA measures are frequently used as measures of operations and the ability to meet debt service requirements, these terms are not necessarily comparable to other similarly titled captions of other companies due to the potential inconsistencies in the method of calculation. Further, Adjusted EBITDA excludes the impact of earnings or charges resulting from matters that we consider not to be indicative of our ongoing operations but could be substantial. In particular, our formulation of Adjusted EBITDA adjusts for certain amounts that are included in calculating net (loss) income as set forth in the following table including, but not limited to, restructuring charges, impairment charges, certain fees payable to our Predecessor private equity sponsors and other advisors, resolution of certain legal matters and a portion of our pension costs and post-retirement benefits costs, which represents the amortization of pension service costs and actuarial gain (loss) associated with these benefits. However, these are expenses that may recur, may vary and/or may be difficult to predict. The unaudited reconciliation of net (loss) income, which is a GAAP measure, to EBITDA and Adjusted EBITDA, which are non-GAAP measures, is presented below for the periods indicated: (a) Effective January 19, 2017, the Company ceased recording interest expense on outstanding pre-petition debt classified as liabilities subject to compromise. Contractual interest expense represents amounts due under the contractual terms of outstanding debt, including debt subject to compromise. For the periods from October 1, 2017 through December 15, 2017 and January 19, 2017 through September 30, 2017, contractual interest expense related to debt subject to compromise of $94 million and $316 million, respectively, had not been recorded as interest expense, as it was not an allowed claim under the Bankruptcy Filing. (b) Reflects the impact of fresh start accounting adjustments in connection with the Company's emergence from bankruptcy. (c) Advisory fees primarily represent costs incurred to assist in the assessment of strategic and financial alternatives to improve the Company's capital structure. (d) Costs in connection with the resolution of certain legal matters include reserves and settlements, as well as associated legal costs. (e) Represents that portion of our pension and post-retirement benefit costs which represent the amortization of prior service costs and net actuarial gain (loss) associated with these benefits. Critical Accounting Policies and Estimates The preparation of financial statements and related disclosures in conformity with GAAP requires the Company's management to make judgments, assumptions and estimates that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and revenue and expenses during the periods reported. Management bases its estimates on historical experience and on various other assumptions it believes to be reasonable under the circumstances. Actual results may differ from these estimates and such differences may be material. Note 2, "Summary of Significant Accounting Policies," to our Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K describes the significant accounting policies and methods used in the preparation of the Company's Consolidated Financial Statements. Management considers the following policies critical because they are important to the portrayal of the Company's financial condition and operating results and they require management to make judgments and estimates about inherently uncertain matters. Revenue Recognition The Company derives revenue primarily from the sale of products and services for communications systems and applications. The Company sells directly through its worldwide sales force and indirectly through its global network of channel partners, including distributors, service providers, dealers, value-added resellers, systems integrators and business partners that provide sales and services support. On October 1, 2018, the Company adopted Accounting Standards Update ("ASU") No. 2014-09, "Revenue from Contracts with Customers (Topic 606)" ("ASC 606"). This standard superseded most of the previous revenue recognition guidance under GAAP and is intended to improve and converge with international standards the financial reporting requirements for revenue recognition. The Company adopted ASC 606 using the modified retrospective transition method. Under the modified retrospective method, results for reporting periods beginning after September 30, 2018 are presented under ASC 606 while prior period financial information is not adjusted and continues to be reported under prior guidance (“ASC 605”). See Note 3, “Recent Accounting Pronouncements - Recently Adopted Accounting Pronouncements,” to our Consolidated Financial Statements included in Part II, Item 8 of the Annual Report on Form 10-K for additional information on the impact of adopting ASC 606. In accordance with ASC 606, the Company accounts for a customer contract when both parties have approved the contract and are committed to perform their respective obligations, each party’s rights can be identified, payment terms can be identified, the contract has commercial substance and it is at least probable that the Company will collect the consideration to which it is entitled. The Company accrues a provision for estimated sales returns and other allowances, including promotional marketing programs and other incentives as a reduction of revenue at the time of sale. When estimating returns, the Company considers customary inventory levels held by third-party distributors. Revenue is recognized upon the transfer of control of the promised products and services to customers. Judgment is required in instances where the Company’s contracts include multiple products and services to determine whether each should be accounted for as a separate performance obligation. The Company enters into contracts that include various combinations of products and services, each of which is generally capable of being distinct as well as distinct within the context of the contracts. The total transaction price for each contract is determined based on the total consideration specified in the contract, including variable consideration such as sales incentives and other discounts. The expected value method is generally used when estimating variable consideration, which typically reduces the total transaction price due to the nature of the elements to which the variable consideration relates. These estimates reflect the Company’s historical experience, current contractual and statutory requirements, specific known market events and trends, industry data and forecasted customer buying patterns. The Company excludes from the transaction price all taxes assessed by governmental authorities that are both (i) imposed on and concurrent with a specific revenue-producing transaction and (ii) collected from customers. Accordingly, such tax amounts are not included as a component of net sales or cost of sales. The expected value method requires judgment and considers multiple factors that may vary over time depending upon the unique facts and circumstances related to each performance obligation. Depending on the facts and circumstances, a change in variable consideration estimate will either be accounted for at the contract level or using the portfolio method. Reserves for contractual stock rotation rights to channel partners to support the management of inventory and certain other sales incentives are determined using the portfolio method. The Company also considers the customers’ rights of return in determining the transaction price where applicable. The Company allocates the transaction price to each performance obligation based on its relative standalone selling price and recognizes revenue as each performance obligation is satisfied. Judgment is required to determine the standalone selling price for each distinct performance obligation. The Company uses a range of selling prices to estimate standalone selling price when each of the products and services is sold separately. The Company typically has more than one standalone selling price for individual products and services due to the stratification of those products and services by customers and circumstances. In these instances, the Company may use information such as the size of the customer and geographic region in determining the standalone selling price. In instances where standalone selling price is not directly observable, such as when the Company does not sell the product or service separately, the Company determines the standalone selling price using information that may include market conditions and other observable inputs. Contract modifications are accounted for as separate contracts if the additional products and services are distinct and priced at standalone selling prices. If the additional products and services are distinct, but not priced at standalone selling prices, the modification is treated as a termination of the existing contract and the creation of a new contract. Lastly, if the additional products and services are not distinct within the context of the contract, the modification is combined with the original contract and either an increase or decrease in revenue is recognized on the modification date. During fiscal 2019, the Company did not recognize any material revenue for contracts modified during the period that had performance obligations satisfied in prior periods. Acquisitions and Fresh Start Accounting The Company accounts for business combinations using the acquisition method, which requires an allocation of the purchase price of an acquired entity to the assets acquired and liabilities assumed based on their estimated fair values at the date of acquisition. Goodwill represents the excess of the purchase price over the net tangible and intangible assets acquired. The estimated useful lives of acquired intangible and long-lived assets are based on many factors including assumptions regarding the effects of obsolescence, demand, competition and other economic factors, expectations regarding the future use of the asset, and the Company's historical experience with similar assets. The assumptions used to determine the estimated useful lives could change due to numerous factors including product demand, market conditions, technological developments, economic conditions and competition. Upon emergence from bankruptcy on December 15, 2017, the Company applied fresh start accounting, which required all assets and liabilities to be remeasured at fair value as of the Emergence Date. See Note 5, "Fresh Start Accounting," to our Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for additional information. Goodwill and Indefinite-lived Intangible Assets Goodwill and indefinite-lived intangible assets are not amortized but are subject to annual testing for impairment each July 1st, or more frequently if events occur or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Goodwill is tested for impairment at the reporting unit level, which is one level below the Company's operating segments. The goodwill impairment assessment is conducted by estimating and comparing the fair value of each of the Company’s reporting units to its carrying value. If the carrying value of a reporting unit exceeds its fair value, the Company recognizes an impairment loss equal to the amount of the excess, limited to the amount of goodwill allocated to that reporting unit. Application of the impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units and the determination of the fair value of each reporting unit. The Company estimates the fair value of each reporting unit using a weighting of fair values derived from an income approach and a market approach. Under the income approach, the fair value of a reporting unit is estimated using a discounted cash flows model. Future cash flows are based on forward-looking information regarding revenue and costs for each reporting unit and are discounted using an appropriate discount rate in a discounted cash flows model. The discounted cash flows model relies on assumptions regarding revenue growth rates, projected gross profit, working capital needs, selling, general and administrative expenses, research and development expenses, business restructuring costs, capital expenditures, income tax rates, discount rates and terminal growth rates. The discount rate the Company uses represents the estimated weighted average cost of capital, which reflects the overall level of inherent risk involved in its reporting unit operations and the rate of return an outside investor would expect to earn. To estimate cash flows beyond the final year of its model, the Company uses a terminal value approach. Under this approach, the Company applies a perpetuity growth assumption to determine the terminal value. The Company incorporates the present value of the resulting terminal value into its estimate of fair value. Forecasted cash flows for each reporting unit consider current economic conditions and trends, estimated future operating results, the Company’s view of growth rates and anticipated future economic conditions. Revenue growth rates inherent in this forecast are based on input from internal and external market intelligence research sources that compare factors such as growth in global economies, regional trends in the telecommunications industry and product evolution from a technological segment basis. Macroeconomic factors such as changes in economies, product evolutions, industry consolidations and other changes beyond the Company’s control could have a positive or negative impact on achieving its forecasts. The market approach estimates the fair value of a reporting unit by applying multiples of operating performance measures to the reporting unit's operating performance (the "Guideline Public Company Method"). These multiples are derived from comparable publicly-traded companies with similar investment characteristics to the reporting unit. The key estimates and assumptions that are used to determine the fair value under this market approach include current and forward 12-month operating performance results, as applicable, and the selection of the relevant multiples to be applied. Changes in these estimates and assumptions could materially affect the determination of fair value and the goodwill impairment test result for each reporting unit. The Company performed an interim quantitative goodwill impairment test for all of its reporting units during the three months ended June 30, 2019 due to a sustained decrease in the Company’s stock price and lower than planned financial results which led to revisions to the Company's long-term forecast during the three months ended June 30, 2019. As a result, the Company performed an interim quantitative goodwill impairment test as of June 30, 2019 to compare the fair values of its reporting units to their respective carrying amounts, including the goodwill allocated to each reporting unit. The results of the Company’s interim goodwill impairment test as of June 30, 2019 indicated that the estimated fair values of the Company’s Unified Communications (“UC”), Global Support Services (“GSS”), Avaya Professional Services (“APS”) and Enterprise Cloud and Managed Solutions (“ECMS”) reporting units were greater than their carrying amounts, however, the carrying amount of the Company’s Contact Center ("CC") reporting unit within the Products & Solutions segment exceeded its estimated fair value primarily due to a reduction in the Company's long-term forecast. As a result, the Company recorded a goodwill impairment charge of $657 million, representing the amount by which the carrying amount of the CC reporting unit exceeded its fair value. The Company performed its annual goodwill impairment test on July 1, 2019 and determined that the carrying amounts of each of the Company's reporting units did not exceed their estimated fair values and therefore no impairment existed. At July 1, 2019, the level of excess fair value over carrying value exceeded 10% for each of the Company's reporting units, except for the Global Support Service ("GSS") reporting unit, which had an excess fair value over carrying value of 7%, and for the Contact Center ("CC") reporting unit, which was at fair value due to the impairment charges described above. The goodwill assigned to the GSS and CC reporting units as of July 1, 2019 was $1,446 and $197 million, respectively. An increase in the GSS discount rate of 65 basis points or a decrease in the GSS long-term growth rate of 95 basis points used in the most recent goodwill impairment test would result in an estimated fair value below its carrying value. The impairment test of indefinite-lived intangible assets consists of a comparison of the fair value of the indefinite-lived intangible assets with their carrying amounts. The Avaya Trade Name is evaluated for impairment using the relief-from-royalty method. Under this methodology, the fair value of the trade name is determined by applying a royalty rate to forecasted net revenues which is then discounted using a risk-adjusted rate of return on capital. Revenue growth rates inherent in the forecast are based on input from internal and external market intelligence research sources that compare factors such as growth in global economies, regional trends in the telecommunications industry and product evolution from a technological segment basis. The royalty rate is determined using a set of observed market royalty rates. As a result of the goodwill triggering events, the Company also performed an interim quantitative impairment test for the Avaya Trade Name as of June 30, 2019, and determined that its estimated fair value exceeded its carrying value and no impairment existed. At July 1, 2019, the Company performed its annual impairment test of the Avaya Trade Name and determined that the estimated fair value of the trade name exceeded its carrying amount by more than 10% and no impairment existed. During the fourth quarter of 2019, the Company closely monitored the key variables and other market factors for all of its reporting units and its indefinite-lived intangible asset and determined that it was not required to perform an interim impairment test. To the extent that business conditions deteriorate further or if changes in key assumptions and estimates differ significantly from management’s expectations, it may be necessary to record additional impairment charges in the future. Income Taxes Income taxes are accounted for under the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the Consolidated Statements of Operations in the period that includes the enactment date. A valuation allowance is recorded to reduce the carrying amounts of deferred tax assets if it is more likely than not that such assets will not be realized. Additionally, the accounting for income taxes requires the Company to evaluate and make an assertion as to whether undistributed foreign earnings will be indefinitely reinvested or repatriated. FASB ASC subtopic 740-10, "Income Taxes-Overall" ("ASC 740-10") prescribes a comprehensive model for the financial statement recognition, measurement, classification and disclosure of uncertain tax positions. ASC 740-10 contains a two-step approach to recognizing and measuring uncertain tax positions. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit based on the technical merits of the position. The second step is to measure the tax benefit as the largest amount that is more than 50% likely of being realized upon settlement. Significant judgment is required in evaluating uncertain tax positions and determining the provision for income taxes. Although the Company believes its reserves are reasonable, no assurance can be given that the final tax outcome of these matters will not be different from that which is reflected in the historical income tax provision and accruals. The Company adjusts its estimated liability for uncertain tax positions periodically due to new information discovered from ongoing examinations by, and settlements with, various taxing authorities, as well as changes in tax laws, regulations and interpretations. The Company’s policy is to recognize, when applicable, interest and penalties on uncertain tax positions as part of income tax expense. As part of the Company’s accounting for business combinations, some of the purchase price is allocated to goodwill and intangible assets. Impairment expenses associated with goodwill are generally not tax deductible and will result in an increased effective income tax rate in the fiscal period any impairment is recorded. The income tax benefit from future releases of the acquisition date valuation allowances or income tax contingencies, if any, are reflected in the income tax provision in the Consolidated Statements of Operations, rather than as an adjustment to the purchase price allocation. Pension and Post-retirement Benefit Obligations The Company sponsors non-contributory defined benefit pension plans covering a portion of its U.S. employees and retirees, and post-retirement benefit plans covering a portion of its U.S. employees and retirees that include healthcare benefits and life insurance coverage. Certain non-U.S. operations have various retirement benefit programs covering substantially all of their employees. The Company’s pension and post-retirement benefit costs are developed from actuarial valuations. Inherent in these valuations are key assumptions, including the discount rate, expected long-term rate of return on plan assets, rate of compensation increase and healthcare cost trend rate. Material changes in pension and post-retirement benefit costs may occur in the future due to changes in these assumptions, in the number of plan participants, in the level of benefits provided, in asset levels and in legislation. The discount rate is subject to change each year, consistent with changes in rates of return on high-quality fixed-income investments currently available and expected to be available during the expected benefit payment period. The Company selects the assumed discount rate for its U.S. pension and post-retirement benefit plans by applying the rates from the Aon AA Only and Aon AA Only Above Median yield curves to the expected benefit payment streams and develops a rate at which it is believed the benefit obligations could be effectively settled. The Company follows a similar process for its non-U.S. pension plans by applying the Aon Euro AA corporate bond yield curve. The market-related value of the Company’s plan assets as of the measurement date is developed using a five-year smoothing technique. First, a preliminary market-related value is calculated by adjusting the market-related value at the beginning of the year for payments to and from plan assets and the expected return on assets during the year. The expected return on assets represents the expected long-term rate of return on plan assets adjusted up to plus or minus 2% based on the actual ten-year average rate of return on plan assets. A final market-related value is determined as the preliminary market-related value, plus 20% of the difference between the actual return and expected return for each of the past five years. Salary growth and healthcare cost trend assumptions are based on the Company's historical experience and future outlook. While the Company believes that the assumptions used in these calculations are reasonable, differences in actual experience or changes in assumptions could materially affect the expense and liabilities related to the Company's defined benefit plans. For the U.S. pension; non-U.S. pension; and post-retirement plans combined, a hypothetical 25 basis point increase or decrease in the discount rate would affect expense for fiscal 2019 by $2 million or $(2) million, respectively. A hypothetical 25 basis point increase or decrease in the discount rate would change the projected benefit obligation as of September 30, 2019 by $(62) million or $64 million, respectively. A hypothetical 25 basis point change in the expected long-term rate of return would affect expense for fiscal 2019 by approximately $3 million.
0.000845
0.001107
0
<s>[INST] "Management’s Discussion and Analysis of Financial Condition and Results of Operations" should be read in conjunction with the Consolidated Financial Statements and related notes thereto included in Part II, Item 8 of this Annual Report on Form 10K. The matters discussed in "Management’s Discussion and Analysis of Financial Condition and Results of Operations" contain certain forwardlooking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forwardlooking statements involve significant risks and uncertainties. See the "Cautionary Note Regarding Forwardlooking Statements" above and Part 1, Item 1A, "Risk Factors" in this Annual Report on Form 10K for additional information regarding forwardlooking statements and the factors that could cause actual results to differ materially from those anticipated in the forwardlooking statements. Overview Avaya is a global leader in digital communications products, solutions and services for businesses of all sizes. We enable organizations around the globe to succeed by creating intelligent communications experiences for customers and employees. Avaya builds open, converged and innovative solutions to enhance and simplify communications and collaboration in the cloud, onpremises or a hybrid of both. Our global, experienced team of professionals delivers awardwinning services from initial planning and design, to seamless implementation and integration, to ongoing managed operations, optimization, training and support. Our business has two operating segments: Products & Solutions and Services. Products & Solutions Products & Solutions encompasses our unified communications and contact center platforms, applications and devices. Unified Communications ("UC"): Avaya's unified communications solutions enable organizations to reimagine what teaming can mean and help companies increase employee productivity, improve customer service and reduce costs. With Avaya's UC solutions, organizations can provide their workers with a single app for allchannel calling, messaging, meetings and team collaboration with the same ease of use they receive from consumer apps. Avaya embeds communications directly into the applications, browsers and devices employees use every day giving people a more natural, efficient and flexible way to connect, engage, respond and share where and how they want for better business results. Avaya offers an open, extensible development platform, so that customers and third parties can easily create custom applications and automated workflows for their unique needs, integrating Avaya’s capabilities into the customer's existing infrastructure and business applications. Our solutions enable a seamless communications experience that fits into how employees work instead of changing how they work. Avaya continues to evolve its UC solutions for cloud deployment, as some customers prefer to consume this service via the cloud. Contact Center ("CC"): Avaya’s industryleading digital contact center solutions enable customers to build a customized portfolio of applications, driving stronger customer engagement and higher customer lifetime value. Our reliable, secure and scalable communications solutions include voice, email, chat, social media, video, performance management and ease of thirdparty integration that can improve customer service and help companies compete more effectively. Like the UC business, Avaya is evolving the CC solution set for cloud development. Avaya also focuses on ensuring an outstanding experience for mobile callers by integrating transformative technologies, including Artificial Intelligence ("AI"), mobility, big data analytics, and cybersecurity into our contact center solutions. As organizations use these solutions to gain a deeper understanding of their customer needs, we believe that their teams become more efficient and effective and their customer loyalty grows. Both UC and CC are supported by our portfolio of innovative business phones and multimedia devices, which is one of the broadest in the industry. Avaya brings consumer technology to employee mobile devices and the desktop in a way that can help our customers enhance customer service, internal and external collaboration, and employee productivity. Customers experience seamless audio and video capabilities for both Avaya and approved thirdparty UC platforms via open Session Initiation Protocol ("SIP") devices. SIP is used for signaling and controlling multimedia communication sessions in applications of Internet telephony for voice and video calls, along with integration with numerous apps that help connect and accelerate business. Developers can easily customize capabilities for their specific needs with our client Software Development Kit ("SDK"). Services Services consists of three business areas: Global Support Services, Enterprise Cloud and Managed Services and Professional Services. Global Support Services features offerings that address the risk of system outages and also help businesses protect their technology investments. We help our customers maintain their competitiveness [/INST] Positive. </s>
2,019
11,847
1,711,786
Hoth Therapeutics, Inc.
2019-04-01
2018-12-31
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULT OF OPERATIONS You should read the following discussion and analysis of our financial condition and plan of operations together with and our financial statements and the related notes appearing elsewhere in this Annual Report on Form 10-K. In addition to historical information, this discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results may 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. All amounts in this report are in U.S. dollars, unless otherwise noted. Overview We are a biopharmaceutical company formed in May 2017 focused on targeted therapeutics for patients suffering from conditions such as atopic dermatitis, also known as eczema. Our primary asset is a sublicense agreement with Chelexa pursuant to which Chelexa has granted us an exclusive sublicense to use its BioLexa Platform, a proprietary, patented, drug compound platform developed at the University of Cincinnati. The license enables us to develop the platform for any indications in humans. Our initial focus will be on the treatment of eczema through the application of a topical cream. Although our initial focus will be on the treatment of eczema, we intend to develop a second topical cream which, upon application, is intended to reduce post-procedure infections, accelerate healing and improve clinical outcomes for patients undergoing aesthetic dermatology procedures. In addition, we intend to conduct a pilot study on the efficacy of BioLexa to accelerate diabetic wound healing. The BioLexa Platform combines an FDA approved zinc chelator with one or more approved antibiotics in a topical dosage form to address unchecked eczema flare-ups by preventing the formation of infectious biofilms and the resulting clogging of sweat ducts which trigger symptoms. It is the first product candidate intended to prevent the symptom triggering flare-ups rather than simply treating symptoms when they occur. On May 26, 2017, we entered into a sublicense agreement with Chelexa, as amended on August 22, 2018 and August 29, 2018, pursuant to which Chelexa granted us an exclusive sublicense to make, use, have made, import, offer for sale, and sell products based upon or involving the use of (i) topical compositions comprising a zinc chelator and gentamicin and (ii) zinc chelators to inhibit biofilm formation, which rights were originally granted to Chelexa pursuant to an exclusive license agreement with the University of Cincinnati. In addition, Chelexa granted us the right to issue exclusive and nonexclusive sublicenses (with the right to further sublicense to third parties) to make, use, have made, import, offer for sale, and sell products based upon the BioLexa Platform. We intend to initially use the BioLexa Platform to develop two different topical cream products: (i) a product to treat eczema and (ii) a product that reduces post-procedure infections, accelerates healing and improves clinical outcomes for patients undergoing aesthetic dermatology procedures. Eczema is a disease that results in inflammation of the skin and is characterized by rash, red skin, and itchiness. Eczema is also referred to as atopic dermatitis. We are concentrating our effort and resources to develop the BioLexa Platform, utilizing our novel formulation and approach for these two markets. The BioLexa Platform has achieved positive results in its initial clinical studies conducted at the University of Miami. BioLexa’s formulation is a new topical dosage form “repurposing” the antibiotic, enabling it to be developed for use in patients following a special regulatory pathway codified in Section 505(b)(2) of the FDA rules. Section 505(b)(2) of the FDCA was enacted to enable sponsors to seek NDA approval for novel repurposed drugs without the need for such sponsors to undertake time consuming and expensive pre-clinical safety studies and Phase 1 safety studies. Proceeding under this regulatory pathway, we will be able to rely upon all of the publicly available safety and toxicology data with respect to gentamicin and zinc chelator in our FDA submissions. We will be required to conduct a Phase 2 study to show the safety of the combination in humans and after such Phase 2 study will be required to proceed to Phase 3 pivotal clinical trials. We believe that this path will dramatically reduce the required clinical development effort, costs and risks as compared to what would be required of us if we were required to conduct pre-clinical safety, toxicology and animal studies together with Phase 1 human safety trials required for new chemical entities which are not eligible to be reviewed pursuant to the Section 505(b)(2) regulatory pathway. We estimate that by using the Section 505(b)(2) regulatory pathway, that the clinical development process may be five to six years shorter than is required for a new chemical entity, and the FDA approval process may be six to nine months shorter than the typical eighteen month period, which we believe may result in lower development costs and shorter development time. As of the date hereof, we have not submitted an NDA to the FDA. In September 2018, we attended the first of a planned series of meetings with the FDA to review the requirements for submission and activation of an IND with respect to the BioLexa Platform for use in eczema. In preparation for such pre-IND meeting, we prepared and presented to the FDA our proposed Phase 2 clinical trial plan for the treatment of eczema in patients over the age of one year old. As part of our pre-IND meeting, the FDA provided us with general guidance with respect to specific animal studies, dosing schedules and suggested human safety studies before we commence clinical trials in pediatric or adult patients. We are also exploring the feasibility, cost and timings advantages of conducting an initial Phase 2 proof of concept clinical trial in a small number of pediatric patients. The objective of this study would be to evaluate the safety and potential efficacy of BioLexa compared to the cream base or vehicle that contains no active ingredients. This Phase 2 proof of concept clinical trial feasibility study may provide us with highly useful information regarding potential safety and efficacy of the BioLexa platform and assist us in developing appropriate sample sizes for the two registration, or regulatory, trials required for FDA approval. We are currently investigating multiple potential venues for conducting such trial both in and outstand of the U.S. We have engaged Camargo to assist us with the FDA process required for Section 505(b)(2) applications and with the evaluation of potential clinical trial venues for the proof of concept study should we determine to undertake such study. Specifically, Camargo has provided and will continue to provide advice and guidance relative to the IND preparation phase for the BioLexa Platform. Camargo will assist us with the refinement of our non-clinical, clinical, clinical pharmacology and biopharmaceutics strategy incorporating the preliminary feedback we received from the FDA during our pre-IND meeting. We believe that the key elements for our market success include: ● the proprietary formulation of two FDA-approved drugs to treat bacterial proliferation reduces development time and costs by giving us the ability to rely on safety and efficacy data from the two approved drugs; ● our proprietary formulation is not a topical corticosteroid, and may not be subject to the same FDA black box warning issues as most commonly prescribed treatments currently in use; and ● a recent peer-reviewed publication titled “Staphylococcal Bacteria May Cause Eczema, Study Reveals”, published by Dr. Herbert B. Allen, highlights that staph-induced biofilms are the root cause of flare-ups in eczema. Our BioLexa product candidate has been demonstrated to prevent the formation of these biofilms with the promise of delaying or completely arresting flare-ups, rather than merely treating symptoms of a flare-up already underway. In addition to our sublicense agreement with Chelexa, we entered into an exclusive license agreement with the University of Cincinnati for a patented, novel genetic marker for food allergies. The genetic marker licensed by us from the University of Cincinnati (i) may be used to identify at risk infants in predicting food allergies, including peanut and milk allergies, (ii) may be used to identify a person’s predisposition to an allergic reaction, thereby avoiding such reaction and (iii) may also determine an individual’s propensity to develop AD, such as eczema. We intend to utilize the genetic marker for purposes of determining an individual’s propensity to develop eczema as well as to identify and treat allergies in at-risk infants. In order to generate revenue from our product candidates, we will need to sell our product candidates either through distribution partnerships or through our own sales efforts. Prior to selling our product candidates, we will need to receive FDA approval of our NDA for each indication that we intend to treat. The first indication we are seeking approval for is the BioLexa Platform for treating eczema. We intend to submit our NDA for such indication by the end of 2021 with approval of such NDA anticipated to be in 2022; however, no assurances can be given that we will receive approval of the NDA in a timely manner, if at all. Results of Operations Components of Our Results of Operations for the Year Ended December 31, 2018 Operating Costs and Expenses Research and Development Expenses For the year ended December 31, 2018, research and development expenses were approximately $1.0 million, of which approximately $0.1 million was related to license acquired, $0.1 million was related to the issuance of 213,166 shares of our common stock pursuant to the sublicense agreement with Chelexa and $0.8 million was related to other research and development expenses. We expect our research and development activities to increase as we develop our existing product candidate and potentially acquire new product candidates, reflecting increasing costs associated with the following: ● employee-related expenses, which include salaries and benefits, and rent expenses; ● license fees and milestone payments related to in-licensed products and technology; ● expenses incurred under agreements with contract research organizations, investigative sites and consultants that conduct our clinical trials and a substantial portion of our preclinical activities; ● the cost of acquiring and manufacturing clinical trial materials; and ● costs associated with non-clinical activities, and regulatory approvals. General and Administrative Expenses For the year ended December 31, 2018, general and administrative expenses were approximately $1.5 million, which primarily consisted of approximately $0.4 million related to payroll expenses, approximately $0.1 million related to the issuance of 145,970 shares of our common stock to two employees and two directors and approximately $0.7 million for professional fees. We anticipate that our general and administrative expenses will increase in future periods, reflecting continued and increasing costs associated with: ● support of our research and development activities; ● stock compensation granted to key employees and non-employees; ● support of business development activities; and ● increased professional fees and other costs associated with the regulatory requirements and increased compliance associated with being a public reporting company. Components of Our Results of Operations for the Period from May 16, 2017 (Inception) through December 31, 2017 Operating Costs and Expenses Research and Development Expenses For the period from May 16, 2017 (inception) through December 31, 2017, research and development expenses were approximately $0.6 million, of which approximately $0.5 million was related to the acquisition of our sublicense with Chelexa, to use the BioLexa Platform, a proprietary, patented, drug compound platform developed at the University of Cincinnati. Such amount includes an upfront cash fee of $0.3 million and $0.2 million associated with the value of 513,777 shares of our common stock issued. Additionally, we incurred approximately $67,000 of expense related to other research and development expenses. We expect our research and development activities to significantly increase as we develop our existing product candidate and potentially acquire new product candidates, reflecting increasing costs associated with the following: ● employee-related expenses, which include salaries and benefits, and rent expenses; ● license fees and milestone payments related to in-licensed products and technology; ● expenses incurred under agreements with contract research organizations, investigative sites and consultants that conduct our clinical trials and a substantial portion of our preclinical activities; ● the cost of acquiring and manufacturing clinical trial materials; and ● costs associated with non-clinical activities and regulatory approvals. General and Administrative Expenses For the period from May 16, 2017 (inception) through December 31, 2017, general and administrative expenses were $1.3 million, which primarily consisted of $1.0 million related to the issuance of 2,430,000 shares of restricted stock to employees and non-employees and $0.2 million related to professional fees. We anticipate that our general and administrative expenses will increase in future periods, reflecting continued and increasing costs associated with: ● support of our expanded research and development activities; ● stock compensation granted to key employees and non-employees; ● support of business development activities; and ● increased professional fees and other costs associated with the regulatory requirements and increased compliance associated with being a public reporting company. Liquidity and Capital Resources We have incurred substantial operating losses since inception, and expect to continue to incur significant operating losses for the foreseeable future and may never become profitable. As of December 31, 2018, we had approximately $0.3 million in cash and an accumulated deficit of approximately $4.5 million. Cash Flows from Operating Activities For the year ended December 31, 2018, net cash used in operations was $2.1 million, which primarily resulted from a net loss of $2.5 million, partially offset by $0.1 million stock-based compensation expense and $0.1 million non-cash research and development expense related with license acquisition. For the period from May 16, 2017 (inception) through December 31, 2017, net cash used in operations was $0.5 million, which primarily resulted from a net loss of $2.0 million, partially offset by $1.0 million stock-based compensation expense and $0.5 million non-cash research and development expense related with license acquisition. Cash Flows from Investing Activities For the year ended December 31, 2018, there was no investing activities. For the period from May 16, 2017 (inception) through December 31, 2017, net cash used in investing activities was $0.3 million, which was related to the purchase of research and development licenses. Cash Flows from Financing Activities For the year ended December 31, 2018, net cash provided by financing activities was $1.2 million, which is the net proceeds raised from investors in consideration for the issuance of 13.77 units (the “Units”). Each Unit consisted of 100,000 shares of Series A Preferred Stock and a warrant to purchase 25% of the shares of common stock issuable upon conversion of the Series A Preferred Stock. For the period from May 16, 2017 (inception) through December 31, 2017, net cash provided by financing activities was $2.0 million, which primarily resulted from $1.3 million of net proceeds raised from investors in consideration for the issuance of 17.26 Units, and $0.7 million of gross proceeds from the issuance of 3,950,000 shares of common stock. On February 20, 2019, we closed the IPO pursuant to which we issued 1,250,000 shares of our common stock for net proceeds of approximately $5.7 million, after deducting underwriting discounts and commissions and offering expenses. We have funded our operations from proceeds from the sale of equity and debt securities. We will require significant additional capital to make the investments we need to execute our longer-term business plan. Our ability to successfully raise sufficient funds through the sale of debt or equity securities when needed is subject to many risks and uncertainties and, even if we are successful, future equity issuances would result in dilution to our existing stockholders and any future debt securities may contain covenants that limit our operations or ability to enter into certain transactions. Our current cash and cash equivalents are sufficient to fund operations for at least the next 12 months; however, we will need to raise additional funding through strategic relationships, public or private equity or debt financings, grants or other arrangements to develop and seek regulatory approvals for our existing and new product candidates. If such funding is not available or not available on terms acceptable to us, our current development plan and plans for expansion of our general and administrative infrastructure may be curtailed. We will need to raise significant additional capital to continue to fund our operations and the clinical trials for BioLexa. We may seek to sell common stock, preferred stock 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 seek to raise cash through collaborative agreements or from government grants. The sale of equity and convertible debt securities may result in dilution to our stockholders and certain of 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. The source, timing and availability of any future financing will depend principally upon market conditions, and, more specifically, on the progress of our clinical development program. Funding may not be available when needed, at all, or on terms acceptable to us. Lack of necessary funds may require us to, among other things, delay, scale back or eliminate expenses including some or all of our planned development, including our clinical trials. Off-Balance Sheet Arrangements; Commitments 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. 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 U.S. generally accepted accounting principles (“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 date of the balance sheet and the reported amounts of expenses during the reporting period. In accordance with U.S. GAAP, we evaluate our estimates and judgments on an ongoing basis. The most significant estimates relate to the valuation of preferred and common stock, the valuation of stock options and the valuation allowance of deferred tax assets resulting from net operating losses. We base our estimates and assumptions on current facts, our limited historical experience from operating for one year and 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. We define our critical accounting policies as those accounting principles 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 2 to our financial statements appearing elsewhere in Annual Report on Form 10-K, we believe the following are the critical accounting policies used in the preparation of our financial statements that require significant estimates and judgments: Stock-based compensation We expense stock-based compensation to employees and non-employees over the requisite service period based on the estimated grant-date fair value of the awards. Stock-based awards with graded-vesting schedules are recognized on a straight-line basis over the requisite service period for each separately vesting portion of the award. We record the expense for stock-based compensation awards subject to performance-based milestone vesting over the remaining service period when management determines that achievement of the milestone is probable. Management evaluates when the achievement of a performance-based milestone is probable based on the expected satisfaction of the performance conditions at each reporting date. All stock-based compensation costs are recorded in general and administrative or research and development costs in the statements of operations based upon the underlying employees’ or non-employees’ roles. Income taxes Income taxes are recorded in accordance with ASC 740, Income Taxes, or ASC 740, which provides for deferred taxes using an asset and liability approach. We recognize deferred tax assets and liabilities for the expected future tax consequences of events that have been included in our financial statements or tax returns. Deferred tax assets and liabilities are determined based on the difference between our financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Valuation allowances are provided, based upon the weight of available evidence, if it is more likely than not that some or all of the deferred tax assets will not be realized. We account for uncertain tax positions in accordance with the provisions of ASC 740. When uncertain tax positions exist, we recognize the tax benefit of tax positions to the extent that the benefit would more likely than not be realized assuming examination by the taxing authority. The determination as to whether the tax benefit will more likely than not be realized is based upon the technical merits of the tax position as well as consideration of the available facts and circumstances. Recent Accounting Pronouncements In February 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2016-02, Leases (Topic 842), which supersedes FASB ASC Topic 840, Leases (Topic 840) and provides principles for the recognition, measurement, presentation and disclosure of leases for both lessees and lessors. The new standard requires lessees to apply a dual approach, classifying leases as either finance or operating leases based on the principle of whether or not the lease is effectively a financed purchase by the lessee. This classification will determine whether lease expense is recognized based on an effective interest method or on a straight-line basis over the term of the lease, respectively. A lessee is also required to record a right-of-use asset and a lease liability for all leases with a term of greater than twelve months regardless of classification. Leases with a term of twelve months or less will be accounted for similar to existing guidance for operating leases. The standard is effective for annual and interim periods beginning after December 15, 2018, with early adoption permitted upon issuance. We have determined that due to the short term nature of our leases, ASU No. 2016-02 will not have a material impact on our financial statements and related disclosures. In June 2018, the FASB issued ASU 2018-07, Compensation-Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting (“ASU 2018-07”). ASU 2018-07 simplifies several aspects of the accounting for nonemployee share-based payment transactions resulting from expanding the scope of Topic 718, Compensation-Stock Compensation, to include share-based payment transactions for acquiring goods and services from nonemployees. ASU 2018-07 is effective for public business entities for fiscal years beginning after December 15, 2018, including interim periods within that fiscal year. The Company is currently assessing the effect this guidance may have on its financial statements. 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 became effective on November 5, 2018. The Company is evaluating the impact of this guidance on its consolidated financial statements. The Company anticipates its first presentation of the revised presentation of changes in stockholders’ equity will be included in its Form 10-Q for the quarter ended March 31, 2019. In August 2018, the FASB issued ASU 2018-13, “Fair Value Measurement (Topic 820), - Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement,” which makes a number of changes meant to add, modify or remove certain disclosure requirements associated with the movement amongst or hierarchy associated with Level 1, Level 2 and Level 3 fair value measurements. This guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. Early adoption is permitted upon issuance of the update. The Company does not expect the adoption of this guidance to have a material impact on its consolidated Financial Statements. Recently Adopted Accounting Standards In May 2017, the Financial Accounting Standards Board (the FASB) issued ASU 2017-09, Compensation-Stock Compensation (Topic 718): Scope of Modification Accounting, (ASU 2017-09). ASU 2017-09 provides clarity and reduces both (1) diversity in practice and (2) cost and complexity when applying the guidance in Topic 718, to a change to the terms or conditions of a share-based payment award. The amendments in ASU 2017-09 should be applied prospectively to an award modified on or after the adoption date. This ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2017. The Company adopted ASU 2017-09 on January 1, 2018. The adoption of this ASU did not have a material impact on the Company’s financial position or results of operations. JOBS Act On April 5, 2012, the JOBS Act was enacted. 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 chosen to take advantage of the extended transition periods available to emerging growth companies under the JOBS Act for complying with new or revised accounting standards until those standards would otherwise apply to private companies provided under the JOBS Act. As a result, our financial statements may not be comparable to those of companies that comply with public company effective dates for complying with new or revised accounting standards. We are in the process of evaluating the benefits of relying on 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 intend to rely on certain of these exemptions, including without limitation, (i) providing an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404(b) of the Sarbanes-Oxley Act and (ii) complying with any requirement that may be adopted by the Public Company Accounting Oversight Board (“PCAOB”) regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements, known as the auditor discussion and analysis. We will remain an “emerging growth company” until the earliest of (i) the last day of the fiscal year in which we have total annual gross revenues of $1.07 billion or more; (ii) the last day of our fiscal year following the fifth anniversary of the date of the IPO; (iii) the date on which we have issued more than $1 billion in nonconvertible debt during the previous three years; or (iv) the date on which we are deemed to be a large accelerated filer under the rules of the SEC.
0.058137
0.058244
0
<s>[INST] Overview We are a biopharmaceutical company formed in May 2017 focused on targeted therapeutics for patients suffering from conditions such as atopic dermatitis, also known as eczema. Our primary asset is a sublicense agreement with Chelexa pursuant to which Chelexa has granted us an exclusive sublicense to use its BioLexa Platform, a proprietary, patented, drug compound platform developed at the University of Cincinnati. The license enables us to develop the platform for any indications in humans. Our initial focus will be on the treatment of eczema through the application of a topical cream. Although our initial focus will be on the treatment of eczema, we intend to develop a second topical cream which, upon application, is intended to reduce postprocedure infections, accelerate healing and improve clinical outcomes for patients undergoing aesthetic dermatology procedures. In addition, we intend to conduct a pilot study on the efficacy of BioLexa to accelerate diabetic wound healing. The BioLexa Platform combines an FDA approved zinc chelator with one or more approved antibiotics in a topical dosage form to address unchecked eczema flareups by preventing the formation of infectious biofilms and the resulting clogging of sweat ducts which trigger symptoms. It is the first product candidate intended to prevent the symptom triggering flareups rather than simply treating symptoms when they occur. On May 26, 2017, we entered into a sublicense agreement with Chelexa, as amended on August 22, 2018 and August 29, 2018, pursuant to which Chelexa granted us an exclusive sublicense to make, use, have made, import, offer for sale, and sell products based upon or involving the use of (i) topical compositions comprising a zinc chelator and gentamicin and (ii) zinc chelators to inhibit biofilm formation, which rights were originally granted to Chelexa pursuant to an exclusive license agreement with the University of Cincinnati. In addition, Chelexa granted us the right to issue exclusive and nonexclusive sublicenses (with the right to further sublicense to third parties) to make, use, have made, import, offer for sale, and sell products based upon the BioLexa Platform. We intend to initially use the BioLexa Platform to develop two different topical cream products: (i) a product to treat eczema and (ii) a product that reduces postprocedure infections, accelerates healing and improves clinical outcomes for patients undergoing aesthetic dermatology procedures. Eczema is a disease that results in inflammation of the skin and is characterized by rash, red skin, and itchiness. Eczema is also referred to as atopic dermatitis. We are concentrating our effort and resources to develop the BioLexa Platform, utilizing our novel formulation and approach for these two markets. The BioLexa Platform has achieved positive results in its initial clinical studies conducted at the University of Miami. BioLexa’s formulation is a new topical dosage form “repurposing” the antibiotic, enabling it to be developed for use in patients following a special regulatory pathway codified in Section 505(b)(2) of the FDA rules. Section 505(b)(2) of the FDCA was enacted to enable sponsors to seek NDA approval for novel repurposed drugs without the need for such sponsors to undertake time consuming and expensive preclinical safety studies and Phase 1 safety studies. Proceeding under this regulatory pathway, we will be able to rely upon all of the publicly available safety and toxicology data with respect to gentamicin and zinc chelator in our FDA submissions. We will be required to conduct a Phase 2 study to show the safety of the combination in humans and after such Phase 2 study will be required to proceed to Phase 3 pivotal clinical trials. We believe that this path will dramatically reduce the required clinical development effort, costs and risks as compared to what would be required of us if we were required to conduct preclinical safety, toxicology and animal studies together with Phase 1 human safety trials [/INST] Positive. </s>
2,019
4,631
1,711,786
Hoth Therapeutics, Inc.
2020-03-02
2019-12-31
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULT OF OPERATIONS You should read the following discussion and analysis of our financial condition and plan of operations together with and our consolidated financial statements and the related notes appearing elsewhere in this Annual Report on Form 10-K. In addition to historical information, this discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results may 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. All amounts in this report are in U.S. dollars, unless otherwise noted. Overview We are a clinical-stage biopharmaceutical company incorporated in May 2017 focused on developing new generation therapies for dermatological disorders. We believe that our pipeline has the potential to improve the quality of life for patients suffering from indications including atopic dermatitis (also known as eczema), chronic wounds, psoriasis, asthma and acne. Our primary asset is a sublicense agreement with Chelexa which we entered into on May 26, 2017, as amended on August 22, 2018 and August 29, 2018, pursuant to which Chelexa has granted us an exclusive sublicense to make, use, have made, import, offer for sale, and sell products based upon or involving the BioLexa Platform, which rights were originally granted to Chelexa pursuant to an exclusive license agreement with the University of Cincinnati. The license enables us to develop the platform for any indications in humans. Our initial focus will be on the treatment of eczema through the application of a topical cream. Although our initial focus will be on the treatment of eczema, we intend to develop a second topical cream which, upon application, is intended to reduce post-procedure infections, accelerate healing and improve clinical outcomes for patients undergoing aesthetic dermatology procedures. In addition, we conducted an initial pilot study on the efficacy of BioLexa to accelerate diabetic wound healing and intend to conduct additional studies with respect to the regenerative effects of the BioLexa Platform in the context of chronic diabetic ulcers, with and without substantial bacterial burden. The BioLexa Platform combines an FDA approved zinc chelator with one or more approved antibiotics in a topical dosage form to address unchecked eczema flare-ups by preventing the formation of infectious biofilms and the resulting clogging of sweat ducts which trigger symptoms. It is the first product candidate intended to prevent the symptom triggering flare-ups rather than simply treating symptoms when they occur. We intend to initially use the BioLexa Platform to develop two different topical cream products: (i) a product to treat eczema and (ii) a product that reduces post-procedure infections, accelerates healing and improves clinical outcomes for patients undergoing aesthetic dermatology procedures. Eczema is a disease that results in inflammation of the skin and is characterized by rash, red skin, and itchiness. Eczema is also referred to as atopic dermatitis. We are concentrating our effort and resources to develop the BioLexa Platform, utilizing our novel formulation and approach for these two markets. The BioLexa Platform has achieved positive results in its initial pre-clinical studies conducted at the University of Miami. BioLexa’s formulation is a new topical dosage form “repurposing” the antibiotic, enabling it to be developed for use in patients following a special regulatory pathway codified in Section 505(b)(2) of the FDA rules. Section 505(b)(2) of the FDCA was enacted to enable sponsors to seek NDA approval for novel repurposed drugs without the need for such sponsors to undertake time consuming and expensive pre-clinical safety studies and Phase 1 safety studies. Proceeding under this regulatory pathway, we will be able to rely upon all of the publicly available safety and toxicology data with respect to gentamicin and zinc chelator in our FDA submissions. We will be required to conduct a Phase 2 study to show the safety of the combination in humans and after such Phase 2 study will be required to proceed to Phase 3 pivotal clinical trials. We believe that this path will dramatically reduce the required clinical development effort, costs and risks as compared to what would be required of us if we were required to conduct pre-clinical safety, toxicology and animal studies together with Phase 1 human safety trials required for new chemical entities which are not eligible to be reviewed pursuant to the Section 505(b)(2) regulatory pathway. We estimate that by using the Section 505(b)(2) regulatory pathway, that the clinical development process may be five to six years shorter than is required for a new chemical entity, and the FDA approval process may be six to nine months shorter than the typical eighteen month period, which we believe may result in lower development costs and shorter development time. As of the date hereof, we have not submitted an NDA to the FDA. In September 2018, we attended the first of a planned series of meetings with the FDA to review the requirements for submission and activation of an IND with respect to the BioLexa Platform for use in eczema. In preparation for such pre-IND meeting, we prepared and presented to the FDA our proposed Phase 2 clinical trial plan for the treatment of eczema in patients over the age of one year old. As part of our pre-IND meeting, the FDA provided us with general guidance with respect to specific animal studies, dosing schedules and suggested human safety studies before we commence clinical trials in pediatric or adult patients. We are currently investigating multiple potential venues for conducting such trial both in and outside of the U.S. We have engaged Camargo to assist us with the FDA process required for Section 505(b)(2) applications and with the evaluation of potential clinical trial venues for the proof of concept study should we determine to undertake such study. Specifically, Camargo has provided and will continue to provide advice and guidance relative to the IND preparation phase for the BioLexa Platform. Camargo will assist us with the refinement of our non-clinical, clinical, clinical pharmacology and biopharmaceutics strategy incorporating the preliminary feedback we received from the FDA during our pre-IND meeting. We believe that the key elements for our market success with respect to BioLexa include: ● the proprietary formulation of two FDA-approved drugs to treat bacterial proliferation reduces development time and costs by giving us the ability to rely on safety and efficacy data from the two approved drugs; ● our proprietary formulation is not a topical corticosteroid, and may not be subject to the same FDA black box warning issues as most commonly prescribed treatments currently in use; and ● a recent peer-reviewed publication titled “Staphylococcal Bacteria May Cause Eczema, Study Reveals”, published by Dr. Herbert B. Allen, highlights that staph-induced biofilms are the root cause of flare-ups in eczema. Our BioLexa product candidate has been demonstrated to prevent the formation of these biofilms with the promise of delaying or completely arresting flare-ups, rather than merely treating symptoms of a flare-up already underway. In addition to our sublicense agreement with Chelexa, we entered into the following agreements: ● an exclusive license agreement with the University of Cincinnati for a patented, novel genetic marker for food allergies. The genetic marker licensed by us from the University of Cincinnati may be used to (i) identify at risk infants in predicting food allergies, including peanut and milk allergies, (ii) identify a person’s predisposition to an allergic reaction, thereby avoiding such reaction and (iii) determine an individual’s propensity to develop AD, such as eczema. We intend to utilize the genetic marker for purposes of determining an individual’s propensity to develop eczema as well as to identify and treat allergies in at-risk infants. ● the Sublicense Agreement with Zylö pursuant to which Zylö granted us an exclusive sublicense to the Licensed Patent Rights (as defined in the Sublicense Agreement) and the Licensed Technology (as defined in the Sublicense Agreement) to, among other things, develop, make and sell the Licensed Products (as defined in the Sublicense Agreement) and to practice the Licensed Technology in the United States and Canada for any and all therapeutic uses related to lupus in human beings, subject to the Field Expansion Rights (as defined in the Sublicense Agreement). ● a license agreement with NCSU pursuant to which NCSU granted us an exclusive license to, among other things, develop, make, use, offer and sell certain licensed products throughout the world with respect to NCSU’s exon skipping approach for treating allergic diseases. ● a patent license agreement with GW pursuant to which GW granted us a license to certain patent rights to, among other things, make, use, offer and sell certain licensed products throughout the world with respect to aprepitant as used in treating side effects from drugs used for the treatment of cancer. In order to generate revenue from our product candidates, we will need to sell our product candidates either through distribution partnerships or through our own sales efforts. Prior to selling our product candidates, we will need to receive FDA approval of our NDA for each indication that we intend to treat. The first indication we are seeking approval for is the BioLexa Platform for treating eczema. We intend to submit our NDA for such indication by the end of 2021 with approval of such NDA anticipated to be in 2022; however, no assurances can be given that we will receive approval of the NDA in a timely manner, if at all. Results of Operations Comparison of Our Results of Operations for the Years Ended December 31, 2019 and 2018 Operating Costs and Expenses Research and Development Expenses For the year ended December 31, 2019, research and development expenses were approximately $2.1 million which primarily consisted of $50,000 related to the Zylö Sublicense Agreement, $10,000 related to a license acquired from the University of Maryland and Isoprene Pharmaceuticals Inc., $25,000 related to a license acquired from the North Carolina State University, and approximately $2.0 million related to other research and development expenses. For the year ended December 31, 2018, research and development expenses were approximately $1.0 million, of which approximately $0.1 million was related to license acquired, $0.1 million was related to the issuance of 213,166 shares of our common stock pursuant to the sublicense agreement with Chelexa and $0.8 million was related to other research and development expenses. We expect our research and development activities to increase as we develop our existing product candidate and potentially acquire new product candidates, reflecting increasing costs associated with the following: ● employee-related expenses, which include salaries and benefits, and rent expenses; ● license fees and milestone payments related to in-licensed products and technology; ● expenses incurred under agreements with CROs, investigative sites and consultants that conduct our clinical trials and a substantial portion of our pre-clinical activities; ● the cost of acquiring and manufacturing clinical trial materials; and ● costs associated with non-clinical activities, and regulatory approvals. General and Administrative Expenses For the year ended December 31, 2019, general and administrative expenses were approximately $5.6 million, which primarily consisted of approximately $2.9 million related to payroll expenses and stock-based compensation, approximately $2.1 million for professional fees and $0.6 million for other expenses. For the year ended December 31, 2018, general and administrative expenses were approximately $1.5 million, which primarily consisted of approximately $0.4 million related to payroll expenses, approximately $0.1 million related to the issuance of 145,970 shares of our common stock to two employees and two directors and approximately $0.7 million for professional fees. We anticipate that our general and administrative expenses will increase in future periods, reflecting continued and increasing costs associated with: ● support of our research and development activities; ● stock compensation granted to key employees and non-employees; ● support of business development activities; and ● increased professional fees and other costs associated with the regulatory requirements and increased compliance associated with being a public reporting company. Liquidity and Capital Resources We have incurred substantial operating losses since inception and expect to continue to incur significant operating losses for the foreseeable future and may never become profitable. As of December 31, 2019, we had approximately $1.7 million in cash, marketable securities of $0.8 million, current liabilities of $0.4 million and an accumulated deficit of approximately $12.2 million. Cash Flows from Operating Activities For the year ended December 31, 2019, net cash used in operations was approximately $4.9 million, which primarily resulted from a net loss of approximately $7.7 million, partially offset by approximately $2.5 million stock-based compensation and changes in operating assets and liabilities of approximately $0.2 million. For the year ended December 31, 2018, net cash used in operations was $2.1 million, which primarily resulted from a net loss of $2.5 million, partially offset by $0.1 million stock-based compensation expense and $0.1 million non-cash research and development expense related with license acquisition. Cash Flows from Investing Activities For the year ended December 31, 2019, net cash used in investing activities was approximately $0.9 million, which was related to the purchase of marketable securities of $0.8 million and the purchase of research and development licenses of $0.9 million. For the year ended December 31, 2018, there was no investing activities. Cash Flows from Financing Activities For the year ended December 31, 2019, net cash provided by financing activities was approximately $7.5 million, including approximately $0.2 million restricted cash. The cash provided by financing activities primarily resulted from approximately $5.8 million in net proceeds from the Company’s initial public offering (the “IPO”) and approximately $1.6 million in net proceeds from a private offering of an aggregate of 407,474 units with each unit consisting of one share of the Company’s common stock and a warrant to purchase one-half share of the Company’s common stock. On February 20, 2019, we closed the IPO pursuant to which we issued 1,250,000 shares of our common stock for net proceeds of approximately $5.8 million, after deducting underwriting discounts and commissions and offering expenses. The $0.2 million restricted cash has been deposited into a third-party escrow account in order to provide a source of funding for certain indemnification obligations the Company has pursuant to its Qualified Independent Underwriter Engagement Agreement. For the year ended December 31, 2018, net cash provided by financing activities was $1.2 million, which is the net proceeds raised from investors in consideration for the issuance of 13.77 units (the “Units”). Each Unit consisted of 100,000 shares of Series A Preferred Stock and a warrant to purchase 25% of the shares of common stock issuable upon conversion of the Series A Preferred Stock. Our ultimate success is dependent on our ability to obtain additional financing and generate sufficient cash flow to meet our obligations on a timely basis. We will require significant amounts of capital to sustain operations, and we will need to make the investments we need to execute our longer-term business plan to support new technologies and help advance innovation. Absent generation of sufficient revenue from the execution of our long-term business plan, we will need to obtain debt or equity financing, especially if we experience downturns in our business that are more severe or longer than anticipated, or if we experience significant increases in expense levels resulting from being a publicly-traded company or from operations. Such additional debt or equity financing may not be available to us on favorable terms, if at all. We plan to pursue our plans with respect to the research and development of our pre-clinical products which will require resources beyond those that we currently have, ultimately requiring additional capital from third party sources. We currently do not expect to generate any revenue and our independent registered public accounting firm has included in its opinion for the year ended December 31, 2019 an explanatory paragraph expressing substantial doubt about our ability to continue as a going concern within one year from the date of this filing. The consolidated financial statements have been prepared assuming that we will continue as a going concern, and do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets, or the amounts and classification of liabilities that may result from the outcome of this uncertainty. Off-Balance Sheet Arrangements 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 or any commitments or contractual obligations. 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 consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). The preparation of these consolidated 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 date of the balance sheet and the reported amounts of expenses during the reporting period. In accordance with U.S. GAAP, we evaluate our estimates and judgments on an ongoing basis. The most significant estimates relate to the valuation of preferred and common stock, the valuation of stock options and the valuation allowance of deferred tax assets resulting from net operating losses. We base our estimates and assumptions on current facts, our limited historical experience and 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. We define our critical accounting policies as those accounting principles 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 2 to our consolidated financial statements appearing elsewhere in Annual Report on Form 10-K, we believe the following are the critical accounting policies used in the preparation of our consolidated financial statements that require significant estimates and judgments: Stock-based compensation We expense stock-based compensation to employees and non-employees over the requisite service period based on the estimated grant-date fair value of the awards. Stock-based awards with graded-vesting schedules are recognized on a straight-line basis over the requisite service period for each separately vesting portion of the award. We record the expense for stock-based compensation awards subject to performance-based milestone vesting over the remaining service period when management determines that achievement of the milestone is probable. Management evaluates when the achievement of a performance-based milestone is probable based on the expected satisfaction of the performance conditions at each reporting date. All stock-based compensation costs are recorded in general and administrative or research and development costs in the statements of operations based upon the underlying employees’ or non-employees’ roles. Income taxes Income taxes are recorded in accordance with Accounting Standards Codification (“ASC”) 740, Income Taxes, or ASC 740, which provides for deferred taxes using an asset and liability approach. We recognize deferred tax assets and liabilities for the expected future tax consequences of events that have been included in our consolidated financial statements or tax returns. Deferred tax assets and liabilities are determined based on the difference between our financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Valuation allowances are provided, if based upon 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 account for uncertain tax positions in accordance with the provisions of ASC 740. When uncertain tax positions exist, we recognize the tax benefit of tax positions to the extent that the benefit would more likely than not be realized assuming examination by the taxing authority. The determination as to whether the tax benefit will more likely than not be realized is based upon the technical merits of the tax position as well as consideration of the available facts and circumstances. Recent Accounting Pronouncements See Note 2 to the consolidated financial statements for a discussion of recent accounting standards and pronouncements. JOBS Act On April 5, 2012, the JOBS Act was enacted. 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 chosen to take advantage of the extended transition periods available to emerging growth companies under the JOBS Act for complying with new or revised accounting standards until those standards would otherwise apply to private companies provided under the JOBS Act. As a result, our consolidated financial statements may not be comparable to those of companies that comply with public company effective dates for complying with new or revised accounting standards. We are in the process of evaluating the benefits of relying on 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 intend to rely on certain of these exemptions, including, without limitation, (i) providing an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404(b) of the Sarbanes-Oxley Act and (ii) complying with any requirement that may be adopted by the Public Company Accounting Oversight Board (“PCAOB”) regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the consolidated financial statements, known as the auditor discussion and analysis. We will remain an “emerging growth company” until the earliest of (i) the last day of the fiscal year in which we have total annual gross revenues of $1.07 billion or more; (ii) the last day of our fiscal year following the fifth anniversary of the date of the IPO; (iii) the date on which we have issued more than $1 billion in nonconvertible debt during the previous three years; or (iv) the date on which we are deemed to be a large accelerated filer under the rules of the SEC.
-0.033739
-0.033635
0
<s>[INST] Overview We are a clinicalstage biopharmaceutical company incorporated in May 2017 focused on developing new generation therapies for dermatological disorders. We believe that our pipeline has the potential to improve the quality of life for patients suffering from indications including atopic dermatitis (also known as eczema), chronic wounds, psoriasis, asthma and acne. Our primary asset is a sublicense agreement with Chelexa which we entered into on May 26, 2017, as amended on August 22, 2018 and August 29, 2018, pursuant to which Chelexa has granted us an exclusive sublicense to make, use, have made, import, offer for sale, and sell products based upon or involving the BioLexa Platform, which rights were originally granted to Chelexa pursuant to an exclusive license agreement with the University of Cincinnati. The license enables us to develop the platform for any indications in humans. Our initial focus will be on the treatment of eczema through the application of a topical cream. Although our initial focus will be on the treatment of eczema, we intend to develop a second topical cream which, upon application, is intended to reduce postprocedure infections, accelerate healing and improve clinical outcomes for patients undergoing aesthetic dermatology procedures. In addition, we conducted an initial pilot study on the efficacy of BioLexa to accelerate diabetic wound healing and intend to conduct additional studies with respect to the regenerative effects of the BioLexa Platform in the context of chronic diabetic ulcers, with and without substantial bacterial burden. The BioLexa Platform combines an FDA approved zinc chelator with one or more approved antibiotics in a topical dosage form to address unchecked eczema flareups by preventing the formation of infectious biofilms and the resulting clogging of sweat ducts which trigger symptoms. It is the first product candidate intended to prevent the symptom triggering flareups rather than simply treating symptoms when they occur. We intend to initially use the BioLexa Platform to develop two different topical cream products: (i) a product to treat eczema and (ii) a product that reduces postprocedure infections, accelerates healing and improves clinical outcomes for patients undergoing aesthetic dermatology procedures. Eczema is a disease that results in inflammation of the skin and is characterized by rash, red skin, and itchiness. Eczema is also referred to as atopic dermatitis. We are concentrating our effort and resources to develop the BioLexa Platform, utilizing our novel formulation and approach for these two markets. The BioLexa Platform has achieved positive results in its initial preclinical studies conducted at the University of Miami. BioLexa’s formulation is a new topical dosage form “repurposing” the antibiotic, enabling it to be developed for use in patients following a special regulatory pathway codified in Section 505(b)(2) of the FDA rules. Section 505(b)(2) of the FDCA was enacted to enable sponsors to seek NDA approval for novel repurposed drugs without the need for such sponsors to undertake time consuming and expensive preclinical safety studies and Phase 1 safety studies. Proceeding under this regulatory pathway, we will be able to rely upon all of the publicly available safety and toxicology data with respect to gentamicin and zinc chelator in our FDA submissions. We will be required to conduct a Phase 2 study to show the safety of the combination in humans and after such Phase 2 study will be required to proceed to Phase 3 pivotal clinical trials. We believe that this path will dramatically reduce the required clinical development effort, costs and risks as compared to what would be required of us if we were required to conduct preclinical safety, toxicology and animal studies together with Phase 1 human safety trials required for new chemical entities which are not eligible to be reviewed pursuant to the Section 505(b)(2) regulatory pathway. We estimate that by using the Section 505(b)(2) regulatory pathway, that the clinical development process may be [/INST] Negative. </s>
2,020
3,747
1,739,104
Elanco Animal Health Inc
2019-02-20
2018-12-31
Item 7. Management’s Discussion and Analysis of Results of Financial Condition and Results of Operations Management’s discussion and analysis of financial condition and results of operations, is intended to assist the reader in understanding and assessing significant changes and trends related to the results of operations and financial position of our consolidated company. This discussion and analysis should be read in conjunction with the consolidated and combined financial statements and accompanying footnotes in Item 8 of Part II of this Annual Report on Form 10-K. Certain statements in this Item 7 of Part II of this Annual Report on Form 10-K constitute forward-looking statements. Various risks and uncertainties, including those discussed in "Forward-Looking Statements" and Item 1A, “Risk Factors,” may cause our actual results and cash generated from operations to differ materially from these forward-looking statements. Overview Founded in 1954 as part of Eli Lilly and Company, Elanco is a premier animal health company that innovates, develops, manufactures and markets products for companion and food animals. Headquartered in Greenfield, Indiana, we are the fourth largest animal health company in the world, with revenue of $3,066.8 million for the year ended December 31, 2018. Globally, we are #1 in medicinal feed additives, #2 in poultry and #3 in cattle, measured by 2017 revenue, according to Vetnosis. We have one of the broadest portfolios of pet parasiticides in the companion animal sector. We offer a diverse portfolio of more than 125 brands that make us a trusted partner to veterinarians and food animal producers in more than 90 countries. We operate our business in a single segment directed at fulfilling our vision of enriching the lives of people through food, making protein more accessible and affordable and through pet companionship, helping pets live longer, healthier lives. We advance our vision by offering products in four primary categories: Companion Animal Disease Prevention (CA Disease Prevention): We have one of the broadest parasiticide portfolios in the companion animal sector based on indications, species and formulations, with products that protect pets from worms, fleas and ticks. Combining our parasiticide portfolio with our vaccines presence, we are a leader in the United States (U.S.) in the disease prevention category based on share of revenue. Companion Animal Therapeutics (CA Therapeutics): We have a broad pain and osteoarthritis portfolio across species, modes of action, indications and disease stages. Pet owners are increasingly treating osteoarthritis in their pets, and our Galliprant product is one of the fastest growing osteoarthritis treatments in the U.S. We also have treatments for otitis (ear infections), as well as cardiovascular and dermatology indications. Food Animal Future Protein & Health (FA Future Protein & Health): Our portfolio in this category, which includes vaccines, nutritional enzymes and animal only antibiotics, serves the growing demand for protein and includes innovative products in poultry and aquaculture production, where demand for animal health products is outpacing overall industry growth. We are focused on developing functional nutritional health products that promote food animal health, including enzymes, probiotics and prebiotics. We are a leader in providing vaccines as alternatives to antibiotics to promote animal health based on share of revenue. Food Animal Ruminants & Swine (FA Ruminants & Swine): We have developed a range of food animal products used extensively in ruminant (e.g., cattle, sheep and goats) and swine production. For the years ended December 31, 2018, 2017 and 2016, our revenue was $3,066.8 million, $2,889.0 million and $2,913.5 million, respectively. For the years ended December 31, 2018, 2017 and 2016, our net income (loss) was $86.5 million, $(310.7) million and $(47.9) million, respectively. Key Trends and Conditions Affecting Our Results of Operations Industry Trends The animal health industry, which focuses on both food animals and companion animals, is a growing industry that benefits billions of people worldwide. As demand for animal protein grows, food animal health is becoming increasingly important. Factors influencing growth in demand for food animal medicines and vaccines include: • one in three people need improved nutrition; • increased global demand for protein, particularly poultry and aquaculture; • natural resource constraints, such as scarcity of arable land, fresh water and increased competition for cultivated land, driving the need for more efficient food production; • loss of productivity due to food animal disease and death; • increased focus on food safety and food security; and • human population growth, increased standards of living, particularly in many emerging markets, and increased urbanization. Growth in food animal nutritional health products (enzymes, probiotics and prebiotics) is influenced, among other factors, by demand for antibiotic alternatives that can promote animal health and increase productivity. Factors influencing growth in demand for companion animal medicines and vaccines include: • increased pet ownership globally; • pets living longer; and • increased pet spending as pets are viewed as members of the family by owners. Product Development and New Product Launches A key element of our targeted value creation strategy is to drive growth through portfolio development and product innovation, primarily in our three targeted growth categories. Our eleven product launches between 2015 and December 31, 2018, have had a significant positive impact on our revenue over those periods, and we expect new products and innovation will continue to have a positive impact on revenue in the future. Revenue from these product launches contributed $274.2 million to revenue for the year ended December 31, 2018. We continue to pursue the development of new chemical and biological molecules through our approach to innovation. Our future growth and success depends on both our pipeline of new products, including new products that we may develop through joint ventures and products that we are able to obtain through license or acquisition, and the expansion of the use of our existing products. We believe we are an industry leader in animal health R&D with a track record of product innovation, business development and commercialization. Impact of Changing Market Demand for Antibiotics In recent years, our operational results have been, and will continue to be, affected by regulations and changing market demand relating to the use of antibiotics and other products intended to increase food animal production. There are two classes of antibiotics used in animal health, shared-class, or medically important, antibiotics and animal-only antibiotics. Shared-class antibiotics are used to treat infectious disease caused by pathogens that occur in both humans and animals. As part of our antibiotic stewardship plan and in compliance with FDA guidance, shared-class antibiotics are labeled only for the treatment of an established need in animals and only with veterinarian oversight. However, not all pathogens that cause disease in animals are infectious in humans, and accordingly animal-only antibiotics are not used in human medicine (i.e., not medically important). From 2015 to 2018, our revenue from shared-class antibiotics declined at a CAGR of 6%, excluding the impact of foreign exchange. This was driven primarily by changing regulations in many markets, including the Veterinary Feed Directive, as well as changing market demand and Elanco’s tiered-approach to antibiotic stewardship, which included removing growth promotion from labels and requiring veterinary oversight in the U.S. and other markets. Globally, during 2018, our revenue from shared-class antibiotics declined 2%, excluding the impact of foreign exchange, and represented 12% (4% from sales in the U.S. and 8% from sales outside of the U.S.) of our total revenue, down from 16% in 2015. From 2015 to 2018, our revenue from animal-only antibiotics grew at a CAGR of 5%, excluding the impact of foreign exchange, driven by sales outside the U.S., which offset a slight decline in the U.S. Globally, during 2018, our revenue from animal-only antibiotics grew 8%, excluding the impact of foreign exchange, and represented 25% of our total revenue, up from 23% in 2015. During 2018, 87% of our revenue from animal-only antibiotics resulted from the sale of ionophores. Ionophores are a special class of animal-only antimicrobials, and because of their animal-only designation, mode of action and spectrum of activity, their use, to date have not been impacted by regulations or changing market demand in many markets outside the U.S. We have intentionally shifted away from shared-class antibiotics, and are focusing on animal-only antibiotics, as well as antibiotic-free solutions. When an animal-only antibiotic exists, we believe it should be the first, preferred antibiotic treatment. Antibiotic resistance concerns, or other health concerns regarding food animal products, may result in additional restrictions, expanded regulations or changes in market demand to further reduce the use of antibiotics in food animals. We believe it is important to protect the benefits of antibiotics in human medicine, while responsibly protecting the health of food animals and the safety of our food supply. Impact of Competition The animal health industry is competitive. Established animal health companies who consistently deliver high quality products enjoy brand loyalty from their customers, which often continues after the loss of patent-based or regulatory exclusivity. In 2018, approximately 72% of our revenue was from products that did not have patent protection. In animal health, while potentially significant, erosion from generic competition is often not as steep as in human health, with the originator often retaining a significant market share. While our largest product, Rumensin, has been subject to generic competition from monensin outside the U.S. for more than 10 years, our revenue from Rumensin sales outside the U.S. grew at a CAGR of 5% from 2015 to 2018. However, generic competition can nevertheless significantly affect our results. We have experienced significant competitive headwinds from generic ractopamine in the U.S. In the third quarter of 2013, a large, established animal health company received U.S. approval for generic ractopamine. U.S. revenue for Optaflexx, our ractopamine beef product, has declined at a CAGR of 24% from 2015 to 2018 as a result of generic competition and the impact of international regulatory restrictions. In 2018, we had an estimated 70% market share of all U.S. ractopamine-treated beef cattle based on management estimates. Although we believe brand loyalty is an important contributor to a product's ongoing success, the animal health industry is also impacted by innovation. We experienced an innovation lag in the companion animal parasiticide space from 2015 to 2017. In the absence of a competitive combined oral flea and tick product, our U.S. companion animal parasiticide portfolio revenue declined 15% in 2017, excluding the impact on revenue resulting from a reduction in inventory levels within our distribution channel. In February 2018, we launched Credelio in the U.S. for the treatment of fleas and ticks. Since the launch of Credelio, our sales of parasiticides in the U.S. have begun to grow again. Productivity Our results during the periods presented have benefited from operational and productivity initiatives implemented following recent acquisitions and in response to changing market demand for antibiotics and other headwinds. Our acquisitions of Lohmann Animal Health in 2014, Novartis Animal Health in 2015 and the BI Vetmedica U.S. vaccines portfolio in 2017, added in the aggregate $1.4 billion in revenue, 4,500 full-time employees, 12 manufacturing and eight R&D sites. In addition, from 2015 to 2018, changing market demand for antibiotics and other headwinds, such as competition with generics and innovation, affected some of our highest gross margin products, resulting in a change to our product mix and driving operating margin lower. In response, we implemented a number of initiatives across manufacturing, R&D and SG&A. Our manufacturing cost savings strategies included improving manufacturing processes and headcount through lean manufacturing (minimizing waste while maintaining productivity), closing of three manufacturing sites, consolidating our CMO network, strategically insourcing certain projects, and pursuing cost savings opportunities with respect to raw materials via a new procurement process. Additional cost savings resulted from reducing the number of R&D sites from 16 to nine, SG&A savings from sales force consolidation, and reducing discretionary and other G&A operating expense. Foreign Exchange Rates Significant portions of our revenue and costs are exposed to changes in foreign exchange rates. Our products are sold in more than 90 countries and, as a result, our revenue is influenced by changes in foreign exchange rates. For the years ended December 31, 2018 and 2017, approximately 52% and 50%, respectively, of our revenue was denominated in foreign currencies. We seek to manage foreign exchange risk, in part, through operational means, including managing same-currency revenue in relation to same-currency costs, and same-currency assets in relation to same-currency liabilities. As we operate in multiple foreign currencies, including the euro, British pound, Brazilian real, Australian dollar, Japanese yen, Canadian dollar, Chinese yuan, and other currencies, changes in those currencies relative to the U.S. dollar will impact our revenue, cost of goods and expenses, and consequently, net income. Exchange rate fluctuations in emerging markets may also have an impact beyond our reported financial results and directly impact operations. These fluctuations may also affect the ability to buy and sell our products between markets impacted by significant exchange rate variances. Foreign exchange rates had a negligible effect on revenue from 2016 to 2018. General Economic Conditions In addition to industry-specific factors, we, like other businesses, face challenges related to global economic conditions. Growth in both the food animal and companion animal sectors is driven in part by overall economic development and related growth, particularly in many emerging markets. In recent years, certain of our customers and suppliers have been affected directly by economic downturns, which decreased the demand for our products. The cost of our products to food animal producers is small relative to their other production costs, including feed, and the use of our products is intended to improve economic outcomes for food animal producers. Similarly, industry sources have reported that pet owners indicated a preference for reducing spending on other aspects of their lifestyle, including entertainment, clothing and household goods, before reducing spending on pet care. While these factors have mitigated the impact of recent downturns in the global economy, further economic challenges could increase cost sensitivity among our customers, which may result in reduced demand for our products and could have a material adverse effect on our financial condition and results of operations. Weather Conditions and the Availability of Natural Resources The animal health industry and demand for many of our animal health products in a particular region are affected by weather conditions, varying weather patterns and weather-related pressures from pests, such as fleas and ticks. As a result, we may experience regional and seasonal fluctuations in our results of operations. Food animal producers depend on the availability of natural resources, including large supplies of fresh water. Their animals' health and their ability to operate could be adversely affected if they experience a shortage of fresh water due to human population growth or floods, droughts or other weather conditions. Drought conditions could negatively impact, among other things, the supply of corn and the availability of grazing pastures. A decrease in harvested corn results in higher corn prices, which could negatively impact the profitability of food animal producers of ruminants, pork and poultry. Higher corn prices and reduced availability of grazing pastures contribute to reductions in herd or flock sizes that in turn result in less spending on animal health products. As such, a prolonged drought could have a material adverse effect on our financial condition and results of operations. Factors influencing the magnitude and timing of effects of a drought on our performance include, but may not be limited to, weather patterns and herd management decisions. In addition, veterinary hospitals and practitioners depend on visits from and access to the animals under their care. Veterinarians' patient volume and ability to operate could be adversely affected if they experience prolonged snow, ice or other severe weather conditions, particularly in regions not accustomed to sustained inclement weather. Adverse weather conditions or a shortage of fresh water may cause veterinarians and food animal producers to purchase less of our products. Disease Outbreaks Sales of our food animal products could be adversely affected by the outbreak of disease carried by animals. Outbreaks of disease may reduce regional or global sales of particular animal-derived food products or result in reduced exports of such products, either due to heightened export restrictions or import prohibitions, which may reduce demand for our products. Also, the outbreak of any highly contagious disease near our main production sites could require us to immediately halt production of our products at such sites or force us to incur substantial expenses in procuring raw materials or products elsewhere. Alternatively, sales of products that treat specific disease outbreaks may increase. Manufacturing and Supply In order to sell our products, we must be able to reliably produce and ship our products in sufficient quantities. Many of our products involve complex manufacturing processes and are sole-sourced from certain manufacturing sites. Minor deviations in our manufacturing or logistical processes, unpredictability of a product's regulatory or commercial success or failure, the lead time necessary to construct highly technical and complex manufacturing sites, and shifting customer demand increase the potential for capacity imbalances. Components of Revenue and Costs and Expenses Revenue Our revenue is primarily derived from sales of our products to third-party distributors, and directly to food producers and veterinarians. For additional information regarding our products, including descriptions of our products, see "Item 1. Business - Products." We aggregate our products into five categories to understand revenue growth: • CA Disease Prevention includes parasiticides and vaccine products for dogs and cats; • CA Therapeutics includes products for the treatment of pain, osteoarthritis, otitis, cardiovascular and dermatology indications in dogs and cats; • FA Future Protein & Health includes vaccines, antibiotics, parasiticides and other products used in poultry and aquaculture production, as well as functional nutritional health products, including enzymes, probiotics and prebiotics; • FA Ruminants & Swine includes vaccines, antibiotics, implants, parasiticides, and other products used in ruminants and swine production, as well as certain other food animal products; and • Strategic Exits includes business activities that we have either exited or made the strategic decision to exit, including the transitional contract manufacturing activity that we acquired in connection with our acquisition of the BI Vetmedica U.S. vaccines portfolio, two terminated legacy U.S. distribution agreements, a terminated distribution agreement outside the U.S.; an equine product not core to our business and a transitional contract manufacturing activity associated with the supply to Lilly of human growth hormone. Costs, Expenses and Other Cost of sales consists primarily of cost of materials, facilities and other infrastructure used to manufacture our products, shipping and handling, inventory losses and expired products. Marketing, selling and administrative expenses consist of, among other things, the costs of marketing, promotion and advertising and the costs of administration (business technology, facilities, legal, finance, human resources, business development, external affairs and procurement). Amortization of intangible assets consist of the amortization expense for intangible assets that have been acquired through business combinations. R&D expenses consist of project costs specific to new product R&D and product lifecycle management, overhead costs associated with R&D operations, regulatory, product registrations and investments that support local market clinical trials for approved indications. We manage overall R&D based on our strategic opportunities and do not disaggregate our R&D expenses incurred by nature or by product as we do not use or maintain such information in managing our business. Asset impairment, restructuring and other special charges consists primarily of impairment of long-term assets, restructuring charges, costs associated with acquiring and integrating businesses, and certain non-recurring expenses, including costs related to the build out of processes and systems to support finance and global supply and logistics, among others, as we become an independent company. Other (income) expense, net consists of net interest (income)/expense, realized or unrealized foreign exchange losses and loss or impairment on other investments. Comparability of Historical Results Our historical results of operations for the periods presented may not be comparable with prior periods or with our results of operations in the future, due to many factors, included but not limited to the factors identified in "Key Trends and Conditions Affecting Our Results of Operations." Our Relationship with Lilly and Additional Standalone Costs Prior to IPO, our business operated solely as part of a division of Lilly. Our consolidated and combined financial statements have been derived from Lilly’s consolidated financial statements and accounting records for the periods prior to the IPO. Our consolidated and combined financial statements reflect our financial position, results of operations and cash flows of the business that were transferred at the time of the separation and do not purport to reflect what the results of operations, comprehensive income/(loss), financial position, equity or cash flows would have been had we operated as an independent, publicly traded company during the periods presented prior to the IPO. Our historical and current results reflect an allocation of costs for certain Lilly corporate costs for the periods prior to the IPO, including, among others, executive oversight, treasury, legal, finance, human resources, tax, internal audit, financial reporting, information technology and investor relations. These allocations are not necessarily indicative of the expenses we may incur as a standalone public company. Although we entered into certain agreements with Lilly in connection with the IPO and the separation, the amount and composition of our expenses may vary from historical levels since the fees charged for the services under the agreement may be higher or lower than the costs reflected in the historical allocations. The total allocations included in our results for the years ended December 31, 2018, 2017 and 2016 were $105.2 million, $151.7 million, and $145.3 million, respectively. See Note 19: Related Party Agreements and Transactions to our consolidated and combined financial statements. We are currently investing in expanding our own administrative functions, including, but not limited to, information technology, facilities management, distribution, human resources, finance and manufacturing, to replace services previously provided by Lilly. Because of initial stand-up costs and overlaps with services previously provided by Lilly, we have incurred and expect to continue to incur certain temporary, duplicative expenses in connection with the separation. We also incurred and expects to continue to incur costs related to the build out of processes and systems to support finance and global supply and logistics, among others. We currently estimate these costs in aggregate to be in a range from $240 million to $290 million, of which a portion will be capitalized and the remainder will be expensed. Lilly utilizes a centralized treasury management system, of which we were part of until our IPO. For periods prior to the IPO, our consolidated and combined financial statements reflect cash held only in bank accounts in our legal name and no allocation of combined cash positions. Our consolidated and combined financial statements do not reflect an allocation of Lilly’s debt or any associated interest expense. In connection with the IPO, we incurred $2.5 billion of long-term borrowings. Our historical results reflect $29.6 million of interest expense during the year ended December 31, 2018 due to the timing of the borrowings, in comparison to our estimated interest expense of approximately $110.0 million on an annual basis. For the periods prior to the IPO, our consolidated and combined financial statements reflect income tax expense (benefit) computed on a separate company basis, as if operating as a standalone entity or a separate consolidated group in each material jurisdiction in which we operate. Our consolidated and combined financial statements for the periods prior to the IPO also reflect certain deferred tax assets and liabilities and income taxes payable based on this approach that did not transfer to us upon the separation, as the underlying tax attributes were used by Lilly or retained by Lilly. As a result of potential changes to our business model and the fact that certain deferred tax assets and liabilities and income taxes payable did not transfer to us, income tax expense (benefit) included in the consolidated and combined financial statements may not be indicative of our future expected tax rate. Our historical results also do not reflect the impact of costs we have incurred and expect to continue to incur as a consequence of becoming a standalone company, including incremental costs associated with being a publicly traded company. We are seeking to institute competitive compensation policies and programs as a standalone public company, the expense for which may differ from the compensation expense allocated by Lilly in our consolidated and combined financial statements. As a result of the IPO, we became subject to the reporting requirements of the Exchange Act and the Sarbanes-Oxley Act. We have additional procedures and practices to establish or expand as a standalone public company. As a result, we will continue to incur additional costs as a standalone public company, including internal audit, external audit, investor relations, stock administration, stock exchange fees and regulatory compliance costs. Recent Significant Acquisitions Our financial results have been impacted by acquisitions and integrations. For the periods presented, these include primarily the acquisitions and integrations of Novartis Animal Health, which closed on January 1, 2015, certain rights to develop, manufacture, market and commercialize Galliprant outside the U.S. and co-promote it in the U.S. acquired from Aratana Therapeutics, Inc., which closed on April 22, 2016, and Boehringer Ingelheim Vetmedica, Inc.'s U.S. feline, canine and rabies vaccine portfolio and other related assets (BIVIVP), which closed on January 3, 2017. For more information, see Note 6: Acquisitions to our consolidated and combined financial statements. Asset Impairment, Restructuring and Other Special Charges During the years ended December 31, 2018, 2017 and 2016 including in connection with the productivity initiatives described above under "Key Trends and Conditions Affecting Our Results of Operations - Productivity," we incurred charges related to asset impairment, restructuring and other special charges, including integration of acquired businesses. These charges include severance costs resulting from actions taken to reduce our costs, asset impairment charges primarily related to competitive pressures for certain companion animal products, product rationalizations, site closures and integration costs related to acquired businesses, primarily Novartis Animal Health and costs related to the build out of processes and systems to support finance and global supply and logistics, among others, as we become an independent company. For more information on these charges, see Note 7: Asset Impairment, Restructuring and Other Special Charges to our consolidated and combined financial statements. Results of Operations The following discussion and analysis of our consolidated and combined statements of operations should be read along with our consolidated and combined financial statements and the notes thereto included elsewhere in this report, which reflect the results of operations of the business transferred to Elanco from Lilly. For more information see Note 2: Basis of Presentation to our consolidated and combined financial statements. Certain amounts and percentages may reflect rounding adjustments. Revenue On a global basis, our revenue within our product categories was as follows: \ (1) Represents revenue from business activities we have either exited or made a strategic decision to exit. On June 30, 2018, Elanco made the decision to exit an equine product not core to its business. Revenue from this product is reflected in Strategic Exits for the year ended December 31, 2018 and in CA Therapeutics for the years ended December 31, 2017 and 2016. Revenue from this product was $1.6 million, $3.4 million and $3.7 million, for the years ended December 31, 2018, 2017 and 2016, respectively. On a global basis, the effect of price, foreign exchange rates and volumes on revenue was as follows: Note: Numbers may not add due to rounding *CER = Constant exchange rate Revenue Total revenue 2018 vs. 2017 Total revenue increased 177.8 million or 6% in 2018 as compared to 2017, reflecting a 3% increase due to higher realized prices and a 3% increase due to higher volumes. In summary, the total revenue increase was due primarily to: • an increase in revenue of $142.1 million or 22% from CA Disease Prevention products, excluding the impact of foreign exchange rates; • an increase in revenue of $18.4 million or 7% from CA Therapeutics products, excluding the impact of foreign exchange rates; • an increase in revenue of $63.8 million or 10% from FA Future Protein & Health products, excluding the impact of foreign exchange rates and partially offset by: • a decrease in revenue of $0.8 million or 0% from FA Ruminants & Swine, excluding the impact of foreign exchange rates and • a decrease in revenue of $49.9 million or 35% from Strategic Exits, excluding the impact of foreign exchange rates. The detailed change in revenue by product category was as follows: • CA Disease Prevention revenue increased by $144.4 million or 22% due primarily to a reduction in channel inventory in 2017 providing a favorable year-on-year comparison, continued uptake of Credelio and Interceptor Plus, as well as realized price increases primarily impacting Trifexis, Capstar (a flea treatment) and Comfortis, partially offset by volume declines in certain parasiticides, primarily Trifexis and Comfortis volumes. • CA Therapeutics revenue increased by $22.3 million or 9% due primarily to the continued uptake of Galliprant and Osurnia, as well as increased demand for Onsior, partially offset by a temporary supply shortage of Percorten V used for the treatment of canine Addison’s Disease. • FA Future Protein & Health revenue increased by $62.0 million or 10% due primarily to the launch of Imvixa and the growth in poultry animal-only antibiotics and poultry vaccines. • FA Ruminants & Swine revenue decreased by $1.0 million due primarily to competitive headwinds for ractopamine based products, offset by growth in animal-only antibiotics, primarily in cattle. • Strategic Exits revenue decreased by $49.9 million or 35% due primarily to the termination of a legacy U.S. distribution agreement in the third quarter of 2017, partially offset by revenue from the contract manufacturing agreement to supply human growth hormone to Lilly. 2017 vs. 2016 Total revenue decreased $24.5 million or 1% in 2017 as compared to 2016 due to lower volumes. In summary, the total revenue decrease was due primarily to: • a decline in revenue of $133.6 million or 10% from FA Ruminants & Swine products, excluding the impact of foreign exchanges rates; and • a decline in revenue of $113.6 million or 18% from CA Disease Prevention products, excluding the impact of acquisition and foreign exchange rates; partially offset by: • the acquisition of the BIVIVP which contributed $216.7 million in 2017; and • an increase in revenue of $18.7 million or 3% from FA Future Protein & Health products, excluding the impact of foreign exchange rates. The detailed change in revenue by product category was as follows: • CA Disease Prevention revenue increased by $31.8 million or 5%. Excluding product revenue from the acquisition of the BIVIVP and the impact of foreign exchange rates, revenue declined $113.6 million or 18% due primarily to competition in certain parasiticides, primarily impacting Trifexis and Comfortis, and a reduction in inventory levels within our U.S. companion animal distribution channel partially offset by the growth of Interceptor Plus. • CA Therapeutics revenue increased by $5.2 million or 2% due primarily to the launch of Galliprant, partially offset by volume declines from competition in our dermatology portfolio. • FA Future Protein & Health revenue increased by $18.4 million or 3% due primarily to growth in poultry products, including animal-only antibiotics, enzymes and vaccines, and to lesser extent aquaculture products. • FA Ruminants & Swine revenue decreased by $134.2 million or 10% due primarily to competition from generic ractopamine-based products, as well as declines in shared-class antibiotics and a reduction in inventory levels within our China distribution channel, partially offset by growth in animal-only antibiotics. • Strategic Exits revenue increased by $54.3 million or 61% due primarily to the acquisition of a transitional contract manufacturing arrangement at Fort Dodge as part of the BIVIVP acquisition, partially offset by the termination in the third quarter of 2017 of a legacy U.S. distribution agreement acquired as part of our Novartis Animal Health acquisition. Costs, Expenses and Other Cost of sales 2018 vs. 2017 Cost of sales increased $79.9 million in 2018 as compared to 2017 primarily due to increased volume of products sold and the write-off of inventory related to the suspension of activities for Imrestor in 2018, partially offset by non-recurring costs incurred in 2017 associated with fair value adjustments to inventory acquired in the BIVIVP acquisition and subsequently sold. 2017 vs. 2016 Cost of sales increased $84.9 million in 2017 as compared to 2016 due primarily to: • the addition of approximately $134.1 million of costs in 2017 related to the acquisition of the BIVIVP, including $54.0 million associated with Strategic Exits contract manufacturing obligations and approximately $42.7 million in non-recurring costs associated with the incremental purchase accounting charges related to the fair value adjustments to inventory acquired that was subsequently sold; • an unfavorable product mix as a result of disproportional revenue decreases of higher margin products primarily resulting from changing market demand for antibiotics and competition headwinds; and • contractual increases in third-party manufacturing agreements; partially offset by: • operational efficiencies and cost savings associated with manufacturing footprint consolidation and overall cost reductions. Research and development 2018 vs. 2017 R&D expenses decreased $5.1 million for 2018 as compared to 2017 due primarily to cost control measures and timing of projects leading to lower spend in 2018. 2017 vs. 2016 R&D expenses decreased $14.1 million in 2017 as compared to 2016 due primarily to savings realized from the consolidation of acquired R&D sites and operations, as well as the termination of certain R&D projects. This decrease was partially offset by expenses incurred in connection with the acquisition of the BIVIVP in 2017. Marketing, selling and administrative 2018 vs. 2017 Marketing, selling and administrative expenses decreased $44.6 million for 2018 as compared to 2017 due primarily to productivity initiatives in sales and administrative functions and reduced direct to consumer programs combined with new product launches in 2017. 2017 vs. 2016 Marketing, selling and administrative expenses decreased $5.0 million in 2017 as compared to 2016 due primarily to savings from productivity initiatives related to salesforce, marketing and administrative functions, more than offsetting the increase from the acquisition of the BIVIVP. Amortization of intangible assets 2018 vs. 2017 Amortization of intangible assets decreased $23.8 million for 2018 as compared to 2017 due primarily to the acceleration of amortization related to certain product exits in 2017. 2017 vs. 2016 Amortization of intangible assets increased $50.5 million in 2017 as compared to 2016 due primarily to the impact of the acquisition of the BIVIVP and, to a lesser extent, the acceleration of amortization related to certain product exits. Asset impairment, restructuring and other special charges For additional information regarding our asset impairment, restructuring and other special charges, see Note 7: Asset Impairment, Restructuring and Other Special Charges to our consolidated and combined financial statements. 2018 vs. 2017 Asset impairment, restructuring and other special charges decreased $246.3 million for the year ended December 31, 2018 as compared to the year ended December 31, 2017 primarily due to a decrease in severance related to the U.S. voluntary early retirement program offered in 2017 as well as a decrease in integration costs related to the BIVIVP acquisition in 2017, partially offset by a gain on disposal of a site that was previously closed as part of the acquisition and integration of Novartis Animal Health in 2017. 2017 vs. 2016 Asset impairment, restructuring and other special charges increased $66.7 million in 2017 as compared to 2016 due primarily to higher severance costs recognized in 2017 due to the U.S. voluntary early retirement program offered to our employees, partially offset by lower integration costs relating to our acquired businesses. Interest expense, net of capitalized interest 2018 vs 2017 Interest expense was $29.6 million for the year ended December 31, 2018 due our issuance of debt in Q3 of 2018. There was no interest expense in 2017 and prior years. Other (income) expense, net 2018 vs 2017 Other (income) expense, net was expense of $41.3 million in 2018 compared to income of $0.1 million in 2017. The increase in expense is primarily due to the increase in the Aratana contingent consideration liability of $37.6 million associated with the Galliprant acquisition. 2017 vs 2016 Other (income) expense, net was flat when comparing 2017 to 2016 with income of $0.1 million in 2017 compared to income of $2.8 million in 2016, a decrease of $2.7 million. Income tax expense Elanco’s historical income tax expense may not be indicative of its future expected tax rate. See “- Comparability of Historical Results - Our Relationship with Lilly and Additional Standalone Costs.” 2018 vs. 2017 Income tax expense decreased $50.5 million for the year ended December 31, 2018 as compared to the year ended December 31, 2017 primarily due to a decrease in the U.S. valuation allowance which was recorded in 2017 based upon the pre-IPO separate return methodology (see Note 2: Basis of Presentation and Note 14: Income Taxes to the consolidated financial statements). 2017 vs. 2016 Income tax expense, increased $52.6 million due primarily to an increase in unrecognized deferred tax assets in 2017 due to a valuation allowance and the tax effect of asset impairment, restructuring and other special charges, partially offset by an income tax benefit related to U.S. tax reform. Liquidity and Capital Resources We historically participated in Lilly’s centralized treasury management system, including centralized cash pooling and overall financing arrangements. We have generated and expect to continue to generate positive cash flows from operations. In connection with the IPO, we entered into various long-term debt agreements as described below. Our primary sources of liquidity are cash on hand, cash flows from operations and funds available under our Credit Facilities. As a significant portion of our business is conducted outside the U.S., we hold a significant portion of cash outside of the U.S. We monitor and adjust the amount of foreign cash based on projected cash flow requirements. Our ability to use foreign cash to fund cash flow requirements in the U.S. may be impacted by local regulations and, to a lesser extent, following U.S. tax reforms, the income taxes associated with transferring cash to the U.S. See “Item 1. Business." We currently intend to indefinitely reinvest foreign earnings for continued use in our foreign operations. As our structure evolves as a standalone company, we may change that strategy, particularly to the extent we identify tax efficient reinvestment alternatives for our foreign earnings or change our cash management strategy. Our principal liquidity needs going forward include funding existing marketed and pipeline products, capital expenditures, business development in our targeted areas, interest expense and an anticipated dividend. We believe our cash and cash equivalents on hand, our operating cash flows and our existing financing arrangements will be sufficient to support our cash needs for the foreseeable future, including for at least the next 12 months. Our ability to meet future funding requirements may be impacted by macroeconomic, business and financial volatility. As markets change, we will continue to monitor our liquidity position. However, a challenging economic environment or an economic downturn may impact our liquidity or ability to obtain future financing. See "Item 1A. Risk Factors - We may not be able to generate sufficient cash to service all of our indebtedness and may be forced to take other actions to satisfy our obligations under our indebtedness, which may not be successful. As of December 31, 2018, cash and cash equivalents was $474.8 million, an increase of $151.4 million, compared to $323.4 million at December 31, 2017. We also held $202.7 million of restricted cash at December 31, 2018, which is available solely to pay the remainder of the purchase for our businesses to Lilly. We have a corresponding liability recorded on our balance sheet and included in Payable to Lilly. Refer to the Consolidated and Combined Statements of Cash Flows for additional details on the significant sources and uses of cash for the years ended December 31, 2018 and December 31, 2017. Revolving and Term Credit Facilities On September 5, 2018, we entered into a revolving credit agreement with a syndicate of banks providing for a five-year $750.0 million senior unsecured revolving credit facility (Revolving Facility). The Revolving Facility bears interest at a variable rate plus specified margin as defined in the agreement and is payable quarterly. There were no borrowings outstanding under the Revolving Facility at December 31, 2018. The Revolving Facility is payable in full at the end of the term. On September 5, 2018 we also entered into a $500.0 million three-year term loan under a term credit facility with a syndicate of banks (the Term Facility and collectively with the Revolving Facility, the Credit Facilities.) The Term Facility bears interest at a variable rate plus margin as defined in Term Facility (3.77% at December 31, 2018) and is payable quarterly. The Term Facility also requires a quarterly principal payment equal to 1.5% of the aggregate initial principal less any prepayment. The Term Facility is payable in full at the end of the term. The Credit Facilities are subject to various financial and other covenants including restrictions on the level of borrowings based on a consolidated leverage ratio and a consolidated interest coverage ratio. We were in compliance with all such covenants as of December 31, 2018. See Note 9 - Debt to our consolidated and combined financial statements. Senior Notes On August 28, 2018, we issued $2.0 billion of senior notes (Senior Notes) in a private placement. The Senior Notes comprised of $500.0 million of 3.912% Senior Notes due August 27, 2021, $750.0 million of 4.272% Senior Notes due August 28, 2023, and $750.0 million of 4.900% Senior Notes due August 28, 2028. We were in compliance with all covenants under the indenture governing the Senior Notes as of December 31, 2018. Long-term debt as of December 31, 2017 was not material. See Note 9 - Debt to our consolidated and combined financial statements. Capital Expenditures Capital expenditures were $134.5 million during 2018, an increase of $35.9 million compared to 2017. We expect 2019 capital expenditures to be approximately $179.0 million. Cash Flows The following table provides a summary of cash flows from operating, investing and financing activities for the periods presented: Operating activities 2018 vs. 2017 Our cash flow from operating activities increased by $313.5 million from $173.8 million for the year ended December 31, 2017 to $487.3 million for the year ended December 31, 2018. The increase is a result of an increase in net income, which was partially offset by cash used to finance working capital, primarily focused on accounts receivable and inventory. 2017 vs. 2016 Our net cash provided by operating activities was $173.8 million in 2017 as compared to cash provided by operating activities of $155.9 million in 2016. This increase in operating cash flows was primarily attributable to: • a decrease in receivables in 2017 as compared to an increase in 2016 due to a one-time impact of standardizing payment terms across our acquired businesses as well as payment receipt timing due to integration of acquired assets; • a decrease in other assets in 2017 as compared to an increase in 2016 primarily due to the timing of tax payments; and • a smaller increase in inventory levels in 2017 as compared to 2016; partially offset by: • increased net losses. Investing activities 2018 vs. 2017 Our cash flow used in investing activities decreased from $964.6 million for the year ended December 31, 2017 to $127.0 million for the year ended December 31, 2018. Our cash used in investing activities for the year ended December 31, 2017 included $882.1 million related to the acquisition of BIVIVP. This decrease was offset by a net increase of $35.9 million in capital expenditures from 2017 to 2018. 2017 vs. 2016 Our net cash used in investing activities was $964.6 million in 2017 as compared to cash used in investing activities of $182.1 million in 2016. This increase in net cash flows used in investing activities was primarily attributable to the acquisition of the BI Vetmedica U.S. vaccines portfolio in 2017. Financing activities 2018 vs. 2017 Our cash from financing activities was a use of cash of $35.2 million in 2018 compared to cash provided by financing activities of $847.5 million in 2017, a change of $882.7 million The cash flows in 2017 relate to net cash provided by transactions with Lilly of $848.3 million compared to cash used in transactions with Lilly of $154.4 million in 2018, a reduction in financing of cash flows between periods of $1.0 billion. This, in addition to the consideration paid to Lilly in connection with the Separation, was partially offset by net cash provided from financing transactions related to the Separation including the proceeds from long-term debt and our IPO. The remainder of the proceeds from the financing related to the Separation will be paid to Lilly in future periods and is reflected as restricted cash in our consolidated balance sheet. 2017 vs. 2016 Our net cash provided by financing activities was $847.5 million in 2017 as compared to cash used in financing activities of $149.6 million in 2016. This increase in net cash provided was primarily attributable to financing provided by Lilly for the acquisition of the BI Vetmedica U.S. vaccines portfolio in 2017. Contractual Obligations Payments due under contractual obligations as of December 31, 2018, are set forth below: (1) Represents open purchase orders as of December 31, 2018 and contractual payment obligations with each of our significant vendors which are noncancelable and are not contingent. (2) We excluded deferred taxes because we cannot reasonably estimate the timing of future cash outflows associated with those liabilities. Off-Balance Sheet Arrangements We have no off-balance sheet arrangements that have a material current effect or that are reasonably likely to have a material future effect on our financial condition, changes in financial condition, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources. Critical Accounting Policies The preparation of financial statements in accordance with U.S. GAAP requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. Certain of our accounting policies are considered critical because these policies are the most important to the depiction of our financial statements and require significant, difficult or complex judgments by us, often requiring the use of estimates about the effects of matters that are inherently uncertain. Actual results that differ from our estimates could have an unfavorable effect on our financial position and results of operations. We apply estimation methodologies consistently from year to year. The following is a summary of accounting policies that we consider critical to the combined financial statements. Revenue Recognition Our gross product revenue is subject to deductions that are generally estimated and recorded in the same period that the revenue is recognized and primarily represents revenue incentives (rebates and discounts) and sales returns. For example: • for revenue incentives, we use our historical experience with similar incentives programs and current sales data to estimate the impact of such programs on revenue and continually monitor the impact of this experience and adjust as necessary; and • for sales returns, we consider items such as: local returns policies and practices; returns as a percentage of revenue; an understanding of the reasons for past returns; estimated shelf life by product; and estimate of the amount of time between shipment and return to estimate the impact of sales returns. If any of our ratios, factors, assessments, experiences or judgments are not indicative or accurate predictors of our future experience, our results could be materially affected. Although the amounts recorded for these revenue deductions are dependent on estimates and assumptions, historically our adjustments to actual results have not been material. The sensitivity of our estimates can vary by program, type of customer and geographic location. Amounts recorded for revenue deductions can result from a complex series of judgments about future events and uncertainties and can rely on estimates and assumptions. Acquisitions and Fair Value We account for the assets acquired and liabilities assumed in an acquisition based on the fair values as of the acquisition date. The excess of the purchase price over the fair value of the acquired net assets, where applicable, is recorded as goodwill. The judgments made in determining estimated fair values assigned to assets acquired and liabilities assumed in a business combination, as well as estimated asset lives, can materially affect our consolidated results of operations. The fair values of intangible assets are re-determined using information available near the acquisition date based on expectations and assumptions that are deemed reasonable by management. Depending on the facts and circumstances, we may deem it necessary to engage an independent valuation expert to assist in valuing significant assets and liabilities. The fair value of any contingent consideration liability that results from a business combination is determined using a market approach based on quoted market values, significant other observable inputs for identical or comparable assets or liabilities, or a discounted cash flow analysis. Estimating the fair value of contingent consideration requires the use of significant estimates and judgments, including, but not limited to, revenue and the discount rate and will be remeasured every reporting period. Impairment of Indefinite-Lived and Long-Lived Assets We review the carrying value of long-lived assets (both intangible and tangible) for potential impairment on a periodic basis and whenever events or changes in circumstances indicate the carrying value of an asset (or asset group) may not be recoverable. We identify impairment by comparing the projected undiscounted cash flows to be generated by the asset (or asset group) to its carrying value. If an impairment is identified, a loss is recorded equal to the excess of the asset's net book value over its fair value utilizing a discounted cash flow analysis, and the cost basis is adjusted. Goodwill and indefinite-lived intangible assets are reviewed for impairment at least annually and when certain impairment indicators are present. When required, a comparison of fair value to the carrying amount of assets is performed to determine the amount of any impairment. The estimated cash flows and fair values used in our impairment reviews require significant judgment with respect to future volume; use of working capital; foreign currency exchange rates; the selection of appropriate discount rates; product mix; income tax rates and other assumptions and estimates. Such estimates and assumptions are determined based upon our business plans and when applicable, market participants' views of us and other similar companies. We make these judgments based on our historical experience, relevant market size, historical pricing of similar products and expected industry trends. These assumptions are subject to change in future periods because of, among other things, additional information, financial information based on further historical experience, changes in competition, our investment decisions, volatility in foreign currency exchange rates, and results of research and development. A change in these assumptions or the use of alternative estimates and assumptions could have a significant impact on the estimated fair values of the assets, and may result in an impairment of the existing assets in a future period. During the years ended December 31, 2018, 2017 and 2016, we recorded asset impairments of $81.9 million, $110.6 million and $98.3 million, respectively, due to changes in estimates or judgments related to the use of the assets. For more information related to our impairment charges, see Note 7: Asset Impairment, Restructuring and Other Special Charges to our consolidated and combined financial statements. Deferred Tax Asset Valuation Allowances We maintain valuation allowances unless it is more likely than not that all or a portion of the deferred tax asset will be realized. Changes in valuation allowances are included in our tax provision in the period of change. In determining whether a valuation allowance is warranted, we evaluate factors such as prior earnings history, expected future earnings, carryback and carryforward periods, and tax strategies that could potentially enhance the likelihood of realization of a deferred tax asset. The realizability assessments made at a given balance sheet date are subject to change in the future, particularly if earnings of a subsidiary are significantly higher or lower than expected, or if we take operational or tax planning actions that could impact the future taxable earnings of a subsidiary. A change in these assumptions may result in an increase or decrease in the realizability of our existing deferred tax assets, and therefore a change in the valuation allowance, in future periods. As of December 31, 2018 and 2017, we had valuation allowances of $21.4 million and $127.7 million, respectively. Quantitative and Qualitative Disclosures About Market Risk Foreign Exchange Risk We operate on a global basis and are exposed to the risk that our earnings, cash flows and equity could be adversely impacted by fluctuations in foreign exchange rates. We are primarily exposed to foreign exchange risk with respect to net assets denominated in the Euro, British pound, Canadian dollar, Australian dollar and Brazilian real. Lilly maintains a foreign currency risk management program through a central shared entity, which enters into derivative contracts to hedge foreign currency risk associated with forecasted transactions for the entire company, including historically for our operations. Gains and losses on derivative contracts entered into by Lilly have been allocated to our results to the extent they were to cover exposure related to our business and offset gains and losses on underlying foreign currency exposures. Following the Separation, we started implementation our own foreign currency risk management program. We also face currency exposure that arises from translating the results of our global operations to the U.S. dollar at exchange rates that have fluctuated from the beginning of the period. We may enter into foreign currency forward or option derivative contracts to reduce the effect of fluctuating currency exchange rates in future periods, but our historical results do not reflect the impact of any such derivatives related to our exposure to foreign currency impacts on translation. We estimate that a hypothetical 10% adverse movement in all foreign currency exchange rates related to the translation of the results of our foreign operations would decrease our net income by approximately $11.2 million for the year ended December 31, 2018. We also bear foreign exchange risk associated with the future cash settlement of an existing NIH. In October 2018, we entered into a fixed interest rate, 5-year, 750 million Swiss franc NIH against Swiss franc assets. The NIH is expected to generate approximately $25 million in cash and contra interest expense per year; however, there is potential for significant 2023 settlement exposure on the 750 million Swiss franc notional if the U.S. dollar devalues versus the Swiss franc. Interest Risk We are exposed to interest rate risk on the long-term debt we incurred in connection with our IPO. Prior to our IPO, we did not have any interest rate exposure. We have cash flow risk associated with our $500.0 million of borrowings that pay interest based on variable rates. We actively monitor our exposure and may enter into financial instruments for the purpose of limiting our exposure based on our assessment of risk. Recently Issued Accounting Pronouncements For discussion of our new accounting standards, see Note 4: Summary of Significant Accounting Policies - Implementation of New Financial Accounting Pronouncements to our consolidated and combined financial statements.
-0.002628
-0.002422
0
<s>[INST] Overview Founded in 1954 as part of Eli Lilly and Company, Elanco is a premier animal health company that innovates, develops, manufactures and markets products for companion and food animals. Headquartered in Greenfield, Indiana, we are the fourth largest animal health company in the world, with revenue of $3,066.8 million for the year ended December 31, 2018. Globally, we are #1 in medicinal feed additives, #2 in poultry and #3 in cattle, measured by 2017 revenue, according to Vetnosis. We have one of the broadest portfolios of pet parasiticides in the companion animal sector. We offer a diverse portfolio of more than 125 brands that make us a trusted partner to veterinarians and food animal producers in more than 90 countries. We operate our business in a single segment directed at fulfilling our vision of enriching the lives of people through food, making protein more accessible and affordable and through pet companionship, helping pets live longer, healthier lives. We advance our vision by offering products in four primary categories: Companion Animal Disease Prevention (CA Disease Prevention): We have one of the broadest parasiticide portfolios in the companion animal sector based on indications, species and formulations, with products that protect pets from worms, fleas and ticks. Combining our parasiticide portfolio with our vaccines presence, we are a leader in the United States (U.S.) in the disease prevention category based on share of revenue. Companion Animal Therapeutics (CA Therapeutics): We have a broad pain and osteoarthritis portfolio across species, modes of action, indications and disease stages. Pet owners are increasingly treating osteoarthritis in their pets, and our Galliprant product is one of the fastest growing osteoarthritis treatments in the U.S. We also have treatments for otitis (ear infections), as well as cardiovascular and dermatology indications. Food Animal Future Protein & Health (FA Future Protein & Health): Our portfolio in this category, which includes vaccines, nutritional enzymes and animal only antibiotics, serves the growing demand for protein and includes innovative products in poultry and aquaculture production, where demand for animal health products is outpacing overall industry growth. We are focused on developing functional nutritional health products that promote food animal health, including enzymes, probiotics and prebiotics. We are a leader in providing vaccines as alternatives to antibiotics to promote animal health based on share of revenue. Food Animal Ruminants & Swine (FA Ruminants & Swine): We have developed a range of food animal products used extensively in ruminant (e.g., cattle, sheep and goats) and swine production. For the years ended December 31, 2018, 2017 and 2016, our revenue was $3,066.8 million, $2,889.0 million and $2,913.5 million, respectively. For the years ended December 31, 2018, 2017 and 2016, our net income (loss) was $86.5 million, $(310.7) million and $(47.9) million, respectively. Key Trends and Conditions Affecting Our Results of Operations Industry Trends The animal health industry, which focuses on both food animals and companion animals, is a growing industry that benefits billions of people worldwide. As demand for animal protein grows, food animal health is becoming increasingly important. Factors influencing growth in demand for food animal medicines and vaccines include: one in three people need improved nutrition; increased global demand for protein, particularly poultry and aquaculture; natural resource constraints, such as scarcity of arable land, fresh water and increased competition for cultivated land, driving the need for more efficient food production; loss of productivity due to food animal disease and death; increased focus on food safety and food security; and human population growth, increased standards of living, particularly in many emerging markets, and increased urbanization. Growth [/INST] Negative. </s>
2,019
9,184
1,739,104
Elanco Animal Health Inc
2020-02-28
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, is intended to assist the reader in understanding and assessing significant changes and trends related to our results of operations and financial position. This discussion and analysis should be read in conjunction with the consolidated and combined financial statements and accompanying footnotes in Item 8 of Part II of this Annual Report on Form 10-K. Certain statements in this Item 7 of Part II of this Annual Report on Form 10-K constitute forward-looking statements. Various risks and uncertainties, including those discussed in "Forward-Looking Statements" and Item 1A, “Risk Factors,” may cause our actual results, financial position, and cash generated from operations to differ materially from these forward-looking statements. Overview Founded in 1954 as part of Eli Lilly & Co. (Lilly), Elanco is a premier animal health company that innovates, develops, manufactures and markets products for companion and food animals. Headquartered in Greenfield, Indiana, we are the fourth largest animal health company in the world, with revenue of $3,071.0 million for the year ended December 31, 2019. Globally, we are #1 in medicinal feed additives, #2 in poultry, and #3 in other pharmaceuticals, which are mainly companion animal therapeutics, measured by 2018 revenue, according to Vetnosis. We have one of the broadest portfolios of pet parasiticides in the companion animal sector. We offer a diverse portfolio of more than 125 brands that make us a trusted partner to veterinarians and food animal producers in more than 90 countries. On September 24, 2018, we completed our initial public offering (IPO), pursuant to which we issued and sold 19.8% of our total outstanding shares. On September 20, 2018, our common stock began trading on the New York Stock Exchange (NYSE) under the symbol “ELAN.” On September 24, 2018, immediately preceding the completion of the IPO, Lilly transferred to us substantially all of its animal health businesses in exchange for (i) all of the net proceeds (approximately $1,659.7 million) we received from the sale of our common stock in the IPO, including the net proceeds we received as a result of the exercise in full of the underwriters’ option to purchase additional shares, (ii) all of the net proceeds (approximately $2,000 million) we received from the issuance of our senior notes; and (iii) all of the net proceeds ($498.6 million) we received from the entry into our term loan facility. In addition, immediately prior to the completion of the IPO, we entered into certain agreements with Lilly that provide a framework for our ongoing relationship with them. On February 8, 2019, Lilly announced an exchange offer whereby Lilly shareholders could exchange all or a portion of Lilly common stock for shares of Elanco common stock owned by Lilly. On that date, we filed a Registration Statement on Form S-4 with the SEC in connection with that exchange offer. The disposition of Elanco shares was completed on March 11, 2019, and resulted in the full separation of Elanco along with the disposal of Lilly's entire ownership and voting interest in Elanco. We operate our business in a single segment directed at fulfilling our vision of enriching the lives of people through food, making protein more accessible and affordable and through pet companionship, helping pets live longer, healthier lives. We advance our vision by offering products in four primary categories: Companion Animal Disease Prevention (CA Disease Prevention): We have one of the broadest parasiticide portfolios in the companion animal sector based on indications, species and formulations, with products that protect pets from worms, fleas and ticks. Combining our parasiticide portfolio with our vaccines presence, we are a leader in the U.S. in the disease prevention category based on share of revenue. Companion Animal Therapeutics (CA Therapeutics): We have a broad pain and osteoarthritis portfolio across species, modes of action, indications and disease stages. Pet owners are increasingly treating osteoarthritis in their pets, and our Galliprant product is one of the fastest growing osteoarthritis treatments in the U.S. We also have treatments for otitis (ear infections), as well as cardiovascular and dermatology indications. Food Animal Future Protein & Health (FA Future Protein & Health): Our portfolio in this category, which includes vaccines, nutritional enzymes and animal only antibiotics, serves the growing demand for protein and includes innovative products in poultry and aquaculture production, where demand for animal health products is outpacing overall industry growth. We are focused on developing functional nutritional health products that promote food animal health, including enzymes, probiotics and prebiotics. We are a leader in providing vaccines as alternatives to antibiotics to promote animal health based on share of revenue. Food Animal Ruminants & Swine (FA Ruminants & Swine): We have developed a range of food animal products used extensively in ruminant (e.g., cattle, sheep and goats) and swine production. For the years ended December 31, 2019, 2018 and 2017, our revenue was $3,071.0 million, $3,066.8 million and $2,889.0 million, respectively. For the years ended December 31, 2019, 2018 and 2017, our net income (loss) was $67.9 million, $86.5 million and $(310.7) million, respectively. Increases or decreases in inventory levels at our channel distributors can positively or negatively impact our quarterly and annual revenue results, leading to variations in quarterly revenues. This can be a result of various factors, such as end customer demand, new customer contracts, heightened and generic competition, the need for certain inventory levels, our ability to renew distribution contracts with expected terms, our ability to implement commercial strategies, regulatory restrictions, unexpected customer behavior, payment terms we extend, which are subject to internal policies, and procedures and environmental factors beyond our control, including weather conditions. Key Trends and Conditions Affecting Our Results of Operations Industry Trends The animal health industry, which focuses on both food animals and companion animals, is a growing industry that benefits billions of people worldwide. As demand for animal protein grows, food animal health is becoming increasingly important. Factors influencing growth in demand for food animal medicines and vaccines include: •one in three people need improved nutrition; •increased global demand for protein, particularly poultry and aquaculture; •natural resource constraints, such as scarcity of arable land, fresh water and increased competition for cultivated land, driving the need for more efficient food production; •loss of productivity due to food animal disease and death; •increased focus on food safety and food security; and •human population growth, increased standards of living, particularly in many emerging markets, and increased urbanization. Growth in food animal nutritional health products (enzymes, probiotics and prebiotics) is influenced, among other factors, by demand for antibiotic alternatives that can promote animal health and increase productivity. Factors influencing growth in demand for companion animal medicines and vaccines include: •increased pet ownership globally; •pets living longer; and •increased pet spending as pets are viewed as members of the family by owners. Factors Affecting Our Results of Operations Product Development and New Product Launches A key element of our targeted value creation strategy is to drive growth through portfolio development and product innovation, primarily in our three targeted growth categories of CA Disease Prevention, CA Therapeutics and FA Future Protein & Health. Since 2015, we have launched or acquired 14 new products, including the additions of Entyce, Nocita and Tanovea in 2019. Revenue from these products contributed $439.2 million to revenue for the year ended December 31, 2019. We continue to pursue the development of new chemical and biological molecules through our approach to innovation. Our future growth and success depends on both our pipeline of new products, including new products that we may develop through joint ventures and products that we are able to obtain through license or acquisition, and the expansion of the use of our existing products. We believe we are an industry leader in animal health R&D, with a track record of product innovation, business development and commercialization. Impact of Changing Market Demand for Antibiotics In recent years, our operational results have been, and will continue to be, affected by regulations and changing market demand relating to the use of antibiotics and other products intended to increase food animal production. There are two classes of antibiotics used in animal health: (i) shared-class, or medically important, antibiotics; and (ii) animal-only antibiotics. Shared-class antibiotics are used to treat infectious disease caused by pathogens that occur in both humans and animals. As part of our antibiotic stewardship plan and in compliance with FDA guidance, shared-class antibiotics are labeled only for the treatment of an established need in animals and only with veterinarian oversight. However, not all pathogens that cause disease in animals are infectious in humans, and accordingly animal-only antibiotics are not used in human medicine (i.e., not medically important). From 2015 to 2019, our revenue from shared-class antibiotics declined at a CAGR of 10%, excluding the impact of foreign exchange. This was driven primarily by changing regulations in many markets, including the Veterinary Feed Directive, as well as changing market demand and Elanco’s tiered-approach to antibiotic stewardship, which included removing growth promotion from labels and requiring veterinary oversight in the U.S. and other markets. Globally, during 2019, our revenue from shared-class antibiotics declined 13%, excluding the impact of foreign exchange, and represented 11% (4% from sales in the U.S. and 7% from sales outside of the U.S.) of our total revenue, down from 16% in 2015. From 2015 to 2019, our revenue from animal-only antibiotics grew at a CAGR of 4%, excluding the impact of foreign exchange, driven by sales outside the U.S., which offset a slight decline in the U.S. Globally, during 2019, our revenue from animal-only antibiotics declined 1%, excluding the impact of foreign exchange, and represented 24% of our total revenue, up from 23% in 2015. During 2019, 87% of our revenue from animal-only antibiotics resulted from the sale of ionophores. Ionophores are a special class of animal-only antimicrobials, and because of their animal-only designation, mode of action and spectrum of activity, their use, to date have not been impacted by regulations or changing market demand in many markets outside the U.S. We have intentionally shifted away from shared-class antibiotics, and are focusing on animal-only antibiotics, as well as antibiotic-free solutions. When an animal-only antibiotic exists, we believe it should be the first, preferred antibiotic treatment. Antibiotic resistance concerns, or other health concerns regarding food animal products, may result in additional restrictions, expanded regulations or changes in market demand to further reduce the use of antibiotics in food animals. We believe it is important to protect the benefits of antibiotics in human medicine, while responsibly protecting the health of food animals and the safety of our food supply. Impact of Competition The animal health industry is competitive. Established animal health companies who consistently deliver high quality products enjoy brand loyalty from their customers, which often continues after the loss of patent-based or regulatory exclusivity. In 2019, approximately 67% of our revenue was from products that did not have patent protection. In animal health, while potentially significant, erosion from generic competition is often not as steep as in human health, with the originator often retaining a significant market share. However, generic competition can nevertheless significantly affect our results. While our largest product, Rumensin (monensin), has been subject to generic competition from monensin outside the U.S. for more than 10 years, our revenue from Rumensin sales outside the U.S. grew at a CAGR of 5% from 2015 to 2019. In the third quarter of 2019, an established animal health company received U.S. approval for generic monensin in cattle and goats for certain indications. U.S. revenue from Rumensin may decline as a result of the generic competition. We have experienced significant competitive headwinds from generic ractopamine in the U.S. In the third quarter of 2013, a large, established animal health company received U.S. approval for ractopamine (the generic to our drugs Paylean and Optaflexx). U.S. revenue for Paylean and Optaflexx, our ractopamine beef and swine products, has declined at a CAGR of 44% and 21%, respectively, from 2015 to 2019 as a result of generic competition and the impact of international regulatory restrictions. In 2019, we had an estimated 70% market share of all U.S. ractopamine-treated beef cattle based on management estimates. Although we believe brand loyalty is an important contributor to a product's ongoing success, the animal health industry is also impacted by innovation. We experienced an innovation lag in the companion animal parasiticide space from 2015 to 2017. In the absence of a competitive combined oral flea and tick product, our U.S. companion animal parasiticide portfolio revenue declined 15% in 2017, excluding the impact on revenue resulting from a reduction in inventory levels within our distribution channel. In February 2018, we launched Credelio in the U.S. for the treatment of fleas and ticks. Since the launch of Credelio, our sales of parasiticides in the U.S. have begun to grow again. Productivity Our results during the periods presented have benefited from operational and productivity initiatives implemented following recent acquisitions and in response to changing market demand for antibiotics and other headwinds. Our acquisitions within the last six years added in the aggregate $1.4 billion in revenue, 4,600 full-time employees, 12 manufacturing and eight R&D sites. In addition, from 2015 to 2019, changing market demand for antibiotics and other headwinds, such as competition with generics and innovation, affected some of our highest gross margin products, resulting in a change to our product mix and driving operating margin lower. In response, we implemented a number of initiatives across the manufacturing, R&D and selling, general and administrative (SG&A) functions. Our manufacturing cost savings strategies included improving manufacturing processes and headcount through lean manufacturing (minimizing waste while maintaining productivity), closing of three manufacturing sites, consolidating our CMO network, strategically insourcing certain projects, and pursuing cost savings opportunities with respect to raw materials via a new procurement process. Additional cost savings resulted from reducing the number of R&D sites from 16 to nine, SG&A savings from sales force consolidation, and reducing discretionary and other general and administrative (G&A) operating expense. Foreign Exchange Rates Significant portions of our revenue and costs are exposed to changes in foreign exchange rates. Our products are sold in more than 90 countries and, as a result, our revenue is influenced by changes in foreign exchange rates. For the years ended December 31, 2019 and 2018, approximately 44% and 52%, respectively, of our revenue was denominated in foreign currencies. As we operate in multiple foreign currencies, including the Euro, British pound, Swiss franc, Brazilian real, Australian dollar, Japanese yen, Canadian dollar, Chinese yuan, and other currencies, changes in those currencies relative to the U.S. dollar will impact our revenue, cost of sales and expenses, and consequently, net income. These fluctuations may also affect the ability to buy and sell our products between markets impacted by significant exchange rate variances. Currency movements decreased revenue by 2% during the year ended December 31, 2019. Currency movements had limited impact on revenue during the years ended December 31, 2018 and 2017. General Economic Conditions In addition to industry-specific factors, we, like other businesses, face challenges related to global economic conditions. Growth in both the food animal and companion animal sectors is driven in part by overall economic development and related growth, particularly in many emerging markets. In recent years, certain of our customers and suppliers have been affected directly by economic downturns, which decreased the demand for our products. The cost of our products to food animal producers is small relative to their other production costs, including feed, and the use of our products is intended to improve economic outcomes for food animal producers. Similarly, industry sources have reported that pet owners indicated a preference for reducing spending on other aspects of their lifestyle, including entertainment, clothing and household goods, before reducing spending on pet care. While these factors have mitigated the impact of recent downturns in the global economy, further economic challenges could increase cost sensitivity among our customers, which may result in reduced demand for our products and could have a material adverse effect on our financial condition and results of operations. Weather Conditions and the Availability of Natural Resources The animal health industry and demand for many of our animal health products in a particular region are affected by weather conditions, varying weather patterns and weather-related pressures from pests, such as fleas and ticks. As a result, we may experience regional and seasonal fluctuations in our results of operations. Food animal producers depend on the availability of natural resources, including large supplies of fresh water. Their animals' health and their ability to operate could be adversely affected if they experience a shortage of fresh water due to human population growth or floods, droughts or other weather conditions. Drought conditions could negatively impact, among other things, the supply of corn and the availability of grazing pastures. A decrease in harvested corn results in higher corn prices, which could negatively impact the profitability of food animal producers of ruminants, pork and poultry. Higher corn prices and reduced availability of grazing pastures contribute to reductions in herd or flock sizes that in turn result in less spending on animal health products. As such, a prolonged drought could have a material adverse effect on our financial condition and results of operations. Factors influencing the magnitude and timing of effects of a drought on our performance include, but may not be limited to, weather patterns and herd management decisions. In addition, veterinary hospitals and practitioners depend on visits from and access to the animals under their care. Veterinarians' patient volume and ability to operate could be adversely affected if they experience prolonged snow, ice or other severe weather conditions, particularly in regions not accustomed to sustained inclement weather. Adverse weather conditions or a shortage of fresh water may cause veterinarians and food animal producers to purchase less of our products. Disease Outbreaks Sales of our food animal products could be adversely affected by the outbreak of disease carried by animals, such as African Swine Fever. Outbreaks of disease may reduce regional or global sales of particular animal-derived food products or result in reduced exports of such products, either due to heightened export restrictions or import prohibitions, which may reduce demand for our products. Also, the outbreak of any highly contagious disease near our main production sites could require us to immediately halt production of our products at such sites or force us to incur substantial expenses in procuring raw materials or products elsewhere. Alternatively, sales of products that treat specific disease outbreaks may increase. Manufacturing and Supply In order to sell our products, we must be able to reliably produce and ship our products in sufficient quantities. Many of our products involve complex manufacturing processes and are sole-sourced from certain manufacturing sites. Minor deviations in our manufacturing or logistical processes, unpredictability of a product's regulatory or commercial success or failure, the lead time necessary to construct highly technical and complex manufacturing sites, and shifting customer demand increase the potential for capacity imbalances. Components of Revenue and Costs and Expenses Revenue Our revenue is primarily derived from sales of our products to third-party distributors, and directly to food producers and veterinarians. For additional information regarding our products, including descriptions of our products, see "Item 1. Business - Products." We aggregate our products into five categories to understand revenue growth: •CA Disease Prevention includes parasiticides and vaccine products for dogs and cats; •CA Therapeutics includes products for the treatment of pain, osteoarthritis, otitis, cardiovascular and dermatology indications in dogs and cats; •FA Future Protein & Health includes vaccines, antibiotics, parasiticides and other products used in poultry and aquaculture production, as well as functional nutritional health products, including enzymes, probiotics and prebiotics; •FA Ruminants & Swine includes vaccines, antibiotics, implants, parasiticides, and other products used in ruminants and swine production, as well as certain other food animal products; and •Strategic Exits includes business activities that we have either exited or made the strategic decision to exit, including the transitional contract manufacturing activity that we acquired in connection with our acquisition of the BI Vetmedica U.S. vaccines portfolio, two terminated legacy U.S. distribution agreements, a terminated distribution agreement outside the U.S., an equine product not core to our business and a transitional contract manufacturing activity associated with the supply to Lilly of human growth hormone. Costs, Expenses and Other Cost of sales consists primarily of cost of materials, facilities and other infrastructure used to manufacture our products, shipping and handling, inventory losses and expired products. Marketing, selling and administrative expenses consist of, among other things, the costs of marketing, promotion and advertising and the costs of administration (business technology, facilities, legal, finance, human resources, business development, external affairs and procurement). Amortization of intangible assets consists of the amortization expense for intangible assets that have been acquired through business combinations. R&D expenses consist of project costs specific to new product R&D and product lifecycle management, overhead costs associated with R&D operations, regulatory, product registrations and investments that support local market clinical trials for approved indications. We manage overall R&D based on our strategic opportunities and do not disaggregate our R&D expenses incurred by nature or by product as we do not use or maintain such information in managing our business. Asset impairment, restructuring and other special charges consist primarily of impairment of long-term assets, restructuring charges, costs associated with acquiring and integrating businesses, and certain non-recurring expenses, including costs related to the build out of processes and systems to support finance and global supply and logistics, among others, to stand our organization up as an independent company. Interest expense, net of capitalized interest consists of interest incurred on our long-term debt. Other-net, expense (income) consists primarily of realized or unrealized foreign exchange losses and loss or impairment on other investments. Comparability of Historical Results Our historical results of operations for the periods presented may not be comparable with prior periods or with our results of operations in the future, due to many factors, included but not limited to the factors identified in "Key Trends and Conditions Affecting Our Results of Operations." Our Relationship with Lilly and Additional Standalone Costs During the period prior to the IPO, our business operated solely as part of a division of Lilly. Our combined financial statements have been derived from Lilly’s consolidated financial statements and accounting records. Our consolidated and combined financial statements reflect our financial position, results of operations and cash flows of the business that was transferred at the time of the separation and do not purport to reflect what the results of operations, comprehensive income/(loss), financial position, equity or cash flows would have been had we operated as an independent, publicly traded company during the periods presented prior to the IPO. Our historical results reflect an allocation of costs for certain Lilly corporate costs for periods prior to the IPO, including, among others, executive oversight, treasury, legal, finance, human resources, tax, internal audit, financial reporting, information technology and investor relations. These allocations are not necessarily indicative of the expenses we may incur as a standalone public company. Although we entered into certain agreements with Lilly in connection with the IPO and the Separation, the amount and composition of our expenses may vary from historical levels since the fees charged for the services under these agreements may be higher or lower than the costs reflected in the historical allocations. The total allocations included in our results for the years ended December 31, 2019, 2018 and 2017 were $0.0 million, $105.2 million, and $151.7 million, respectively. See Note 20: Related Party Agreements and Transactions to our consolidated and combined financial statements. We are currently investing in expanding our own administrative functions, including, but not limited to, information technology, facilities management, distribution, human resources, and manufacturing, to replace services previously provided by Lilly. Because of initial stand-up costs and overlaps with services previously provided by Lilly, we have incurred and expect to continue to incur certain temporary, duplicative expenses in connection with the Separation. We have also incurred and expect to continue to incur costs related to the build out of processes and systems to support finance and global supply and logistics, among others. We currently estimate these costs taken together to be in a range from $240 million to $290 million, net of potential real estate dispositions and employee benefit changes, of which a portion will be capitalized and the remainder will be expensed. Lilly utilizes a centralized treasury management system, of which we were a part until our IPO. For periods prior to the IPO, our consolidated and combined financial statements reflect cash held only in bank accounts in our legal name and no allocation of combined cash positions. Our consolidated and combined financial statements do not reflect an allocation of Lilly’s debt or any associated interest expense. In connection with the IPO, we incurred $2.5 billion of long-term borrowings. Our historical results reflect $29.6 million of interest expense during the year ended December 31, 2018 due to the timing of the borrowings, in comparison to our interest expense of $78.9 million during the year ended December 31, 2019. For the periods prior to the IPO, our consolidated and combined financial statements reflect income tax expense (benefit) computed on a separate company basis, as if operating as a standalone entity or a separate consolidated group in each material jurisdiction in which we operate. Our consolidated and combined financial statements for the periods prior to the IPO also reflect certain deferred tax assets and liabilities and income taxes payable based on this approach that did not transfer to us upon the Separation, as the underlying tax attributes were used by Lilly or retained by Lilly. As a result of potential changes to our business model and the fact that certain deferred tax assets and liabilities and income taxes payable did not transfer to us, income tax expense (benefit) included in the consolidated and combined financial statements may not be indicative of our future expected tax rate. Our historical results prior to IPO also do not reflect the impact of costs we have incurred and expect to continue to incur as a consequence of becoming a standalone company, including incremental costs associated with being a publicly traded company. Subsequent to the IPO, we have implemented competitive compensation policies and programs as a standalone public company. Our historical results prior to the IPO reflect compensation costs that were allocated by Lilly. As a result of the IPO, we became subject to the reporting requirements of the Securities Exchange Act of 1934 and the Sarbanes-Oxley Act. We are continuing to establish or expand additional procedures and practices as a standalone public company. As a result, we will continue to incur additional costs as a standalone public company, including internal audit, external audit, investor relations, stock administration, stock exchange fees and regulatory compliance costs. Recent Significant Acquisitions Our financial results have been impacted by acquisitions and integrations. For the periods presented, these include primarily the acquisitions and integrations of Novartis Animal Health, which closed on January 1, 2015, Boehringer Ingelheim Vetmedica, Inc.'s U.S. feline, canine and rabies vaccine portfolio and other related assets (BIVIVP), which closed on January 3, 2017, Aratana Therapeutics, Inc., which closed on July 18, 2019, and Prevtec Microbia Inc., which closed on July 31, 2019. For more information, see Note 6: Acquisitions to our consolidated and combined financial statements. Asset Impairment, Restructuring and Other Special Charges During the years ended December 31, 2019, 2018 and 2017 including in connection with the productivity initiatives described above under "Key Trends and Conditions Affecting Our Results of Operations - Productivity," we incurred charges related to asset impairment, restructuring and other special charges, including integration of acquired businesses. These charges include severance costs resulting from actions taken to reduce our costs, asset impairment charges primarily related to competitive pressures for certain companion animal products, product rationalizations, site closures and integration costs related to acquired businesses, primarily Novartis Animal Health, and costs related to the build out of processes and systems to support finance and global supply and logistics, among others, as we stand our organization up as an independent company. For more information on these charges, see Note 7: Asset Impairment, Restructuring and Other Special Charges to our consolidated and combined financial statements. Results of Operations The following discussion and analysis of our consolidated and combined statements of operations should be read along with our consolidated and combined financial statements and the notes thereto included elsewhere in this report. For more information, see Note 2: Basis of Presentation to our consolidated and combined financial statements. Certain amounts and percentages may reflect rounding adjustments. NM - Not meaningful Revenue On a global basis, our revenue within our product categories was as follows: (1) Represents revenue from business activities we have either exited or made a strategic decision to exit. On June 30, 2018, Elanco made the decision to exit an equine product not core to its business. Revenue from this product is reflected in Strategic Exits for the years ended December 31, 2019 and 2018 and in CA Therapeutics for the year ended December 31, 2017. Revenue from this product was $0.4 million, $1.6 million and $3.4 million for the years ended December 31, 2019, 2018 and 2017, respectively. On a global basis, the effect of price, foreign exchange rates and volumes on changes in revenue as compared to the prior year was as follows: Note: Numbers may not add due to rounding *CER = Constant exchange rate Revenue Total revenue 2019 vs. 2018 Total revenue increased $4.2 million or 0.1% in 2019 as compared to 2018, reflecting a 2% increase in price, offset by a 2% unfavorable impact from foreign exchange rates. Volume was flat as compared to prior year. In summary, the total revenue increase was due primarily to: •an increase in revenue of $72.0 million or 25% from CA Therapeutics products, excluding the impact of foreign exchange rates; and •an increase in revenue of $59.5 million or 8% from FA Future Protein & Health products, excluding the impact of foreign exchange rates; partially offset by: •a decrease in revenue of $46.1 million or 4% from FA Ruminants & Swine products, excluding the impact of foreign exchange rates; •a decrease in revenue of $7.3 million or 1% from CA Disease Prevention products, excluding the impact of foreign exchange rates; •a decrease in revenue of $14.2 million or 15% from Strategic Exits, excluding the impact of foreign exchange rates; and •a decrease in revenue of $59.7 million due to the negative impact of foreign exchange rates. The detailed change in revenue by product category was as follows: •CA Disease Prevention revenue decreased by $16.7 million or 2%, driven by a decline in volume and to a lesser extent the unfavorable impact of foreign exchange rates, partially offset by an increase in price. The revenue decrease was a result of several unfavorable comparisons to 2018. In 2018, vaccines benefited from the initial stocking of a new customer agreement, customers purchased higher than normal levels of parasiticides and vaccines to achieve desired incentive levels across companion animal, and all remaining inventory for Parastar was sold prior to rationalizing the product, all contributing to the unfavorable comparison for the year. The decrease was also driven by declines in sales of older generation parasiticides, partially offset by the continued growth of Credelio and Interceptor Plus, including the initial stocking of a new customer agreement in the third quarter of 2019. •CA Therapeutics revenue increased by $64.9 million or 23%, driven by increased volume and to a lesser extent price, partially offset by the impact of foreign exchange rates. The revenue increase was driven by increased demand for products across the therapeutics portfolio, primarily Galliprant, initial stocking for a new customer agreement in the third quarter of 2019, and inclusion of sales of Entyce and Nocita, as a result of the acquisition of Aratana. •FA Future Protein & Health revenue increased by $33.9 million or 5%, driven by both increased volume and price, partially offset by an unfavorable impact from foreign exchange rates. Growth was driven by the aqua portfolio, poultry vaccines and nutritional products, partially offset by the loss of sales for certain products in China as a result of changing antibiotic policies. •FA Ruminants & Swine revenue decreased by $63.7 million or 5%, driven by a decline in volume and to a lesser extent the unfavorable impact of foreign exchange rates, partially offset by an increase in price. The decline in revenue was driven by softness in swine products due to African Swine Fever across Asia, a disruption in global supply of certain third-party produced injectable cattle products, reduced U.S. producer use of Paylean, decreased Rumensin sales as a result of the generic entrant, and the impact from the Australian drought. These decreases were partially offset by revenue generated from Posilac™ sales as a result of the revised commercial agreement entered into in the third quarter of 2019. •Strategic Exits revenue decreased by $14.2 million to $79.7 million and represented 3% of total revenue. 2018 vs. 2017 Total revenue increased $177.8 million or 6% in 2018 as compared to 2017, reflecting a 3% increase due to higher realized prices and a 3% increase due to higher volumes. In summary, the total revenue increase was due primarily to: •an increase in revenue of $142.1 million or 22% from CA Disease Prevention products, excluding the impact of foreign exchange rates; •an increase in revenue of $18.4 million or 7% from CA Therapeutics products, excluding the impact of foreign exchange rates; •an increase in revenue of $63.8 million or 10% from FA Future Protein & Health products, excluding the impact of foreign exchange rates and partially offset by: •a decrease in revenue of $0.8 million or 0% from FA Ruminants & Swine, excluding the impact of foreign exchange rates and •a decrease in revenue of $49.9 million or 35% from Strategic Exits, excluding the impact of foreign exchange rates. The detailed change in revenue by product category was as follows: •CA Disease Prevention revenue increased by $144.4 million or 22% due primarily to a reduction in channel inventory in 2017 providing a favorable year-on-year comparison, continued uptake of Credelio and Interceptor Plus, as well as realized price increases primarily impacting Trifexis, Capstar (a flea treatment) and Comfortis, partially offset by volume declines in certain parasiticides, primarily Trifexis and Comfortis volumes. •CA Therapeutics revenue increased by $22.3 million or 9% due primarily to the continued uptake of Galliprant and Osurnia, as well as increased demand for Onsior, partially offset by a temporary supply shortage of Percorten™ V used for the treatment of canine Addison’s Disease. •FA Future Protein & Health revenue increased by $62.0 million or 10% due primarily to the launch of Imvixa and the growth in poultry animal-only antibiotics and poultry vaccines. •FA Ruminants & Swine revenue decreased by $1.0 million due primarily to competitive headwinds for ractopamine based products, offset by growth in animal-only antibiotics, primarily in cattle. •Strategic Exits revenue decreased by $49.9 million or 35% due primarily to the termination of a legacy U.S. distribution agreement in the third quarter of 2017, partially offset by revenue from the contract manufacturing agreement to supply human growth hormone to Lilly. Costs, Expenses and Other Cost of sales 2019 vs. 2018 Cost of sales decreased $103.5 million in 2019 as compared to 2018 due primarily to manufacturing productivity improvements and charges recorded during the year ended December 30, 2018 for inventory adjustments related to the suspension of commercial activities of Imrestor and the closure of the Larchwood, Iowa facility, partially offset by unfavorable product mix and logistics costs. 2018 vs. 2017 Cost of sales increased $79.9 million in 2018 as compared to 2017 primarily due to increased volume of products sold and the write-off of inventory related to the suspension of activities for Imrestor in 2018, partially offset by non-recurring costs incurred in 2017 associated with fair value adjustments to inventory acquired in the BIVIVP acquisition and subsequently sold. Research and development 2019 vs. 2018 R&D expenses increased $23.5 million for 2019 as compared to 2018 primarily due to additional costs from acquired businesses during the year, including Aratana and Prevtec, increased costs from R&D infrastructure investments, and project spend as a result of pipeline progression. 2018 vs. 2017 R&D expenses decreased $5.1 million in 2018 as compared to 2017 due primarily to cost control measures and timing of projects leading to lower spend in 2018. Marketing, selling and administrative 2019 vs. 2018 Marketing, selling and administrative expenses increased $25.0 million for 2019 as compared to 2018 due primarily to additional costs from acquired businesses during the year, primarily Aratana, and increased marketing efforts for our companion animal portfolio, and increased expenses as a result of operating as a standalone public company, partially offset by slightly lower selling costs and lower costs due to continued productivity initiatives and cost control measures across the business. 2018 vs. 2017 Marketing, selling and administrative expenses decreased $44.6 million in 2018 as compared to 2017 due primarily to productivity initiatives in sales and administrative functions and reduced direct to consumer programs combined with new product launches in 2017. Amortization of intangible assets 2019 vs. 2018 Amortization of intangible assets increased $3.0 million for 2019 as compared to 2018 primarily due to the addition of amortization of intangible assets recorded from the acquisitions of Aratana and Prevtec in 2019 and the acceleration of the amortization of certain software assets to be retired prior to the end of their previously estimated respective useful lives due to our separation from Lilly. 2018 vs. 2017 Amortization of intangible assets decreased $23.8 million in 2018 as compared to 2017 due primarily to the acceleration of amortization related to certain product exits in 2017. Asset impairment, restructuring and other special charges For additional information regarding our asset impairment, restructuring and other special charges, see Note 7: Asset Impairment, Restructuring and Other Special Charges to our consolidated and combined financial statements. 2019 vs. 2018 Asset impairment, restructuring and other special charges increased $56.7 million in 2019 as compared to 2018 primarily due to higher transaction costs directly related to business acquisitions, including the pending acquisition of the animal health business of Bayer, higher integration costs of acquisitions, and costs associated with the implementation of new systems, programs, and processes due to the Separation from Lilly as well as severance costs, exit costs, impairment charges, and write-down charges recorded in 2019, as more fully described in Note 7. 2018 vs. 2017 Asset impairment, restructuring and other special charges decreased $246.3 million in 2018 as compared to 2017 primarily due to a decrease in severance related to the U.S. voluntary early retirement program offered in 2017 as well as a decrease in integration costs related to the BIVIVP acquisition in 2017, partially offset by a gain on disposal of a site that was previously closed as part of the acquisition and integration of Novartis Animal Health in 2017. Interest expense, net of capitalized interest 2019 vs. 2018 Interest expense increased $49.3 million for the year ended December 31, 2019 due to the timing of the issuance of debt in the third quarter of 2018. 2018 vs. 2017 Interest expense was $29.6 million for the year ended December 31, 2018 due to our issuance of debt in the third quarter of 2018. There was no interest expense in 2017 and prior years. Other-net, expense (income) 2019 vs. 2018 Other-net, expense decreased $13.9 million from $41.3 million in 2018 to $27.4 million in 2019. The decrease in expense is primarily due to the increase in the Aratana contingent consideration liability of $37.6 million associated with the Galliprant acquisition recorded in 2018, partially offset by the impact of $8.3 million of expense recorded in 2019 due to the release of a tax indemnity asset related to the 2015 acquisition of Novartis and $13.0 million of unfavorable adjustments to the contingent consideration liabilities recorded for Galliprant during 2019. 2018 vs. 2017 Other-net, expense (income) was expense of $41.3 million in 2018 compared to income of $0.1 million in 2017. The increase in expense is primarily due to the increase in the Aratana contingent consideration liability of $37.6 million associated with the Galliprant acquisition. Income tax expense Elanco’s historical income tax expense may not be indicative of its future expected tax rate. See “Comparability of Historical Results, Our Relationship with Lilly and Additional Standalone Costs.” 2019 vs. 2018 Income tax expense decreased $17.3 million in 2019 as compared to 2018. The decrease is primarily attributable to lower pre-tax earnings primarily due to restructuring charges, in addition to the release of tax reserves related to final resolution of the Brazilian tax matter. See Note 15: Income Taxes to our consolidated and combined financial statements. 2018 vs. 2017 Income tax expense decreased $50.5 million in 2018 as compared to 2017. The decrease is primarily due to a decrease in the U.S. valuation allowance, which was recorded in 2017 based upon the pre-IPO separate return methodology. See Note 2: Basis of Presentation and Note 15: Income Taxes to our consolidated and combined financial statements. Liquidity and Capital Resources We historically participated in Lilly’s centralized treasury management system, including centralized cash pooling and overall financing arrangements. We have generated and expect to continue to generate positive cash flows from operations. In connection with the IPO, we entered into various long-term debt agreements as described below. Our primary sources of liquidity are cash on hand, cash flows from operations and funds available under our Credit Facilities. As a significant portion of our business is conducted outside the U.S., we hold a significant portion of cash outside of the U.S. We monitor and adjust the amount of foreign cash based on projected cash flow requirements. Our ability to use foreign cash to fund cash flow requirements in the U.S. may be impacted by local regulations and, to a lesser extent, following U.S. tax reforms, the income taxes associated with transferring cash to the U.S. See Note 15: Income Taxes to our consolidated and combined financial statements. We currently intend to indefinitely reinvest foreign earnings for continued use in our foreign operations. As our structure evolves as a standalone company, we may change that strategy, particularly to the extent we identify tax efficient reinvestment alternatives for our foreign earnings or change our cash management strategy. Our principal liquidity needs going forward include funding existing marketed and pipeline products, capital expenditures, business development in our targeted areas, interest expense and funding the acquisition of the animal health business of Bayer. We believe our cash and cash equivalents on hand, our operating cash flows, our existing financing arrangements and financing arrangements entered into in 2020 will be sufficient to support our cash needs for the foreseeable future, including for at least the next 12 months. Our ability to meet future funding requirements may be impacted by macroeconomic, business and financial volatility. As markets change, we will continue to monitor our liquidity position. However, a challenging economic environment or an economic downturn may impact our liquidity or ability to obtain future financing. See "Item 1A. Risk Factors - We may not be able to generate sufficient cash to service all of our indebtedness and may be forced to take other actions to satisfy our obligations under our indebtedness, which may not be successful." As of December 31, 2019, cash and cash equivalents was $334.0 million, a decrease of $140.8 million compared to $474.8 million at December 31, 2018. We also held $11.1 million of restricted cash at December 31, 2019, which is available solely to pay the remainder of the purchase for our businesses to Lilly. We have a corresponding liability recorded on our balance sheet and included in Payable to Lilly. Refer to the Consolidated and Combined Statements of Cash Flows for additional details on the significant sources and uses of cash for the years ended December 31, 2019, 2018 and 2017. Cash Flows The following table provides a summary of cash flows from operating, investing and financing activities for the periods presented: Operating activities 2019 vs. 2018 Our cash flow from operating activities decreased by $263.2 million from $487.3 million for the year ended December 31, 2018 to $224.1 million for the year ended December 31, 2019. The decrease in operating cash flows was primarily attributable to a decrease in net income, increases in accounts receivable and inventories, and changes in timing of payments in the ordinary course of business. We have extended our payment terms in the past in certain customer situations and may need to continue this practice going forward as a result of competitive pressures and the need for certain inventory levels at our channel distributors to avoid supply disruptions. Further extensions of customer payment terms could result in additional uses of our cash flow. 2018 vs. 2017 Our cash flow from operating activities increased by $313.5 million from $173.8 million for the year ended December 31, 2017 to $487.3 million for the year ended December 31, 2018. The increase is a result of an increase in net income, which was partially offset by cash used to finance working capital, primarily focused on accounts receivable and inventory. Investing activities 2019 vs. 2018 Our cash flow used for investing activities increased by $107.8 million, to $234.8 million for the year ended December 31, 2019 compared to $127.0 million for the year ended December 31, 2018. The change was primarily driven by cash paid for the acquisition of Prevtec during 2019 and increases in purchases of software from 2018 to 2019. 2018 vs. 2017 Our cash flow used for investing activities decreased from $964.6 million for the year ended December 31, 2017 to $127.0 million for the year ended December 31, 2018. Our cash used in investing activities for the year ended December 31, 2017 included $882.1 million related to the acquisition of BIVIVP. This decrease was offset by a net increase of $35.9 million in capital expenditures from 2017 to 2018. Financing activities 2019 vs. 2018 Our cash used for financing activities increased by $269.6 million to $304.8 million in 2019 compared to $35.2 million in 2018. Cash used in financing activities during 2018 reflected the impact of our IPO and the issuance of long-term debt in connection with our Separation from Lilly during the period. $4.2 billion of cash was generated from those transactions, which was mostly offset by $4.1 billion of payments to Lilly in connection with local country asset purchases and other financing activities related to the Separation. During 2019, we made $121.1 million of payments on our term credit facility as well as $191.6 million of payments to Lilly in connection with local country asset purchases and other financing activities related to the Separation. 2018 vs. 2017 Our cash used for financing activities was a $35.2 million in 2018 compared to cash provided by financing activities of $847.5 million in 2017, a change of $882.7 million. The cash flows in 2017 relate to net cash provided by transactions with Lilly of $848.3 million compared to cash used in transactions with Lilly of $154.4 million in 2018, a reduction in financing of cash flows between periods of $1.0 billion. This, in addition to the consideration paid to Lilly in connection with the Separation, was partially offset by net cash provided from financing transactions related to the Separation including the proceeds from long-term debt and our IPO. The remainder of the proceeds from the financing related to the Separation will be paid to Lilly in future periods and is reflected as restricted cash in our consolidated balance sheet. Capital Expenditures Capital expenditures were $140.4 million during 2019, an increase of $5.9 million compared to 2018. We expect 2020 capital expenditures to be approximately $150 million. Description of Indebtedness For a complete description of our debt and available credit facilities as of December 31, 2019, see Note 9: Debt to our consolidated and combined financial statements. Contractual Obligations Payments due under contractual obligations as of December 31, 2019, are set forth below: (1) We excluded deferred taxes because we cannot reasonably estimate the timing of future cash outflows associated with those liabilities. (2) Our long-term debt obligations include both our expected principal and interest obligations and our interest rate swaps. We used current period assumptions for interest rates to compute expected interest payments on variable rate debt instruments and swaps. (3) Represents open purchase orders as of December 31, 2019 and contractual payment obligations with each of our significant vendors which are noncancelable and are not contingent. In connection with our pending acquisition of the animal health business of Bayer as discussed in Note 6: Acquisitions, in August 2019, we entered into a commitment letter that provides for financing consisting of up to $750 million in a revolving facility, $3.0 billion in a term facility, and $2.75 billion in a senior secured bridge facility. In connection with the financing commitment letter, we will incur fixed commitment fees of $40.4 million that will become due and payable upon the closing of the pending acquisition or the termination of the Purchase Agreement with Bayer. These fees have not been recorded on the consolidated balance sheet as of December 31, 2019. See Note 22: Subsequent Events to our consolidated and combined financial statements for updates regarding financing secured after the balance sheet date. Critical Accounting Policies The preparation of financial statements in accordance with U.S. GAAP requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. Certain of our accounting policies are considered critical because these policies are the most important to the depiction of our financial statements and require significant, difficult or complex judgments by us, often requiring the use of estimates about the effects of matters that are inherently uncertain. Actual results that differ from our estimates could have an unfavorable effect on our financial position and results of operations. We apply estimation methodologies consistently from year to year. The following is a summary of accounting policies that we consider critical to the consolidated and combined financial statements. Revenue Recognition Our gross product revenue is subject to deductions that are generally estimated and recorded in the same period that the revenue is recognized and that primarily represent revenue incentives (rebates and discounts) and sales returns. For example: •for revenue incentives, we use our historical experience with similar incentives programs and current sales data and estimates of inventory levels at our channel distributors to evaluate the impact of such programs on revenue and continually monitor the impact of this experience and adjust as necessary; and •for sales returns, we consider items such as: local returns policies and practices; returns as a percentage of revenue; an understanding of the reasons for past returns; estimated shelf life by product; and estimate of the amount of time between shipment and return to estimate the impact of sales returns. If any of our ratios, factors, assessments, experiences or judgments are not indicative or accurate predictors of our future experience, our results could be materially affected. Although the amounts recorded for these revenue deductions are dependent on estimates and assumptions, historically our adjustments to actual results have not been material. The sensitivity of our estimates can vary by program, type of customer and geographic location. Amounts recorded for revenue deductions can result from a complex series of judgments about future events and uncertainties and can rely on estimates and assumptions. See Note 4: Summary of Significant Accounting Policies to our consolidated and combined financial statements for further discussion regarding our revenue recognition policy. Acquisitions and Fair Value We account for the assets acquired and liabilities assumed in an acquisition based on their respective fair values as of the acquisition date. The excess of the purchase price over the fair value of the acquired net assets, where applicable, is recorded as goodwill. The judgments made in determining estimated fair values assigned to assets acquired and liabilities assumed in a business combination, as well as estimated asset lives, can materially affect our consolidated results of operations. The fair values of intangible assets are re-determined using information available at the acquisition date based on expectations and assumptions that are deemed reasonable by management. These fair value estimates require significant judgment with respect to future volume and prices, use of working capital, the selection of appropriate discount rates, product mix, income tax rates and other assumptions and estimates. Such estimates and assumptions are determined based upon our business plans and when applicable, market participants' views of us and other similar companies. Depending on the facts and circumstances, we may deem it necessary to engage an independent valuation expert to assist in valuing significant assets and liabilities. We determine fair value of any contingent consideration liability that results from a business combination by utilizing a market approach (i.e., based on quoted market values, significant other observable inputs for identical or comparable assets or liabilities) a discounted cash flow analysis, or a Monte Carlo simulation (i.e., based on multiple potential financial outcomes using estimated variables such as expected revenues, growth rates, and a discount rate). Estimating the fair value of contingent consideration requires the use of significant estimates and judgments, including, but not limited to, revenue and the discount rate and will be remeasured every reporting period. Impairment of Indefinite-Lived and Long-Lived Assets We review the carrying value of long-lived assets (both intangible and tangible) for potential impairment on a periodic basis and whenever events or changes in circumstances indicate the carrying value of an asset (or asset group) may not be recoverable. We identify impairment by comparing the projected undiscounted cash flows to be generated by the asset (or asset group) to its carrying value. If an impairment is identified, a loss is recorded equal to the excess of the asset's net book value over its fair value utilizing a discounted cash flow analysis, and the cost basis is adjusted. Goodwill and indefinite-lived intangible assets are reviewed for impairment at least annually and when certain impairment indicators are present. When required, a comparison of fair value to the carrying amount of assets is performed to determine the amount of any impairment. The estimated cash flows and fair values used in our impairment reviews require significant judgment with respect to future volume; use of working capital; foreign currency exchange rates; the selection of appropriate discount rates; product mix; income tax rates and other assumptions and estimates. Such estimates and assumptions are determined based upon our business plans and when applicable, market participants' views of us and other similar companies. We make these judgments based on our historical experience, relevant market size, historical pricing of similar products and expected industry trends. These assumptions are subject to change in future periods because of, among other things, additional information, financial information based on further historical experience, changes in competition, our investment decisions, volatility in foreign currency exchange rates, and results of research and development. A change in these assumptions or the use of alternative estimates and assumptions could have a significant impact on the estimated fair values of the assets, and may result in an impairment of the existing assets in a future period. During the years ended December 31, 2019, 2018 and 2017, we recorded asset impairments of $15.4 million, $81.9 million and $110.6 million, respectively, primarily due to product rationalization or changes in business strategy. For more information related to our impairment charges, see Note 7: Asset Impairment, Restructuring and Other Special Charges to our consolidated and combined financial statements. Deferred Tax Asset Valuation Allowances We maintain valuation allowances unless it is more likely than not that all or a portion of the deferred tax asset will be realized. Changes in valuation allowances are included in our tax provision in the period of change. In determining whether a valuation allowance is warranted, we evaluate factors such as prior earnings history, expected future earnings, carryback and carryforward periods, and tax strategies that could potentially enhance the likelihood of realization of a deferred tax asset. The realizability assessments made at a given balance sheet date are subject to change in the future, particularly if earnings of a subsidiary are significantly higher or lower than expected, or if we take operational or tax planning actions that could impact the future taxable earnings of a subsidiary. A change in these assumptions may result in an increase or decrease in the realizability of our existing deferred tax assets, and therefore a change in the valuation allowance, in future periods. As of December 31, 2019 and 2018, we had valuation allowances of $32.7 million and $21.4 million, respectively. Quantitative and Qualitative Disclosures About Market Risk Foreign Exchange Risk We operate on a global basis and are exposed to the risk that our earnings, cash flows and equity could be adversely impacted by fluctuations in foreign exchange rates. We are primarily exposed to foreign exchange risk with respect to net assets denominated in the Euro, Swiss franc, British pound, Canadian dollar, Australian dollar and Brazilian real. As part of the TSA, Lilly maintained a foreign currency risk management program through a central shared entity, which entered into derivative contracts to hedge foreign currency risk associated with forecasted transactions for the entire company, including historically for our operations. Gains and losses on derivative contracts entered into by Lilly were previously allocated to our results to the extent they were to cover exposure related to our business and offset gains and losses on underlying foreign currency exposures. We implemented our own foreign currency risk management program and assumed all hedging activities in the second quarter of 2019. We face foreign currency exchange exposures when we enter into transactions arising from subsidiary trade and loan payables and receivables denominated in foreign currencies. We also face currency exposure that arises from translating the results of our global operations to the U.S. dollar at exchange rates that have fluctuated from the beginning of the period. We may enter into foreign currency forward or option derivative contracts to reduce the effect of fluctuating currency exchange rates in future periods, but our historical results prior to 2018 do not reflect the impact of any such derivatives related to our exposure to foreign currency impacts on translation. We estimate that a hypothetical 10% adverse movement in all foreign currency exchange rates related to the translation of the results of our foreign operations would decrease our net income by approximately $7.4 million for the year ended December 31, 2019. We also bear foreign exchange risk associated with the future cash settlement of an existing NIH. In October 2018, we entered into a fixed interest rate, 5-year, 750 million Swiss franc NIH against Swiss franc assets. The NIH is expected to generate approximately $25 million in cash and contra interest expense per year; however, there is potential for significant 2023 settlement exposure on the 750 million Swiss franc notional if the U.S. dollar devalues versus the Swiss franc. Interest Risk We are exposed to interest rate risk on the long-term debt we incurred in connection with our IPO. Prior to our IPO, we did not have any interest rate exposure. We have cash flow risk associated with our $371.4 million of borrowings under the Term Credit Facility that pay interest based on variable rates. We actively monitor our exposure and may enter into financial instruments to fix the interest rate based on our assessment of the risk. Recently Issued Accounting Pronouncements For discussion of our new accounting standards, see Note 4: Summary of Significant Accounting Policies - Implementation of New Financial Accounting Pronouncements to our consolidated and combined financial statements.
-0.043834
-0.043636
0
<s>[INST] Overview Founded in 1954 as part of Eli Lilly & Co. (Lilly), Elanco is a premier animal health company that innovates, develops, manufactures and markets products for companion and food animals. Headquartered in Greenfield, Indiana, we are the fourth largest animal health company in the world, with revenue of $3,071.0 million for the year ended December 31, 2019. Globally, we are #1 in medicinal feed additives, #2 in poultry, and #3 in other pharmaceuticals, which are mainly companion animal therapeutics, measured by 2018 revenue, according to Vetnosis. We have one of the broadest portfolios of pet parasiticides in the companion animal sector. We offer a diverse portfolio of more than 125 brands that make us a trusted partner to veterinarians and food animal producers in more than 90 countries. On September 24, 2018, we completed our initial public offering (IPO), pursuant to which we issued and sold 19.8% of our total outstanding shares. On September 20, 2018, our common stock began trading on the New York Stock Exchange (NYSE) under the symbol “ELAN.” On September 24, 2018, immediately preceding the completion of the IPO, Lilly transferred to us substantially all of its animal health businesses in exchange for (i) all of the net proceeds (approximately $1,659.7 million) we received from the sale of our common stock in the IPO, including the net proceeds we received as a result of the exercise in full of the underwriters’ option to purchase additional shares, (ii) all of the net proceeds (approximately $2,000 million) we received from the issuance of our senior notes; and (iii) all of the net proceeds ($498.6 million) we received from the entry into our term loan facility. In addition, immediately prior to the completion of the IPO, we entered into certain agreements with Lilly that provide a framework for our ongoing relationship with them. On February 8, 2019, Lilly announced an exchange offer whereby Lilly shareholders could exchange all or a portion of Lilly common stock for shares of Elanco common stock owned by Lilly. On that date, we filed a Registration Statement on Form S4 with the SEC in connection with that exchange offer. The disposition of Elanco shares was completed on March 11, 2019, and resulted in the full separation of Elanco along with the disposal of Lilly's entire ownership and voting interest in Elanco. We operate our business in a single segment directed at fulfilling our vision of enriching the lives of people through food, making protein more accessible and affordable and through pet companionship, helping pets live longer, healthier lives. We advance our vision by offering products in four primary categories: Companion Animal Disease Prevention (CA Disease Prevention): We have one of the broadest parasiticide portfolios in the companion animal sector based on indications, species and formulations, with products that protect pets from worms, fleas and ticks. Combining our parasiticide portfolio with our vaccines presence, we are a leader in the U.S. in the disease prevention category based on share of revenue. Companion Animal Therapeutics (CA Therapeutics): We have a broad pain and osteoarthritis portfolio across species, modes of action, indications and disease stages. Pet owners are increasingly treating osteoarthritis in their pets, and our Galliprant product is one of the fastest growing osteoarthritis treatments in the U.S. We also have treatments for otitis (ear infections), as well as cardiovascular and dermatology indications. Food Animal Future Protein & Health (FA Future Protein & Health): Our portfolio in this category, which includes vaccines, nutritional enzymes and animal only antibiotics, serves the growing demand for protein and includes innovative products in poultry and aquaculture production, where demand for animal health products is outpacing overall industry growth. We are focused on developing [/INST] Negative. </s>
2,020
9,956
1,463,361
Unity Biotechnology, Inc.
2019-03-06
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 the section entitled “Selected Financial Data” and our audited financial statements and related notes included elsewhere in this report. This discussion and other parts of this report contain forward-looking statements that involve risks and uncertainties, such as our plans, objectives, expectations, intentions and beliefs. Our actual results could differ materially from those discussed in these forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified below and those discussed in the section entitled “Risk Factors” included elsewhere in this report. Overview We are a biotechnology company engaged in researching and developing therapeutics to extend healthspan by slowing, halting or reversing age-related diseases. Our initial focus is on creating senolytic medicines to selectively eliminate senescent cells and thereby treat age-related diseases, such as musculoskeletal, opthalmologic and pulmonary diseases. Since the commencement of our operations, we have invested a significant portion of our efforts and financial resources in research and development activities, and we have incurred net losses each year since inception. Our net losses were $76.4 million and $44.7 million for the years ended December 31, 2018 and 2017, respectively. We do not have any products approved for sale, and we have never generated any revenue from contracts with customers. As of December 31, 2018, we had an accumulated deficit of $163.3 million, and we do not expect positive cash flows from operations in the foreseeable future. We expect to continue to incur net operating losses for at least the next several years as we continue our research and development efforts, advance our drug candidates through preclinical and clinical development, seek regulatory approval, prepare for and, if approved, proceed to commercialization. Prior to our initial public offering, or IPO, we had funded our operations primarily from the issuance and sale of convertible preferred stock and convertible promissory notes. In May 2018, we completed our IPO pursuant to which we issued 5,000,000 shares of our common stock at a price of $17.00 per share. We received proceeds of approximately $75.9 million, after deducting underwriting discounts, commissions, and offering-related transaction costs from the IPO. We do not expect to generate revenue from any drug candidates that we develop until we obtain regulatory approval for one or more of such drug candidates and commercialize our products or enter into collaborative agreements with third parties. Substantially all of our net losses have resulted from costs incurred in connection with our research and development programs and from general and administrative costs associated with our operations. As a result, we will need to raise additional capital. If sufficient funds on acceptable terms are not available when needed, we could be required to significantly reduce our operating expenses and delay, reduce the scope of, or eliminate one or more of our development programs. We rely on third parties in the conduct of our preclinical studies and clinical trials and for manufacturing and supply of our drug candidates. We have no internal manufacturing capabilities, and we will continue to rely on third parties, many of whom are single-source suppliers, for our preclinical and clinical trial materials, as well as the commercial supply of our products. In addition, we do not yet have a marketing or sales organization or commercial infrastructure. Accordingly, we will incur significant expenses to develop a marketing and sales organization and commercial infrastructure in advance of generating any product sales. Components of Our Results of Operations Research and Development Expenses Research and development expenses consist primarily of costs incurred for the development of our drug candidates, which include: • personnel-related expenses, including salaries, benefits and stock-based compensation for personnel contributing to research and development activities; • laboratory expenses including supplies and services; • expenses incurred under agreements with third-party contract manufacturing organizations, contract research organizations, research and development service providers, academic research institutions, and consultants; • expenses related to license and sponsored research agreements; • clinical trial expenses; and • facilities and other allocated expenses, including expenses for rent and facilities maintenance, and depreciation and amortization. We expect our research and development expenses to increase as we advance our drug candidates into and through preclinical and clinical trials and pursue regulatory approval of our drug candidates. The process of conducting the clinical trials required to obtain regulatory approval is costly and time-consuming. Clinical trials generally become larger and costlier to conduct as they advance into later stages and we are required to make estimates for expense accruals related to clinical trial expenses. The actual probability of success for our drug candidates may be affected by a variety of factors including: the safety and efficacy of our drug candidates, early clinical data, investment in our clinical program, the ability of collaborators, if any, to successfully develop any drug candidates we license to them, competition, manufacturing capability and commercial viability. We may never succeed in achieving regulatory approval for any of our drug candidates. Program costs that are direct external expenses are tracked on a program-by-program basis once they enter clinical studies. Due to the early-stage nature of our lead programs, the costs of our programs are not material. As a result of the uncertainties discussed above, 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 our drug 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, audit and accounting services, and depreciation and amortization expense related to property and equipment. Personnel costs consist of salaries, benefits, insurance and stock-based compensation. We expect to continue to incur additional expenses associated with operating as a public company, including expenses related to compliance with the rules and regulations of the Securities and Exchange Commission and standards applicable to companies listed on a national securities exchange, additional insurance expenses, investor relations activities and other administrative and professional services. We also expect to increase the size of our administrative headcount to support the growth of our business and operate as a public company. Fair Value of Contingent Consideration Our license agreements include contingent consideration in the form of the obligation to issue additional shares of our common stock based if we achieve certain milestones. To determine whether such contingent consideration constitutes an asset acquisition, we assess whether it meets the definition of a derivative and/or whether it can be classified within stockholders’ equity, until such time that equity classification criteria are met or the milestones expire. As of December 31, 2018, we have recorded a liability related to contingent consideration because the net settlement criteria required for the contingent consideration to be defined as a derivative had been met whereas the equity classification criteria had not been met. The derivative related to this contingent consideration is measured at fair value as of each balance sheet date with the related change in fair value being reflected in operating expenses. The contingent consideration expense is driven by the change in the estimated fair value of the liability, which is determined using a probability-weighted valuation approach model that reflects the probability and timing of future issuances common shares. Interest Income Interest income is primarily related to interest earned on our marketable securities for the years ended December 31, 2018, 2017 and 2016. Results of Operations Comparison of the Years Ended December 31, 2018 and 2017 The following table sets forth the significant components of our results of operations (in thousands): Contribution Revenue Contribution revenue for the year ended December 31, 2017 was related to funding we recognized from a third-party organization in 2017 for the performance of certain research and development activities in pursuit of that organization’s philanthropic mission. We did not engage in similar activities in 2018, therefore we did not recognize any contribution revenue for the year ended December 31, 2018. Research and Development Research and development expenses increased by $21.5 million, to $58.9 million for the year ended December 31, 2018 from $37.4 million for the year ended December 31, 2017. The increase was primarily due to increases of $11.3 million for personnel-related expenses, of which $4.3 million was related to non-cash stock-based compensation, $7.8 million for direct research and development activities and $2.4 million for facilities-related costs. General and Administrative General and administrative expenses increased by $6.4 million, to $16.0 million for the year ended December 31, 2018 from $9.6 million for the year ended December 31, 2017. The increase was primarily due to increases of $4.8 million for personnel related expenses, of which $2.1 million was related to non-cash stock-based compensation, $1.9 million in professional services expenses primarily related to activities in preparation of becoming a public company, $0.5 million in insurance expense and $0.5 million for facilities-related costs. The increases were partially offset by a $1.3 million in unconditional funding provided to academic institutions. Change in fair value of contingent consideration Expenses related to the change in fair value of contingent consideration was $4.5 million for the year ended December 31, 2018. The contingent consideration expense was due to a change in the estimated fair value of the liability under our license agreements as the probability of milestone events requiring settlement through the issuance of shares of our common stock increase. The fair value is determined using a probability-weighted valuation approach model which considers our stock price and the probability and timing of the achievement of certain milestones at the balance sheet date. Interest Income Our interest income was $3.3 million for the year ended December 31, 2018, as compared to $1.1 million for the year ended December 31, 2017, as we invested our cash and proceeds from our Series C financing and IPO in marketable securities. Comparison of the years ended December 31, 2017 and 2016 The following table sets forth the significant components of our results of operations: Contribution Revenue Contribution revenue for the year ended December 31, 2017 was related to funding we recognized from a third-party organization in 2017 for the performance of certain research and development activities in pursuit of that organization’s philanthropic mission. Research and Development Research and development expenses increased by $23.7 million from $13.7 million for the year ended December 31, 2016 to $37.4 million for the year ended December 31, 2017. The increase was primarily due to an increase of $10.4 million for direct research and development costs related to consultants, third-party contract research organizations, and preclinical studies as we expanded and continued to progress our development programs. Additionally, we had a $8.6 million increase in personnel-related expenses, of which $1.5 million related to stock-based compensation due to an increase in our headcount, an increase of $1.9 million in lab supplies as we expanded our lab space, $1.0 million in facility-related costs, and a $1.0 million increase in depreciation and amortization primarily related to leasehold improvements associated with our new space. General and Administrative General and administrative expenses increased by $4.5 million from $5.1 million for the year ended December 31, 2016 to $9.6 million for the year ended December 31, 2017. The increase was primarily due to an increase in personnel-related expenses of $2.9 million, of which $1.3 million related to stock-based compensation, as a result of an increase in our headcount and an increase of $1.3 million related to unconditional funding provided to academic institutions in 2017. Loss on Extinguishment of Promissory Notes We recognized a loss on extinguishment of promissory notes issued in July, September, and October 2016 of $9.4 million upon the settlement of such notes in 2016 for shares of Series B convertible preferred stock. Interest Income (Expense), net Our interest income was $1.1 million for the year ended December 31, 2017 as we invested our cash in marketable securities. We recognized interest expense of $2.2 million for the year ended December 31, 2016 primarily related to the discount created from a contingent beneficial conversion on the February, April, and May 2016 promissory notes which was recognized upon the conversion of such notes in 2016 into shares of Series B preferred stock. Liquidity, Capital Resources and Capital Requirements Sources of Liquidity We have incurred net losses each year since inception. We do not have any products approved for sale and have never generated any revenue from product sales. Historically, we have incurred operating losses as a result of ongoing efforts to develop our drug candidates, including conducting ongoing research and development, preclinical studies and providing general and administrative support for these operations. As of December 31, 2018, we had an accumulated deficit of $163.3 million, and we do not expect positive cash flows from operations in the foreseeable future. We expect our operating losses and net cash used in operating activities will increase over at least the next several years as we continue our research and development activities, advance our drug candidates through preclinical and clinical testing and move into later and more costly stages of drug development, hire personnel and prepare for regulatory submissions and the commercialization of our drug candidates. We have historically financed our operations primarily through issuance and sale of common stock, convertible preferred stock and convertible promissory notes and will continue to be dependent upon equity and/or debt financing until we are able to generate positive cash flows from our operations. In March 2018, we sold 3,590,573 shares of Series C convertible preferred stock at $15.3317 per share for proceeds of $54.9 million. In April 2018, we sold 322,852 shares of Series C convertible preferred stock at $15.3317 per share for additional proceeds of $5.0 million. In May 2018, we completed our IPO and received net proceeds of $75.9 million, after deducting underwriting discounts, commissions and offering expenses payable by us. As of December 31, 2018, we had $171.1 million in cash, cash equivalents and marketable securities. Future Funding Requirements To date we have not generated any revenue for contracts with customers and have only received a contribution from a third-party organization for certain research and development activities to support their philanthropic mission. We expect to continue to incur significant losses for the foreseeable future, and we expect the losses to increase as we continue the development of, and seek regulatory approvals for, our drug candidates, and begin to commercialize any approved products. We are subject to all of the risks typically related to the development of new drug candidates, and we may encounter unforeseen expenses, difficulties, complications, delays and other unknown factors that may adversely affect our business. Moreover, following the completion of our IPO, we have incurred additional ongoing costs associated with operating as a public company. We anticipate that we will need substantial additional funding in connection with our continuing operations. Until we can generate a sufficient amount of revenue from the commercialization of our drug candidates or from collaborative agreements with third parties, if ever, we expect to finance our future cash needs through public or private equity or debt financings. Additional capital may be raised through the sale of our equity securities, incurring debt, entering into licensing, collaboration agreements with partners, receiving research contributions, grants or other sources of financing to fund our operations. There can be no assurance that sufficient funds will be available to us on attractive terms or at all. If we are unable to obtain additional funding from these or other sources, it may be necessary to significantly reduce our rate of spending through reductions in staff and delaying, scaling back, or stopping certain research and development programs. Insufficient liquidity may also require us to relinquish rights to drug candidates at an earlier stage of development or on less favorable terms than we would otherwise choose. Since our inception, we have incurred significant losses and negative cash flows from operations. We have an accumulated deficit of $163.3 million through December 31, 2018. We expect to incur substantial additional losses in the future as we conduct and expand our research and development activities. We believe that our existing cash, cash equivalents and marketable securities will be sufficient to enable us to fund our projected operations through at least the next 12 months. Based on our current operating plans, we expect our existing capital resources will fund our planned operating expenses into 2021, including through clinical data readout from our Phase 1 clinical study of UBX0101 and data readouts from additional Phase 1 clinical studies of our lead program for ophthalmologic diseases. We have based our projections of operating capital requirements on assumptions that may prove to be incorrect and we may use all our available capital resources sooner than we expect. Because of the numerous risks and uncertainties associated with research, development and commercialization of biotechnology products, we are unable to estimate the exact amount of our operating capital requirements. Our future funding requirements will depend on many factors, including, but not limited to: • the scope, progress, results and costs of researching and developing UBX0101, UBX1967 or any other drug candidates, and conducting preclinical studies and clinical trials, including our ongoing Phase 1 clinical study of UBX0101, which was initiated in the second quarter of 2018; • the timing of, and the costs involved in, obtaining regulatory approvals for our lead drug candidates or any future drug candidates; • the number and characteristics of any additional drug candidates we develop or acquire; • the timing and amount of any milestone payments we are required to make pursuant to our license agreements; • the cost of manufacturing our lead drug candidates or any future drug candidates and any products we successfully commercialize; • the cost of building a sales force in anticipation of product commercialization; • the cost of commercialization activities if our lead drug candidates or any future drug candidates are approved for sale, including marketing, sales and distribution costs; • our ability to establish and maintain strategic collaborations, licensing or other arrangements and the financial terms of any such agreements, including the timing and amount of any future milestone, royalty or other payments due under any such agreement; • any product liability or other lawsuits related to our products; • the expenses needed to attract, hire and retain skilled personnel; • the costs associated with being a public company; • the costs involved in preparing, filing, prosecuting, maintaining, defending and enforcing our intellectual property portfolio; and • the timing, receipt and amount of sales of any future approved or cleared products, if any. Cash Flows The following table sets forth a summary of the primary sources and uses of cash and restricted cash for each of the periods presented below (in thousands): Operating Activities Cash used in operating activities of $56.6 million for the year ended December 31, 2018 consisted primarily of a net loss of $76.4 million adjusted for net non-cash charges of $14.6 million and net changes to our operating assets and liabilities of $5.1 million. Our non-cash charges consisted primarily of $9.4 million in stock-based compensation, $4.5 million change in fair value of contingent consideration and $2.2 million in depreciation and amortization, partially offset by a $1.0 million in amortization of premium and discounts on marketable securities and $0.6 million in accretion of our tenant improvement allowance. The net change in our operating assets and liabilities consisted of a decrease of $1.4 million in contribution receivable, and increases of $2.2 million in accounts payable, $1.6 million in accrued compensation and $1.4 million in accrued liabilities and other current liabilities, partially offset by a decrease of $0.6 million in other long-term assets and $0.8 million in prepaid expenses and other current assets. Cash used in operating activities of $38.4 million for the year ended December 31, 2017 consisted primarily of a net loss of $44.7 million, which was partially offset by non-cash charges of $4.0 million and a decrease in our net operating assets of $2.3 million. Our non-cash charges primary consisted of $1.3 million for depreciation and amortization expense and $3.0 million for stock-based compensation expense. The decrease in our net operating assets of $2.3 million was primarily due to an increase in accrued compensation of $1.6 million related to our bonus accrual and increases in accounts payable of $1.2 million and accrued and other current liabilities of $1.3 million as we expand our operations, partially offset by an increase in our contribution receivable of $1.4 million. Cash used in operating activities of $16.4 million for the year ended December 31, 2016 consisted primarily of a net loss of $30.4 million, which was partially offset by non-cash charges of $12.0 million and a decrease in our net operating assets of $2.0 million. Our non-cash charges primarily consisted of $9.4 million for loss on extinguishment of our July, September, and October 2016 promissory notes and $2.2 million for interest expense related to our February, April and May 2016 promissory notes. The decrease in our net operating assets was due primarily to an increase in accrued and other current liabilities of $1.0 million primarily related to deferred rent for our facility lease entered into in 2016 and an increase in our accrued compensation of $0.5 million. Investing Activities Cash used in investing activities of $72.2 million for the year ended December 31, 2018 was related to purchases of marketable securities of $204.1 million, purchases of property and equipment of $1.2 million and the purchase of an investment in stock of $0.5 million, which were offset by maturities of marketable securities of $133.6 million. Cash used in investing activities of $86.3 million for the year ended December 31, 2017 was related to purchases of marketable securities of $134.5 million and purchases of property and equipment of $1.7 million, which were partially offset by maturities of marketable securities of $49.8 million. Cash used in investing activities of $2.7 million for the year ended December 31, 2016 was related to the purchases of property and equipment of $2.2 million and the purchase of an investment in stock of $0.5 million. Financing Activities Cash provided by financing activities of $136.9 million for the year ended December 31, 2018 was primarily related to net proceeds from our sale of common stock in our IPO of $75.9 million, net proceeds from issuance of Series C convertible preferred stock of $59.9 million, proceeds from repayment of recourse notes of $0.9 million, and proceeds from issuance of common stock upon exercise of stock options of $0.4 million. Cash provided by financing activities of $42.8 million for the year ended December 31, 2017 was primarily related to net proceeds from the issuance of shares of our convertible preferred stock. Cash provided by financing activities of $107.9 million for the year ended December 31, 2016 was primarily related to net proceeds of $91.0 million from the issuance of shares of our convertible preferred stock and proceeds of $16.9 million from the issuance of convertible promissory notes which have since been converted into or settled with shares of convertible preferred stock. Contractual Obligations and Other Commitments The following table summarizes our contractual obligations as of December 31, 2018: (1) Our contractual obligations and commitments primarily relate to our facilities lease agreement. We have a lease for laboratory and office space in Brisbane, California. The current lease is for approximately 39,000 square feet and the lease period expires in October 2022. We are party to various license agreements pursuant to which we have in-licensed rights to various technologies, including patents, research “know-how” and proprietary research tools, for the discovery, research, development and commercialization of drug products to treat age-related diseases. The license agreements obligate us to make certain milestone payments related to specified clinical development and sales milestone events, as well as tiered royalties in the low-single digits based on sales of licensed products. This table does not include any milestone payments or royalty payments to third parties as the amounts, timing and likelihood of such payments are not known. See Note 5 to our financial statements “License Agreements” for additional information. In February 2019, we entered into a lease agreement for approximately 62,655 rentable square feet of office and laboratory space in South San Francisco, California. The term of the lease agreement will commence on the later of: (i) the earlier to occur of (a) October 1, 2019, and (b) the date upon which we begin conducting business on the premises, and (ii) the date the landlord’s construction and tenant improvements have been completed. The lease has an initial term of ten years from the commencement date, and we have an option to extend the initial term for an additional eight years at the then fair rental value as determined pursuant to the lease agreement. The total base rent for the first twelve months will be $5.25 per rental square foot and will escalate by approximately 3.5% annually beginning from the 13th month of the lease agreement. We will also be responsible for the operating expenses and tax expenses allocated to the building, and the operating expenses and tax expenses attributable to the common areas. The landlord will provide us with a tenant improvement allowance of up to a maximum amount of approximately $7.8 million, and we have the right to use up to approximately $2.8 million as an additional tenant improvement allowance that must be paid back as described in the lease agreement. In connection with the execution of the lease agreement, we delivered a letter of credit of approximately $0.9 million to the landlord. Off-Balance Sheet Arrangements We have not entered into any off-balance sheet arrangements. While we have an investment in a variable interest entity, its purpose is not to provide off-balance sheet financing. Critical Accounting Polices and Estimates This discussion and analysis of our financial condition and results of operations is based on our 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 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 the notes to our financial statements included elsewhere in this prospectus, we believe that the following accounting policies are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving management’s judgments and estimates. Research and Development Expenses Costs related to research and development of drug candidates are charged to research and development expense as incurred. Research and development costs include, but are not limited to, payroll and personnel expenses for personnel contributing to research and development activities, laboratory supplies, outside services, licenses acquired to be used in research and development and allocated overhead, including rent, equipment, depreciation and utilities. Payments made prior to the receipt of goods or services to be used in research and development are deferred and recognized as expense in the period in which the related goods are received or services are rendered. Such payments are evaluated for current or long-term classification based on when they will be realized. We have and may continue to enter into license agreements to access and utilize certain technology. We evaluate if the license agreement is an acquisition of an asset or a business. To date none of our license agreements have been considered to be an acquisition of a business. For asset acquisitions, the upfront payments to acquire such licenses, as well as any future milestone payments made before product approval, are immediately recognized as research and development expense when due, provided there is no alternative future use of the rights in other research and development projects. These license agreements may also include contingent consideration in the form of cash and additional issuances of our common stock. Contingent Consideration Liability We have entered into license agreements to access and utilize certain intellectual property and technology and may enter into additional license agreements in the future. In each case, we evaluate if the license agreement results in the acquisition of an asset or a business. To date, none of our license agreements have been considered an acquisition of a business. If a license agreement is deemed to constitute an asset acquisition, the upfront payments to acquire such licenses, as well as any future milestone payments made before product approval, are immediately recognized as research and development expense when due, provided there is no alternative future use of the rights in other research and development projects. Several of our license agreements also include contingent consideration in the form of an obligation to issue additional shares of our common stock if we achieve certain milestones. To determine whether such contingent consideration constitutes anasset acquisition, we assess on a continuous basis whether the contingent consideration meets the definition of a derivative and/or whether it can be classified within stockholders’ equity, until such time that equity classification criteria are met or the milestones expireThe derivative related to the contingent consideration arising from our license agreements is measured at fair value as of each balance sheet date with the related change in fair value being reflected in operating expenses. Upon a reassessment event that results in the contingent consideration no longer meeting the definition of a derivative and/or meeting equity classification critera, the final change in fair value of the insutrment is recorded within operating expenses and the liability is reclassified into stockholders’ equity. We value the contingent consideration liability using a probability-weighted valuation approach model that reflects the probability and timing of achieving the milestones which trigger the obligation to issue additional shares of common stock. The probability of achieving the defined milestones for each licensed product is estimated on a quarterly basis by our management team. The total contingent consideration may change significantly over time as preclinical and/or clinical development progresses and additional data is obtained, impacting our assumptions regarding the probability of successfully achieving the relevant milestones and the time frame in which they are expected to be achieved. For example, significant increases in the estimated probability of achieving a milestone would result in a significantly higher fair value measurement, while significant decreases in the estimated probability of achieving a milestone would result in a significantly lower fair value measurement. Judgment is employed in determining these assumptions at each subsequent period. Updates to assumptions could have a significant impact on our results of operations in any given period. Actual results may differ from estimates. We believe the fair values used to record contingent consideration liability are based upon reasonable estimates and assumptions given the facts and circumstances as of the related valuation dates. Variable Interest Entities At the inception of each arrangement that we enter into with a third party entity, and at each reporting date thereafter, we assess whether we are the primary beneficiary of that arrangement such that it constitutes a variable interest entity, or VIE. This assessment is based on our power to direct the activities of the third party that most significantly impact the third party’s economic performance and our obligation to absorb losses or the right to receive benefits from the third party that could potentially be significant to it. Stock-Based Compensation We recognize compensation costs related to stock options granted to employees and nonemployees based on the estimated fair value of the awards on the date of grant, and we recognize forfeitures as they occur. For awards that vest solely based on service conditions or a combination of service and performance conditions, 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 awards is generally recognized on a straight-line basis over the requisite service period, which is typically their vesting period. Forfeitures are recognized as they occur. Prior to our IPO, the fair value of our shares of common stock underlying the stock options was the responsibility of and determined by our Board. Because there was no public market for our common stock, the Board determined the fair value of common stock at the time of grant of the option by considering a number of objective and subjective factors, including, among others: the prices at which we sold shares of our convertible 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; progress of our research and development activities; our stage of development and material risks related to its business; the fact that the option grants involve illiquid securities in a private company; and the likelihood of achieving a liquidity event, such as an initial public offering or sale, in light of prevailing market conditions. Following the IPO, the market traded price of the shares of common stock underlying the stock options is the fair value of our stock as reported on The Nasdaq Global Select Market on the grant date. The Black-Scholes option-pricing model requires the use of highly subjective assumptions to determine the fair value of stock-based awards. These assumptions include: • Expected term-The expected term represents the period that the stock-based awards are expected to be outstanding. We use, due to insufficient historical data, the simplified method to determine the expected term, which is based on the average of the time-to-vesting and the contractual life of the options. • Expected volatility-Due to our limited trading history for our common stock, the expected volatility is 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. The comparable companies are chosen based on their size, stage in the product development 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. For options granted to non-employee consultants, the fair value of these options is also remeasured using the Black-Scholes option-pricing model reflecting consistent assumptions as applied to employee options in each of the reported periods, other than the expected term, which is assumed to be the remaining contractual life of the option. We have also granted stock options to certain key employees that vest in conjunction with certain performance and market conditions. We estimate the fair value of these awards using a lattice model, taking into consideration the market conditions. No expense will be recorded related to these awards until the achievement of the performance condition becomes probable. Once the achievement of the performance condition becomes probable, expense related to these awards is recognized using the accelerated attribution method with a cumulative catch-up adjustment over the derived service period relating to the market conditions, if the market conditions have not been met. As these awards vest in their entirety upon achievement of the market conditions, any unrecognized expense would be accelerated if the market conditions are achieved prior to the completion of the derived service period. We will continue to use judgment in evaluating the expected volatility, expected terms and forfeiture rates utilized for our stock-based compensation expense calculations on a prospective basis. In addition to the Black-Scholes assumptions, we estimate our forfeiture rate based on an analysis of our actual forfeitures and we will continue to evaluate the adequacy of the forfeiture rate based on actual forfeiture experience, analysis of employee turnover behavior and other factors. The impact from any forfeiture rate adjustment would be recognized in full in the period of adjustment, and if the actual number of future forfeitures differs from our estimates, we might be required to record adjustments to stock-based compensation in future periods. As of December 31, 2018, we had $20.6 million of unrecognized compensation expense related to unvested stock options, which is expected to be recognized over an estimated weighted-average period of 4.1 years. For stock option awards subject to ratable vesting, we recognize compensation cost on a straight-line basis over the service period for the entire award. In future periods, our stock-based compensation expense is expected to increase as a result of recognizing our existing unrecognized stock-based compensation for awards that will vest and as we issue additional stock-based awards to attract and retain our employees. Income Taxes We use the asset and liability method of accounting for income taxes, in which deferred tax assets and liabilities are recognized for future tax consequences attributable to the differences between the financial statement carrying amounts of existing assets and liabilities, their respective tax bases, net operating loss carryforwards, and credit carryforwards. Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be reversed. Current income tax expense or benefit represents the amount of income taxes expected to be payable or refundable for the current year. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income in the period that includes the enactment date. We record a valuation allowance to reduce our deferred tax assets to reflect the net amount that we believe is more likely than not to be realized. Realization of our deferred tax assets is dependent on the generation of future taxable income, the amount and timing of which are uncertain. The valuation allowance requires an assessment of both positive and negative evidence when determining whether it is more likely than not that deferred tax assets are recoverable. Based upon the weight of available evidence at December 31, 2018, we continue to maintain a full valuation allowance against all of our deferred tax assets after management considered all available evidence both positive and negative, including but not limited to our historical operating results, income or loss in recent periods, cumulative income in recent years, forecasted earnings, future taxable income, and significant risk and uncertainty related to forecasts.. We recognize the tax effects of an uncertain tax position only if it is more likely than not to be sustained based solely on its technical merits as of the reporting date and only in an amount more likely than not to be sustained upon review by the tax authorities. We recognize interest accrued and penalties related to unrecognized tax benefits in our tax provision. We evaluate uncertain tax positions on a quarterly basis. The evaluations are based on a number of factors, including changes in facts and circumstances, changes in tax law, correspondence with tax authorities during the course of the audit, and effective settlement of audit issues. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact the income tax provision in the period in which such determination is made. The resolution of our uncertain income tax positions is dependent on uncontrollable factors such as law changes, new case law, and the willingness of the income tax authorities to settle, including the timing thereof and other factors. Although we do not anticipate significant changes to our uncertain income tax positions in the next twelve months, items outside of our control could cause our uncertain income tax positions to change in the future, which would be recorded in our statements of operations. Our provision for income taxes includes the effects of any accruals that we believe are appropriate, as well as the related net interest and penalties. On December 22, 2017, the Tax Cuts and Jobs Act (“Tax Act”) was signed into law. The Tax Act lowered the Federal corporate tax rate from 35% to 21% and made numerous other tax law changes. The Company has measured deferred tax assets at the enacted tax rate expected to apply when these temporary differences are expected to be realized or settled. U.S. GAAP requires companies to recognize the effect of tax law changes in the period of enactment. As a result of the impact of the Tax Act, in December 2017, the SEC staff issued Staff Accounting Bulletin No. 118 (SAB 118), Income Tax Accounting Implications of the Tax Act or TCJA, which allows SEC registrants to record provisional amounts during a measurement period not to extend beyond one year of the enactment date. Since the Act was passed late in the fourth quarter of 2017, and ongoing guidance and accounting interpretation are expected over the next 12 months, Management considers its accounting of the various tax laws impacted by the Tax Act to be reasonable despite any forthcoming guidance. Any subsequent adjustment to these amounts will be adjusted accordingly as further guidance comes out. In the fourth quarter of 2018, we completed our analysis to determine the effect of the Tax Act and no material adjustments were recognized as of December 31, 2018. As of December 31, 2018, our total deferred tax assets were $38 million. Due to our lack of earnings history and uncertainties surrounding our ability to generate future taxable income, the net deferred tax assets have been fully offset by a valuation allowance. The deferred tax assets were primarily comprised of federal and state tax net operating losses, and Research and Development Credits. Utilization of NOLs may be limited by the “ownership change” rules, as defined in Section 382 of the Code. The Company has engaged a third party to perform a Section 382 analysis covering from inception in 2010 to December 31, 2018 balance sheet reporting date. The Company has had various rounds of funding since inception (Series A-1, A-2, B) that have resulted in a change in ownership which limits the amount of net operating losses that may be used in the future. The Company has written off any deferred tax assets that will not be accessible due to the limitation from Section 382/383 with a corresponding adjustment to the valuation allowance.. 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 to enable us to comply 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 See Note 2 to our Financial Statements “Summary of Significant Accounting Policies” for information.
-0.106196
-0.105974
0
<s>[INST] Overview We are a biotechnology company engaged in researching and developing therapeutics to extend healthspan by slowing, halting or reversing agerelated diseases. Our initial focus is on creating senolytic medicines to selectively eliminate senescent cells and thereby treat agerelated diseases, such as musculoskeletal, opthalmologic and pulmonary diseases. Since the commencement of our operations, we have invested a significant portion of our efforts and financial resources in research and development activities, and we have incurred net losses each year since inception. Our net losses were $76.4 million and $44.7 million for the years ended December 31, 2018 and 2017, respectively. We do not have any products approved for sale, and we have never generated any revenue from contracts with customers. As of December 31, 2018, we had an accumulated deficit of $163.3 million, and we do not expect positive cash flows from operations in the foreseeable future. We expect to continue to incur net operating losses for at least the next several years as we continue our research and development efforts, advance our drug candidates through preclinical and clinical development, seek regulatory approval, prepare for and, if approved, proceed to commercialization. Prior to our initial public offering, or IPO, we had funded our operations primarily from the issuance and sale of convertible preferred stock and convertible promissory notes. In May 2018, we completed our IPO pursuant to which we issued 5,000,000 shares of our common stock at a price of $17.00 per share. We received proceeds of approximately $75.9 million, after deducting underwriting discounts, commissions, and offeringrelated transaction costs from the IPO. We do not expect to generate revenue from any drug candidates that we develop until we obtain regulatory approval for one or more of such drug candidates and commercialize our products or enter into collaborative agreements with third parties. Substantially all of our net losses have resulted from costs incurred in connection with our research and development programs and from general and administrative costs associated with our operations. As a result, we will need to raise additional capital. If sufficient funds on acceptable terms are not available when needed, we could be required to significantly reduce our operating expenses and delay, reduce the scope of, or eliminate one or more of our development programs. We rely on third parties in the conduct of our preclinical studies and clinical trials and for manufacturing and supply of our drug candidates. We have no internal manufacturing capabilities, and we will continue to rely on third parties, many of whom are singlesource suppliers, for our preclinical and clinical trial materials, as well as the commercial supply of our products. In addition, we do not yet have a marketing or sales organization or commercial infrastructure. Accordingly, we will incur significant expenses to develop a marketing and sales organization and commercial infrastructure in advance of generating any product sales. Components of Our Results of Operations Research and Development Expenses Research and development expenses consist primarily of costs incurred for the development of our drug candidates, which include: personnelrelated expenses, including salaries, benefits and stockbased compensation for personnel contributing to research and development activities; laboratory expenses including supplies and services; expenses incurred under agreements with thirdparty contract manufacturing organizations, contract research organizations, research and development service providers, academic research institutions, and consultants; expenses related to license and sponsored research agreements; clinical trial expenses; and facilities and other allocated expenses, including expenses for rent and facilities maintenance, and depreciation and amortization. We expect our research and development expenses to increase as we advance our drug candidates into and through preclinical and clinical trials and pursue regulatory approval of our drug candidates. The process of conducting the clinical trials required to obtain regulatory approval is costly and timeconsuming. Clinical trials generally become larger and costlier to conduct as they advance into later stages and we are required to make estimates for expense accruals related to clinical trial expenses. The actual probability of success for our drug candidates may be affected by a variety of factors including: the safety and efficacy of our drug candidates, early clinical data, investment in our clinical program, the ability [/INST] Negative. </s>
2,019
7,319
1,463,361
Unity Biotechnology, Inc.
2020-03-11
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 the section entitled “Selected Financial Data” and our audited financial statements and related notes included elsewhere in this report. This discussion and other parts of this report contain forward-looking statements that involve risks and uncertainties, such as our plans, objectives, expectations, intentions and beliefs. Our actual results could differ materially from those discussed in these forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified below and those discussed in the section entitled “Risk Factors” included elsewhere in this report. Overview We are a biotechnology company engaged in researching and developing therapeutics to extend healthspan by slowing, halting or reversing diseases of aging. Our initial focus is on creating senolytic medicines to selectively eliminate senescent cells and thereby treat age-related diseases, such as musculoskeletal, ophthalmologic and pulmonary diseases. In June 2019, we reported top-line results from our Phase 1 clinical study of UBX0101, our lead product candidate, in patients with moderate-to-severe osteoarthritis, or OA, of the knee. The study demonstrated that UBX0101 was well-tolerated. Dose-dependent improvement in several clinical measures, including pain and function, as well as modulation of multiple senescence-associated secretory phenotype (SASP) factors and disease-related biomarkers, was observed after a single dose of UBX0101. In the fourth quarter of 2019, we initiated a Phase 2 study of UBX0101 in patients with painful, moderate-to-severe OA of the knee. As of mid-February 2020, this study was fully enrolled and we expect top-line results for 12- and 24-week endpoints in the second half of 2020. The study is randomized, double-blind, and placebo-controlled and will evaluate three doses (0.5 mg, 2.0 mg and 4.0 mg) of UBX0101 administered via a single intra-articular injection. The primary measure is an assessment of pain at 12 weeks using the WOMAC-A instrument. Secondary measures will include safety and tolerability, pain (by NRS) and function (by WOMAC-C) at 12 weeks, as well as these same measures at 24 weeks. In the first quarter of 2020, we initiated a Phase 1b study of UBX0101 in patients with painful, moderate-to-severe OA of the knee to evaluate the safety, tolerability and initial effectiveness of both a higher dose and repeat doses. We intend to enroll approximately 36 patients and expect top-line results for 12- and 24-week endpoints from the second half of 2020 and the first half of 2021, respectively. This Phase 1b study is randomized, double-blind, and placebo-controlled and will evaluate an 8.0 mg dose of UBX0101 administered via a single intra-articular injection as well as two 4.0 mg doses of UBX0101 administered via intra-articular injection one month apart. The primary measures will be safety and tolerability. Secondary measures will include pain (using the WOMAC-A and NRS instruments) and function (by WOMAC-C) at 12 weeks, as well as similar measures at 24 weeks. Our lead ophthalmology candidates, UBX1325 and UBX1967, are currently in the final phases of Investigational New Drug, or IND, -enabling non-clinical toxicology studies. Both senolytic molecules are inhibitors of particular members of the Bcl-2 family of apoptosis regulatory proteins which have shown distinct pharmacokinetic profiles in preclinical studies. We intend to complete IND-enabling studies for both molecules prior to selecting the first molecule to advance to a first-in-human study to explore safety and tolerability of this novel mechanism of action for age-related eye diseases. We expect to initiate a Phase 1 safety study for this program in the second half of 2020 and receive initial results from this study in 2021. The overall clinical program is directed at multiple age-related diseases of the eye, such as age-related macular degeneration, diabetic retinopathy and diabetic macular edema. Since the commencement of our operations, we have invested a significant portion of our efforts and financial resources in research and development activities, and we have incurred net losses each year since inception. Our net losses were $82.2 million and $76.4 million for the years ended December 31, 2019 and 2018, respectively. We do not have any products approved for sale, and we have never generated any revenue from contracts with customers. As of December 31, 2019, we had an accumulated deficit of $245.5 million, and we do not expect positive cash flows from operations in the foreseeable future. We expect to continue to incur net operating losses for at least the next several years as we continue our research and development efforts, advance our drug candidates through preclinical and clinical development, seek regulatory approval, prepare for and, if approved, proceed to commercialization. We entered into a lease agreement in February 2019 for our new corporate headquarters, office and laboratory space in South San Francisco, California. The lease agreement, which has an initial term of ten years, commenced in May 2019. Pursuant to the lease agreement, the landlord provided us with a tenant improvement allowance of up to $7.8 million and will finance up to $2.9 million for additional tenant improvements subject to repayment provisions as described in the lease agreement. The value of this tenant improvement allowance of $10.7 million was recorded as a component of deferred rent and leasehold improvements on the balance sheet at December 31, 2019. Our corporate headquarters were formerly located in Brisbane, California, where we lease approximately 39,000 square feet of office and laboratory space pursuant to a lease dated May 13, 2016. We identified and moved into our new office in South San Francisco in 2019 to accommodate our anticipated growth. Prior to our initial public offering, or IPO, we had funded our operations primarily from the issuance and sale of convertible preferred stock and convertible promissory notes. In May 2018, we completed our IPO pursuant to which we issued 5,000,000 shares of our common stock at a price of $17.00 per share. We received proceeds of approximately $75.9 million, after deducting underwriting discounts, commissions, and offering-related transaction costs from the IPO. On June 3, 2019, we entered into a sales agreement, or the Sales Agreement, with Cowen and Company, LLC, or Cowen, to sell shares of our common stock, from time to time, with aggregate gross sales proceeds of up to $75.0 million through an at-the-market equity offering program under which Cowen will act as sales agent, or the ATM Offering Program. During the year ended December 31, 2019, we issued and sold 3,974,908 shares of our common stock through the ATM Offering Program and received net proceeds of approximately $26.1 million, after deducting commissions and other offering expenses of $1.4 million. We do not expect to generate revenue from any drug candidates that we develop until we obtain regulatory approval for one or more of such drug candidates and commercialize our products or enter into collaborative agreements with third parties. Substantially all of our net losses have resulted from costs incurred in connection with our research and development programs and from general and administrative costs associated with our operations. As a result, we will need to raise additional capital. If sufficient funds on acceptable terms are not available when needed, we could be required to significantly reduce our operating expenses and delay, reduce the scope of, or eliminate one or more of our development programs. We rely on third parties in the conduct of our preclinical studies and clinical trials and for manufacturing and supply of our drug candidates. We have no internal manufacturing capabilities, and we will continue to rely on third parties, many of whom are single-source suppliers, for our preclinical and clinical trial materials, as well as the commercial supply of our products. In addition, we do not yet have a marketing or sales organization or commercial infrastructure. Accordingly, we will incur significant expenses to develop a marketing and sales organization and commercial infrastructure in advance of generating any product sales. Components of Our Results of Operations Research and Development Expenses Research and development expenses consist primarily of costs incurred for the development of our drug candidates, which include: • personnel-related expenses, including salaries, benefits and stock-based compensation for personnel contributing to research and development activities; • laboratory expenses including supplies and services; • clinical trial expenses; • expenses incurred under agreements with third-party contract manufacturing organizations, contract research organizations, research and development service providers, academic research institutions, and consultants; • expenses related to license and sponsored research agreements; and • facilities and other allocated expenses, including expenses for rent and facilities maintenance, and depreciation and amortization. We expect our research and development expenses to increase as we advance our drug candidates into and through preclinical and clinical trials and pursue regulatory approval of our drug candidates. The process of conducting the clinical trials required to obtain regulatory approval is costly and time-consuming. Clinical trials generally become larger and more costly to conduct as they advance into later stages and we are required to make estimates for expense accruals related to clinical trial expenses. The actual probability of success for our drug candidates may be affected by a variety of factors including: the safety and efficacy of our drug candidates, early clinical data, investment in our clinical program, the ability of collaborators, if any, to successfully develop any drug candidates we license to them, competition, manufacturing capability and commercial viability. We may never succeed in achieving regulatory approval for any of our drug candidates. Program costs that are direct external expenses are tracked on a program-by-program basis once they enter clinical studies. As a result of the uncertainties discussed above, 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 our drug 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, audit and accounting services, and depreciation and amortization expense related to property and equipment. Personnel costs consist of salaries, benefits, insurance and stock-based compensation. We expect to continue to incur additional expenses associated with operating as a public company, including expenses related to compliance with the rules and regulations of the Securities and Exchange Commission and standards applicable to companies listed on a national securities exchange, additional insurance expenses, investor relations activities and other administrative and professional services. We also expect to continue to increase the size of our administrative headcount to support the growth of our business and operate as a public company. Fair Value of Contingent Consideration Certain of our license agreements include contingent consideration in the form of additional issuances of our common stock based on the achievement of certain milestones. For asset acquisitions, we assess whether such contingent consideration obligation meets the definition of a derivative and/or can be equity classified, until such time that the contingency or equity classification criteria is met or expires. As of December 31, 2019, we have recorded a liability related to contingent consideration as the net settlement criteria of the definition of a derivative had been met and equity classification criteria had not been met. The derivative related to this contingent consideration is measured at fair value as of each balance sheet date with the related change in fair value being reflected in operating results. Gains or losses on contingent consideration expense is driven by changes in the estimated fair value of the liability, which is determined using a probability-weighted valuation approach model that reflects the probability and timing of future issuances of our common shares. Interest Income Interest income is primarily related to interest earned on our marketable securities for the years ended December 31, 2019, 2018 and 2017. Other Income (Expense) We hold an equity investment in a Hong-Kong-based clinical-stage biopharmaceutical company called Ascentage Pharma Group International, or Ascentage International. In October 2019, Ascentage International completed an initial public offering of shares of its common stock on the Hong Kong stock exchange. Following the initial public offering, the underlying nature of our investment in Ascentage International changed and met the definition of an investment in an equity security with a readily determinable fair value to be measured at fair value on a recurring basis, based on quoted stock price available on the Hong Kong Stock Exchange. Other income/(expense) includes changes in fair value of the investment in this equity security. Results of Operations Comparison of the Years Ended December 31, 2019 and 2018 The following table sets forth the significant components of our results of operations (in thousands): Research and Development Research and development expenses increased by $12.1 million, to $71.0 million for the year ended December 31, 2019 from $58.9 million for the year ended December 31, 2018. The increase was primarily due to increases of $2.3 million for personnel-related expenses, which was partially offset by a decrease of $1.1 million related to non-cash stock compensation expense, $6.7 million for outside research and development activities and $3.1 million in lab and facilities-related costs. General and Administrative General and administrative expenses increased by $4.0 million, to $20.0 million for the year ended December 31, 2019 from $16.0 million for the year ended December 31, 2018. The increase was primarily due to increases of $3.4 million for personnel-related expenses, of which $2.5 million was related to non-cash stock compensation expense, and $0.6 million in insurance-related expense partially offset by $0.5 million decrease in professional fees. Change in fair value of contingent consideration Change in fair value of contingent consideration reflects a decrease in the contingent consideration liability of $1.4 million for the year ended December 31, 2019. The decrease in the fair value of contingent consideration was primarily due to changes in our stock price. Interest Income Our interest income was $3.3 million for the year ended December 31, 2019, as compared to $3.3 million for the year ended December 31, 2018. Other Income (Expense) Other income of $4.1 million for the year ended December 31, 2019 was primarily due to a change in the fair value of our investment in the common stock of Ascentage International. In October 2019, Ascentage International completed an initial public offering of shares of its common stock on the Hong Kong stock exchange which caused a change in our underlying investment resulting in it meeting the definition of an equity security with a readily determinable fair value. The increase in the fair value of our investment in Ascentage International was due to changes in the quoted stock price following the initial public offering. Comparison of the years ended December 31, 2018 and 2017 The following table sets forth the significant components of our results of operations (in thousands): Contribution Revenue Contribution revenue for the year ended December 31, 2017 was related to funding we recognized from a third-party organization in 2017 for the performance of certain research and development activities in pursuit of that organization’s philanthropic mission. Research and Development Research and development expenses increased by $21.5 million, to $58.9 million for the year ended December 31, 2018 from $37.4 million for the year ended December 31, 2017. The increase was primarily due to increases of $11.3 million for personnel-related expenses, of which $4.3 million was related to non-cash stock-based compensation, $7.8 million for direct research and development activities and $2.4 million for facilities-related costs. General and Administrative General and administrative expenses increased by $6.4 million, to $16.0 million for the year ended December 31, 2018 from $9.6 million for the year ended December 31, 2017. The increase was primarily due to increases of $4.8 million for personnel related expenses, of which $2.1 million was related to non-cash stock-based compensation, $1.9 million in professional services expenses primarily related to activities in preparation of becoming a public company, $0.5 million in insurance expense and $0.5 million for facilities-related costs. The increases were partially offset by a $1.3 million in unconditional funding provided to academic institutions. Change in fair value of contingent consideration Expenses related to the change in fair value of contingent consideration was $4.5 million for the year ended December 31, 2018. The contingent consideration expense was due to a change in the estimated fair value of the liability under our license agreements as the probability of milestone events requiring settlement through the issuance of shares of our common stock increase. The fair value is determined using a probability-weighted valuation approach model which considers our stock price and the probability and timing of the achievement of certain milestones at the balance sheet date. Interest Income Our interest income was $3.3 million for the year ended December 31, 2018, as compared to $1.1 million for the year ended December 31, 2017, as we invested our cash and proceeds from our Series C financing and IPO in marketable securities. Liquidity, Capital Resources and Capital Requirements Sources of Liquidity We have incurred net losses each year since inception. We do not have any products approved for sale and have never generated any revenue from product sales. Historically, we have incurred operating losses as a result of ongoing efforts to develop our drug candidates, including conducting ongoing research and development, preclinical studies and providing general and administrative support for these operations. As of December 31, 2019, we had an accumulated deficit of $245.5 million, and we do not expect positive cash flows from operations in the foreseeable future. We expect our operating losses and net cash used in operating activities will increase over at least the next several years as we continue our research and development activities, advance our drug candidates through preclinical and clinical testing and move into later and more costly stages of drug development, hire personnel and prepare for regulatory submissions and the commercialization of our drug candidates. We have historically financed our operations primarily through private placements of preferred stock and promissory notes and more recently through our IPO and proceeds from our ATM Offering Program, and will continue to be dependent upon equity and/or debt financing until we are able to generate positive cash flows from our operations. Prior to our IPO in May 2018, we financed our operations primarily through issuance and sale of convertible preferred stock and convertible promissory notes and we will continue to be dependent upon equity and/or debt financing until we are able to generate positive cash flows from our operations. In March 2018, we sold 3,590,573 shares of Series C convertible preferred stock at $15.3317 per share for proceeds of $54.9 million. In April 2018, we sold 322,852 shares of Series C convertible preferred stock at $15.3317 per share for additional proceeds of $5.0 million. In May 2018, we consummated our IPO and received net proceeds of $75.9 million, after deducting underwriting discounts, commissions and offering expenses payable by us. In June 2019, we filed a Registration Statement on Form S-3, or the Shelf Registration Statement, covering the offering of up to $250.0 million of common stock, preferred stock, debt securities, warrants and units. The Shelf Registration Statement included a prospectus covering the offering, issuance and sale of up to $75.0 million of our common stock from time to time through the “ATM Offering Program. The SEC declared the Shelf Registration Statement effective in June 2019. In June 2019, we also entered into a sales agreement, or the Sales Agreement, with Cowen and Company LLC, or Cowen, pursuant to which we may sell from time to time, at our option, up to $75.0 million of our common stock through the ATM Offering Program under which Cowen will act as sales agent. During the year ended December 31, 2019, we issued and sold 3,974,908 shares of our common stock through the ATM Offering Program and received net proceeds of approximately $26.1 million, after deducting commissions and other offering expenses of $1.4 million. Future Funding Requirements To date we have not generated any revenue from contracts with customers and have received a contribution from a third-party organization for certain research and development activities to support their philanthropic mission. We expect to continue to incur significant losses for the foreseeable future, and we expect the losses to increase as we continue the development of, and seek regulatory approvals for, our drug candidates, and begin to commercialize any approved products. We are subject to all of the risks typically related to the development of new drug candidates, and we may encounter unforeseen expenses, difficulties, complications, delays and other unknown factors that may adversely affect our business. Moreover, following the completion of our IPO, we have begun to incur additional ongoing costs associated with operating as a public company. We anticipate that we will need substantial additional funding in connection with our continuing operations. Until we can generate a sufficient amount of revenue from the commercialization of our drug candidates or from collaborative agreements with third parties, if ever, we expect to finance our future cash needs through various means. Additional capital may be raised through the sale of our equity securities, incurring debt, entering into licensing or collaboration agreements with partners, receiving research contributions, grants or other sources of financing to fund our operations. There can be no assurance that sufficient funds will be available to us on attractive terms or at all. If we are unable to obtain additional funding from these or other sources, it may be necessary to significantly reduce our rate of spending through reductions in staff and delaying, scaling back, or stopping certain research and development programs. Insufficient liquidity may also require us to relinquish rights to drug candidates at an earlier stage of development or on less favorable terms than we would otherwise choose. Since our inception, we have incurred significant losses and negative cash flows from operations. We have an accumulated deficit of $245.5 million through December 31, 2019. We expect to incur substantial additional losses in the future as we conduct and expand our research and development activities. We believe that our existing cash, cash equivalents and marketable securities will be sufficient to enable us to fund our projected operations through at least the next 12 months. Based on our current operating plans, we expect our existing capital resources will fund our planned operating expenses into the second half of 2021, including through clinical data readouts from the Phase 2 clinical study of UBX0101 we initiated in the fourth quarter of 2019 and, the higher dose and repeat dose Phase 1b study of UBX0101 we initiated in the first quarter of 2020, as well as initial data from Phase 1 clinical study of one of our lead molecules in age-related eye disease. We have based our projections of operating capital requirements on assumptions that may prove to be incorrect and we may use all our available capital resources sooner than we expect. Because of the numerous risks and uncertainties associated with research, development and commercialization of biotechnology products, we are unable to estimate the exact amount of our operating capital requirements. Our future funding requirements will depend on many factors, including, but not limited to: • the scope, progress, results and costs of researching and developing UBX0101, UBX132, UBX1967, or any other drug candidates, and conducting preclinical studies and clinical studies, including our ongoing Phase 2 clinical study of UBX0101, which we initiated in the fourth quarter of 2019, the Phase 1b clinical study of UBX0101, which we initiated in the first quarter of 2020, and our planned initial clinical studies in our ophthalmology program; • the timing of, and the costs involved in, obtaining regulatory approvals for our lead drug candidates or any future drug candidates; • the number and characteristics of any additional drug candidates we develop or acquire; • the timing and amount of any milestone payments we are required to make pursuant to our license agreements; • the cost of manufacturing our lead drug candidates or any future drug candidates and any products we successfully commercialize; • the cost of building a sales force in anticipation of product commercialization; • the cost of commercialization activities if our lead drug candidates or any future drug candidates are approved for sale, including marketing, sales and distribution costs; • our ability to establish and maintain strategic collaborations, licensing or other arrangements and the financial terms of any such agreements, including the timing and amount of any future milestone, royalty or other payments due under any such agreement; • any product liability or other lawsuits related to our products; • the expenses needed to attract, hire and retain skilled personnel; • the costs associated with being a public company; • the costs involved in preparing, filing, prosecuting, maintaining, defending and enforcing our intellectual property portfolio; and • the timing, receipt and amount of sales of any future approved or cleared products, if any. Cash Flows The following table sets forth a summary of the primary sources and uses of cash and restricted cash for each of the periods presented below (in thousands): Operating Activities Cash used in operating activities of $72.4 million for the year ended December 31, 2019 consisted primarily of a net loss of $82.2 million adjusted for net non-cash charges of $6.2 million and net changes to our operating assets and liabilities of $3.6 million. Our non-cash charges consisted primarily of $10.9 million in stock-based compensation, $2.7 million in depreciation and amortization and $1.0 million in common stock granted to a third party, partially offset by a $1.4 million change in fair value of contingent consideration, $1.3 million in accretion of our tenant improvement allowance and $1.2 million in net accretion and amortization of premium and discounts on marketable securities. The net change in our operating assets and liabilities consisted of increases of $2.5 million in deferred rent, net of current portion, and $2.1 million in accrued compensation, partially offset by a decreases of $0.6 million in accrued liabilities and other current liabilities, $0.2 million in accounts payable and a $0.2 million increase in prepaid expenses and other current assets. Cash used in operating activities of $56.6 million for the year ended December 31, 2018 consisted primarily of a net loss of $76.4 million adjusted for net non-cash charges of $14.6 million and net changes to our operating assets and liabilities of $5.1 million. Our non-cash charges consisted primarily of $9.4 million in stock-based compensation, $4.5 million change in fair value of contingent consideration and $2.2 million in depreciation and amortization, partially offset by a $1.0 million in amortization of premium and discounts on marketable securities and $0.6 million in accretion of our tenant improvement allowance. The net change in our operating assets and liabilities consisted of a decrease of $1.4 million in contribution receivable, and increases of $2.2 million in accounts payable, $1.6 million in accrued compensation and $1.4 million in accrued liabilities and other current liabilities, partially offset by a decrease of $0.6 million in other long-term assets and $0.8 million in prepaid expenses and other current assets. Cash used in operating activities of $38.4 million for the year ended December 31, 2017 consisted primarily of a net loss of $44.7 million, which was partially offset by non-cash charges of $4.0 million and a decrease in our net operating assets of $2.3 million. Our non-cash charges primary consisted of $1.3 million for depreciation and amortization expense and $3.0 million for stock-based compensation expense. The decrease in our net operating assets of $2.3 million was primarily due to an increase in accrued compensation of $1.6 million related to our bonus accrual and increases in accounts payable of $1.2 million and accrued and other current liabilities of $1.3 million as we expand our operations, partially offset by an increase in our contribution receivable of $1.4 million. Investing Activities Cash provided by investing activities of $68.0 million for the year ended December 31, 2019 was related to maturities of marketable securities of $188.8 million which were offset by purchases of marketable securities of $119.2 million and purchases of property and equipment of $1.6 million. Cash used in investing activities of $72.2 million for the year ended December 31, 2018 was related to purchases of marketable securities of $204.1 million, purchases of property and equipment of $1.2 million and the purchase of an investment in stock of $0.5 million, which were offset by maturities of marketable securities of $133.6 million. Cash used in investing activities of $86.3 million for the year ended December 31, 2017 was related to purchases of marketable securities of $134.5 million and purchases of property and equipment of $1.7 million, which were partially offset by maturities of marketable securities of $49.8 million. Financing Activities Cash provided by financing activities of $27.4 million for the year ended December 31, 2019 was related to $26.1 million in proceeds from the sale of common stock through our ATM Offering Program, net of issuance costs, $0.8 million in proceeds from the issuance of common stock under the 2018 Employee Stock Purchase Plan and proceeds from issuance of common stock upon exercise of stock options, net of repurchases, of $0.6 million. Cash provided by financing activities of $136.9 million for the year ended December 31, 2018 was primarily related to net proceeds from our sale of common stock in our IPO of $75.9 million, net proceeds from issuance of Series C convertible preferred stock of $59.9 million, proceeds from repayment of recourse notes of $0.9 million, and proceeds from issuance of common stock upon exercise of stock options of $0.4 million. Cash provided by financing activities of $42.8 million for the year ended December 31, 2017 was primarily related to net proceeds from the issuance of shares of our convertible preferred stock. Contractual Obligations and Other Commitments Contractual obligations represent future cash commitments and liabilities under agreements with third parties, and exclude contingent liabilities for which we cannot reasonably predict future payment. The following table summarizes our contractual obligations as of December 31, 2019 (in thousands): (1) Our contractual obligations and commitments primarily relate to our facilities lease agreements for laboratory and office space. At December 31, 2019, our lease agreements were for approximately 39,000 square feet in Brisbane, California, with the lease period expiring in October 2022 and approximately 63,000 square feet in South San Francisco, California, with the lease period expiring in October 2029. In February 2019, we entered into a lease agreement for new office and laboratory space in South San Francisco, California. The term of the lease agreement commenced in May 2019. The lease has an initial term of ten years from the commencement date, and we have an option to extend the initial term for an additional eight years at the then market rental rates as determined pursuant to the lease agreement. The total base rent payment escalates annually based on a fixed percentage beginning from the 13th month of the lease agreement. We will also be responsible for the operating expenses and tax expenses allocated to the building, and the operating expenses and tax expenses attributable to the common areas. Pursuant to the lease agreement, the landlord provided us with a tenant improvement allowance of up to $7.8 million and will finance up to $2.9 million for additional tenant improvements subject to repayment provisions as described in the lease agreement. We are party to various license agreements pursuant to which we have in-licensed rights to various technologies, including patents, research “know-how” and proprietary research tools, for the discovery, research, development and commercialization of drug candidates to treat age-related diseases. The license agreements obligate us to make certain milestone payments related to specified clinical development and sales milestone events, as well as tiered royalties in the low-single digits based on sales of licensed products. The table above does not include any milestone payments or royalty payments to third parties as the amounts, timing and likelihood of such payments are not known. See Note 5 to our financial statements “License Agreements” for additional information. Indemnification In the normal course of business, we enter into contracts and agreements that contain a variety of representations and warranties and provide for general indemnifications. Our exposure under these agreements is unknown because it involves claims that may be made against us in the future but have not yet been made. To date, we have not paid any claims or been required to defend any action related to our indemnification obligations. However, we may record charges in the future as a result of these indemnification obligations. In accordance with our certificate of incorporation and bylaws, we have potential indemnification obligations to our officers and directors for specified events or occurrences, subject to some limits, while they are serving at our request in such capacities. There have been no claims to date, and we have director and officer insurance that may enable us to recover a portion of any amounts paid for future potential claims. Off-Balance Sheet Arrangements We have not entered into any off-balance sheet arrangements. While we have an investment in a variable interest entity, its purpose is not to provide off-balance sheet financing. Critical Accounting Polices and Estimates This 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 (“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 date of the financial statements, as well as the reported expenses incurred during the reporting periods. These items are monitored and analyzed by us for changes in facts and circumstances, and material changes in these estimates could occur in the future. 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. Changes in estimates are reflected in reported results for the period in which they become known. 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 included elsewhere in this prospectus, we believe that the following accounting policies are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving management’s judgments and estimates. Research and Development Expenses and Accruals Costs related to research and development of drug candidates are charged to research and development expense as incurred. Research and development costs include, but are not limited to, payroll and personnel expenses for personnel contributing to research and development activities, laboratory supplies, outside services, licenses acquired to be used in research and development, manufacturing of clinical material, pre-clinical testing and consultants and allocated overhead, including rent, equipment, depreciation and utilities. Research and development costs are expensed as incurred unless there is an alternative future use in other research and development projects. Payments made prior to the receipt of goods or services to be used in research and development are deferred and recognized as expense in the period in which the related goods are received or services are rendered. Such payments are evaluated for current or long-term classification based on when they will be realized. As part of the process of preparing our financial statements, we are required to estimate expenses resulting from our obligations under contracts with vendors and consultants and clinical site agreements in connection with conducting clinical trials. The financial terms of these contracts are subject to negotiations which vary from contract to contract and may result in payment flows that do not match the periods over which materials or services are provided under such contracts. Our objective is to reflect the appropriate expenses in our financial statements by matching those expenses with the period in which services and efforts are expended. We account for these expenses according to the progress of the production of clinical trial materials or based on progression of the clinical trial, as measured by patient progression and the timing of various aspects of the trial. We determine accrual estimates by taking into account discussion with applicable personnel and outside service providers as to the progress or state of consummation of goods and services, or the services completed. During the course of a clinical trial, we adjust the rate of expense recognition if actual results differ from our estimates. We make estimates of accrued expenses as of each balance sheet date in our financial statements based on the facts and circumstances known at that time. Our clinical trial accrual is dependent in part upon the timely and accurate reporting of contract research organizations, contract manufacturers and other third-party vendors. 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 may result in our reporting changes in estimates in any particular period. Adjustments to prior period estimates have not been material for the years ended December 31, 2019 and 2018. We have and may continue to enter into license agreements to access and utilize certain technology. We evaluate if the license agreement is an acquisition of an asset or a business. To date none of our license agreements have been considered to be an acquisition of a business. For asset acquisitions, the upfront payments to acquire such licenses, as well as any future milestone payments made before product approval, are immediately recognized as research and development expense when due, provided there is no alternative future use of the rights in other research and development projects. These license agreements may also include contingent consideration in the form of cash and additional issuances of our common stock. Contingent Consideration Liability We have entered into license agreements to access and utilize certain intellectual property and technology and may enter into additional license agreements in the future. In each case, we evaluate if the license agreement results in the acquisition of an asset or a business. To date, none of our license agreements have been considered an acquisition of a business. If a license agreement is deemed to constitute an asset acquisition, the upfront payments to acquire such licenses, as well as any future milestone payments made before product approval, are immediately recognized as research and development expense when due, provided there is no alternative future use of the rights in other research and development projects. Several of our license agreements also include contingent consideration in the form of an obligation to issue additional shares of our common stock if we achieve certain milestones. For contingent consideration related to our asset acquisitions, we assess on a continuous basis whether the contingent consideration meets the definition of a derivative and/or whether it can be classified within stockholders’ equity, until such time that equity classification criteria are met or the milestones expire. The derivative related to the contingent consideration arising from our license agreements is measured at fair value as of each balance sheet date with the related change in fair value being reflected in operating expenses. Upon a reassessment event that results in the contingent consideration no longer meeting the definition of a derivative and/or meeting equity classification criteria, the final change in fair value of the instrument is recorded within operating expenses and the liability is reclassified into stockholders’ equity. We value the contingent consideration liability using a probability-weighted valuation approach model that reflects the probability and timing of achieving the milestones which trigger the obligation to issue additional shares of common stock. The probability of achieving the defined milestones for each licensed product is estimated on a quarterly basis by our management team. The total contingent consideration may change significantly over time as preclinical and/or clinical development progresses and additional data is obtained, impacting our assumptions regarding the probability of successfully achieving the relevant milestones and the time frame in which they are expected to be achieved. For example, significant increases in the estimated probability of achieving a milestone would result in a significantly higher fair value measurement, while significant decreases in the estimated probability of achieving a milestone would result in a significantly lower fair value measurement. Judgment is employed in determining these assumptions at each subsequent period. Updates to assumptions could have a significant impact on our results of operations in any given period. Actual results may differ from estimates. We believe the fair values used to record contingent consideration liability are based upon reasonable estimates and assumptions given the facts and circumstances as of the related valuation dates. Stock-Based Compensation We recognize compensation costs related to stock-based awards granted to employees and nonemployees based on the estimated fair value of the awards on the date of grant, and we recognize forfeitures as they occur. For awards that vest solely based on service conditions or a combination of service and performance conditions, 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 awards is generally recognized on a straight-line basis over the requisite service period, which is typically their vesting period. Forfeitures are recognized as they occur. Prior to our IPO, the fair value of our shares of common stock underlying the stock options was the responsibility of and determined by our Board. Because there was no public market for our common stock, the Board determined the fair value of common stock at the time of grant of the option by considering a number of objective and subjective factors, including, among others: the prices at which we sold shares of our convertible 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; progress of our research and development activities; our stage of development and material risks related to its business; the fact that the stock option grants involve illiquid securities in a private company; and the likelihood of achieving a liquidity event, such as an initial public offering or sale, in light of prevailing market conditions. Following the IPO, the market traded price of the shares of common stock underlying the stock-based awards is the fair value of our stock as reported on The Nasdaq Global Select Market on the grant date. The Black-Scholes option-pricing model requires the use of highly subjective assumptions to determine the fair value of stock-based awards. These assumptions include: • Expected term-The expected term represents the period that the stock-based awards are expected to be outstanding. We use, due to insufficient historical data, the simplified method to determine the expected term, which is based on the average of the time-to-vesting and the contractual life of the options. • Expected volatility-Due to our limited trading history for our common stock, the expected volatility is 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. The comparable companies are chosen based on their size, stage in the product development 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. For stock options granted to non-employee consultants, the fair value of these options is also remeasured using the Black-Scholes option-pricing model reflecting consistent assumptions as applied to employee options in each of the reported periods, other than the expected term, which is assumed to be the remaining contractual life of the option. We have also granted stock options to certain key employees that vest in conjunction with certain performance and market conditions. We estimate the fair value of these awards using a lattice model, taking into consideration the market conditions. No expense will be recorded related to these awards until the achievement of the performance condition becomes probable. Once the achievement of the performance condition becomes probable, expense related to these awards is recognized using the accelerated attribution method with a cumulative catch-up adjustment over the derived service period relating to the market conditions, if the market conditions have not been met. As these awards vest in their entirety upon achievement of the market conditions, any unrecognized expense would be accelerated if the market conditions are achieved prior to the completion of the derived service period. We will continue to use judgment in evaluating the expected volatility, expected terms and forfeiture rates utilized for our stock-based compensation expense calculations on a prospective basis. In addition to the Black-Scholes assumptions, we estimate our forfeiture rate based on an analysis of our actual forfeitures and we will continue to evaluate the adequacy of the forfeiture rate based on actual forfeiture experience, analysis of employee turnover behavior and other factors. The impact from any forfeiture rate adjustment would be recognized in full in the period of adjustment, and if the actual number of future forfeitures differs from our estimates, we might be required to record adjustments to stock-based compensation in future periods. As of December 31, 2019, we had $28.1 million of unrecognized compensation expense related to unvested stock options and restricted stock units, which is expected to be recognized over an estimated weighted-average period of 3.5 years. For stock-based awards subject to ratable vesting, we recognize compensation cost on a straight-line basis over the service period for the entire award. In future periods, our stock-based compensation expense is expected to increase as a result of recognizing our existing unrecognized stock-based compensation for awards that will vest and as we issue additional stock-based awards to attract and retain our employees. 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 to enable us to comply 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 See Note 2 to our Financial Statements “Summary of Significant Accounting Policies” for information.
0.060084
0.06033
0
<s>[INST] Overview We are a biotechnology company engaged in researching and developing therapeutics to extend healthspan by slowing, halting or reversing diseases of aging. Our initial focus is on creating senolytic medicines to selectively eliminate senescent cells and thereby treat agerelated diseases, such as musculoskeletal, ophthalmologic and pulmonary diseases. In June 2019, we reported topline results from our Phase 1 clinical study of UBX0101, our lead product candidate, in patients with moderatetosevere osteoarthritis, or OA, of the knee. The study demonstrated that UBX0101 was welltolerated. Dosedependent improvement in several clinical measures, including pain and function, as well as modulation of multiple senescenceassociated secretory phenotype (SASP) factors and diseaserelated biomarkers, was observed after a single dose of UBX0101. In the fourth quarter of 2019, we initiated a Phase 2 study of UBX0101 in patients with painful, moderatetosevere OA of the knee. As of midFebruary 2020, this study was fully enrolled and we expect topline results for 12 and 24week endpoints in the second half of 2020. The study is randomized, doubleblind, and placebocontrolled and will evaluate three doses (0.5 mg, 2.0 mg and 4.0 mg) of UBX0101 administered via a single intraarticular injection. The primary measure is an assessment of pain at 12 weeks using the WOMACA instrument. Secondary measures will include safety and tolerability, pain (by NRS) and function (by WOMACC) at 12 weeks, as well as these same measures at 24 weeks. In the first quarter of 2020, we initiated a Phase 1b study of UBX0101 in patients with painful, moderatetosevere OA of the knee to evaluate the safety, tolerability and initial effectiveness of both a higher dose and repeat doses. We intend to enroll approximately 36 patients and expect topline results for 12 and 24week endpoints from the second half of 2020 and the first half of 2021, respectively. This Phase 1b study is randomized, doubleblind, and placebocontrolled and will evaluate an 8.0 mg dose of UBX0101 administered via a single intraarticular injection as well as two 4.0 mg doses of UBX0101 administered via intraarticular injection one month apart. The primary measures will be safety and tolerability. Secondary measures will include pain (using the WOMACA and NRS instruments) and function (by WOMACC) at 12 weeks, as well as similar measures at 24 weeks. Our lead ophthalmology candidates, UBX1325 and UBX1967, are currently in the final phases of Investigational New Drug, or IND, enabling nonclinical toxicology studies. Both senolytic molecules are inhibitors of particular members of the Bcl2 family of apoptosis regulatory proteins which have shown distinct pharmacokinetic profiles in preclinical studies. We intend to complete INDenabling studies for both molecules prior to selecting the first molecule to advance to a firstinhuman study to explore safety and tolerability of this novel mechanism of action for agerelated eye diseases. We expect to initiate a Phase 1 safety study for this program in the second half of 2020 and receive initial results from this study in 2021. The overall clinical program is directed at multiple agerelated diseases of the eye, such as agerelated macular degeneration, diabetic retinopathy and diabetic macular edema. Since the commencement of our operations, we have invested a significant portion of our efforts and financial resources in research and development activities, and we have incurred net losses each year since inception. Our net losses were $82.2 million and $76 [/INST] Positive. </s>
2,020
7,891
1,660,280
Tenable Holdings, Inc.
2019-03-01
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, or this Form 10-K. This Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. 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. Such forward-looking statements are subject to a number of risks, uncertainties, assumptions and other factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified herein, and those discussed in the section titled “Risk Factors,” set forth in Part I, Item 1A of this Form 10-K and in our other filings with the SEC. You should not rely upon forward-looking statements as predictions of future events. Furthermore, such forward-looking statements speak only as of the date of this report. Except as required by law, we undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements. Overview We are the first and only provider of solutions for a new category of cybersecurity that we call Cyber Exposure. Cyber Exposure is a discipline for managing and measuring cybersecurity risk in the digital era. Our enterprise platform enables broad visibility into an organization’s cyber exposure across the modern attack surface and deep insights that help organizations translate vulnerability data into business insights to understand and reduce their cybersecurity risk. Our enterprise platform offerings, including Tenable.io, Tenable.sc, and Industrial Security, are built to provide organizations with the breadth of visibility to accurately understand both traditional and modern attack surfaces and the depth of insight that stems from risk-based analytics, prioritization and benchmarking. Our Cyber Exposure platform automatically discovers assets, including those in cloud environments, and assesses these assets for the presence of vulnerabilities, internal and regulatory compliance violations, misconfigurations and other cybersecurity issues, analyzes and prioritizes cybersecurity risks based on the likelihood of a vulnerability being exploited and the business criticality of the asset, and provides an objective way to measure an organization’s cyber exposure. Our enterprise platform offerings are primarily sold on a subscription basis with terms ranging from one to three years, primarily one year. These offerings are typically prepaid in advance. To a lesser extent, we generate ratably recognizable revenue from perpetual licenses and from the related ongoing maintenance. Many of our enterprise platform customers initially use either our free or paid version of Nessus, one of the industry’s most widely deployed vulnerability assessment solutions. Nessus, which is the technology that underpins our enterprise platform offerings, is designed to quickly and accurately identify vulnerabilities, configuration and compliance issues and malware. Our free version of Nessus, Nessus Home, allows for vulnerability assessment over a limited number of IP addresses. We believe many of our Nessus customers begin with Nessus Home and subsequently upgrade to Nessus Professional, the paid version of Nessus; however, we expect many users to continue to use Nessus Home. We have experienced rapid growth in recent years. Revenue in 2018, 2017 and 2016 was $267.4 million, $187.7 million and $124.4 million, respectively, representing year-over-year growth of 42% and 51%, respectively. Our net loss in 2018, 2017 and 2016 was $73.5 million, $41.0 million and $37.2 million, respectively, as we continue to invest in our business and market opportunity. Initial Public Offering On July 30, 2018, we completed our IPO, in which we issued and sold 12,535,000 shares of common stock at the IPO price of $23.00 for net proceeds to us of $264.6 million, after underwriting discounts and commissions and other offering expenses. Upon the completion of our IPO, all 15,847,500 shares of our Series A Redeemable Convertible Preferred Stock, or Series A, and 39,538,354 shares of our Series B Redeemable Convertible Preferred Stock, or Series B, automatically converted into an aggregate of 55,385,854 shares of our common stock. Financial Highlights Below are our key financial results: Factors Affecting Our Performance Product Leadership We offer the first and only Cyber Exposure platform to provide visibility into the broadest range of traditional and modern IT assets across cloud and on-premises environments. We are intensely focused on continued innovation that empowers organizations to understand and reduce their cyber exposure. This includes ongoing development of our enterprise platform offerings. In February 2017, we released Tenable.io, our SaaS offering that is designed to provide broad visibility and insights across a broad range of traditional and modern IT assets and cloud environments. We continue to expand the capabilities of our enterprise platform offerings, as well as our Nessus products, specifically as it relates to the ability to scan for and detect the rapidly expanding volume of vulnerabilities. We intend to continue to invest in our engineering capabilities and marketing activities to maintain our position in the highly-competitive market for cybersecurity solutions. Our results of operations may fluctuate as we make these investments to drive increased customer adoption and usage. New Enterprise Platform Customer Acquisition We believe that our customer base provides a significant opportunity to expand sales of our enterprise platform offerings and that our ability to continue to grow our enterprise platform customers will increase future opportunities for renewals and follow-on sales. We believe that we have significant room to capture additional market share. We expect to grow our enterprise platform customers by continuing to expand our sales organization and leveraging our channel partner network, which we believe will allow us to identify new enterprise customers, enter new markets, including internationally, as well as to convert more of our existing Nessus Professional customers to enterprise platform customers. We have increased our sales and marketing headcount in recent years and we will continue to invest significantly in our partner network and sales and marketing capability in order to grow domestically and internationally. Retaining and Expanding Revenue from Existing Customers Our enterprise platform offerings utilize IT asset-based or IP address-based pricing models. Once enterprise customers have licensed our platform offerings, they typically seek broader coverage over their traditional IT assets, including networking infrastructure, desktops and on-premises servers. As customers launch new applications or migrate existing applications to the cloud and deploy web applications, containers, internet of things, or IoT, and operational technology, or OT, they often increase the scope of their subscriptions and/or add additional perpetual licenses to our enterprise platforms. We are also focused on upselling customers from Nessus Professional to our enterprise platform offerings. Nessus customers are typically organizations or independent security consultants that use Nessus for a single vulnerability assessment at a point in time. We seek to convert our Nessus Professional users to customers of our enterprise platform offerings, which provide continuous visibility and insights into their attack surface. Further, we plan to expand existing platform capabilities and launch new products, such as Tenable.io Lumin, which we believe will drive new product purchases and follow-on purchases over time, thereby contributing to customer renewals. We believe that there is a significant opportunity to drive additional sales to existing customers, and we expect to invest in sales and marketing and customer success personnel and activities to achieve additional revenue growth from existing customers. Our ability to increase sales to existing customers will depend on a number of factors, including satisfaction or dissatisfaction with our products and services, competition, pricing, economic conditions or overall changes in our spending levels. Investing in Business Growth Since our founding, we have invested significantly in growing our business. We intend to continue to invest in sales and marketing to grow our sales team, expand brand and Cyber Exposure awareness and optimize our channel partner network. We also intend to continue to invest in our research and development team to further our technological leadership position in Cyber Exposure and enhance the functionality of our solutions. Any investments we make in our sales and marketing and research and development teams will occur in advance of experiencing the benefits from such investments, so it may be difficult for us to determine if we are efficiently allocating resources in those areas. These investment activities could increase our net losses over the short term if our revenue growth does not increase at higher rates. However, we expect that these investments will ultimately benefit our results of operations. Key Operating and Financial Metrics To supplement our consolidated financial statements, which are prepared and presented in accordance with GAAP, we use certain operating metrics and non-GAAP financial measures, as described below, to understand and evaluate our core operating performance. These non-GAAP financial measures, which may be different than similarly titled measures used by other companies, are presented to enhance investors’ overall understanding of our financial performance and should not be considered a substitute for, or superior to, the financial information prepared and presented in accordance with GAAP. We believe that these operating metrics and non-GAAP financial measures provide useful information about our operating and financial performance, enhance the overall understanding of our past performance and future prospects and allow for greater transparency with respect to important metrics used by management for financial and operational decision-making. We present these operating metrics and non-GAAP financial measures to assist investors in seeing our operating and financial performance using a management view and because we believe that these measures provide an additional tool for investors to use in comparing our core operating and financial performance over multiple periods with other companies in our industry. Calculated Current Billings We use the non-GAAP measure of calculated current billings, which we believe is a key metric to measure our periodic performance. Given that most of our customers pay in advance, we typically recognize a majority of the related revenue ratably over time. We use calculated current billings to measure and monitor our ability to provide our business with the working capital generated by upfront payments from our customers. Calculated current billings consists of revenue recognized in a period plus the change in current deferred revenue in the corresponding period. We believe that calculated current billings, which excludes deferred revenue for periods beyond twelve months in a customer’s contractual term, more closely correlates with annual contract value and that the variability in total billings, depending on the timing of large multi-year contracts and the preference for annual billing versus multi-year upfront billing, may distort growth in one period over another. While we believe that calculated current billings provides valuable insight into the cash that will be generated from sales of our subscriptions, this metric may vary from period-to-period for a number of reasons, and therefore has a number of limitations as a quarter-to-quarter or year-over-year comparative measure. For example, calculated current billings include amounts that have not yet been recognized as revenue; an increasing number of large sales transactions, for which the timing has and will continue to vary, may occur in quarters subsequent to or in advance of those that we anticipate; and our calculation of current billings may be different from other companies that report similar financial measures. Additionally, calculated current billings in any one period may be impacted by the timing of customer renewals, including early renewals, which could favorably or unfavorably impact year-over-year comparisons. Because of these and other limitations, you should consider calculated current billings along with revenue and our other GAAP financial results. The following table presents a reconciliation of revenue, the most directly comparable financial measure calculated in accordance with GAAP, to calculated current billings: _______________ (1) In connection with adopting ASC 606, we recorded $19.0 million of current deferred revenue on January 1, 2017 related to perpetual license revenue recognized in prior periods. Free Cash Flow We use the non-GAAP measure of free cash flow, which we define as GAAP net cash flows from operating activities reduced by purchases of property and equipment. We believe free cash flow is an important liquidity measure of the cash (if any) that is available, after purchases of property and equipment, for investment in our business and to make acquisitions. We believe that free cash flow is useful to investors as a liquidity measure because it measures our ability to generate or use cash. Our use of free cash flow has limitations as an analytical tool and you should not consider it in isolation or as a substitute for an analysis of our results under GAAP. First, free cash flow is not a substitute for net cash used in operating activities. Second, other companies may calculate free cash flow or similarly titled non-GAAP financial measures differently or may use other measures to evaluate their performance, all of which could reduce the usefulness of free cash flow as a tool for comparison. Additionally, the utility of free cash flow is further limited as it does not reflect our future contractual commitments and does not represent the total increase or decrease in our cash balance for a given period. Because of these and other limitations, you should consider free cash flow along with our GAAP financial measures. The following table presents a reconciliation of net cash used in operating activities, the most directly comparable financial measure calculated in accordance with GAAP, to free cash flow: _______________ (1) Contributions to our employee stock purchase plan during the year ended December 31, 2018 contributed $6.3 million to free cash flow. Enterprise Platform Customers We believe that our customer base provides a significant opportunity to expand sales of our enterprise platform offerings. The following tables summarize key components of our customer base: _______________ (1) We define an enterprise platform customer as a customer that has licensed Tenable.io or Tenable.sc for an annual amount of $5,000 or greater. New enterprise platform customers represent new customer logos during the periods presented and do not include customer conversions from Nessus Professional to enterprise platforms. Non-GAAP Loss from Operations and Non-GAAP Operating Margin We use non-GAAP loss from operations, which excludes the effect of stock-based compensation and amortization of intangible assets, as a key indicator of our financial performance, along with non-GAAP operating margin, which is calculated as non-GAAP loss from operations divided by our revenue in the period. We believe that these non-GAAP financial measures provide useful information about our core operating results over multiple periods. There are a number of limitations related to the use of the non-GAAP financial measures as compared to GAAP loss from operations and operating margin, including that non-GAAP loss from operations and non-GAAP operating margin exclude stock-based compensation expense, which has been, and will continue to be for the foreseeable future, a significant recurring expense in our business and an important part of our compensation strategy. The following table presents a reconciliation of loss from operations, the most directly comparable financial measure calculated in accordance with GAAP, to non-GAAP loss from operations, and operating margin, the most directly comparable financial measure calculated in accordance with GAAP, to non-GAAP operating margin: Non-GAAP Net Loss, Non-GAAP Net Loss Per Share and Pro Forma Non-GAAP Net Loss Per Share We use non-GAAP net loss, which excludes the effect of the accretion of Series A and B redeemable convertible preferred stock, stock-based compensation and amortization of intangible assets, as well as the related tax impact, to calculate non-GAAP net loss per share and pro forma non-GAAP net loss per share. Pro forma non-GAAP net loss per share is calculated by giving effect to the conversion of our redeemable convertible preferred stock into common stock as though the conversion occurred at the beginning of each period presented. We believe that these non-GAAP measures provide important information to management and investors because they facilitate comparisons of our core operating results over multiple periods. The following table presents a reconciliation of net loss, and net loss per share attributable to common stockholders, the most comparable financial measures calculated in accordance with GAAP, to non-GAAP net loss, non-GAAP net loss per share and pro forma non-GAAP net loss per share: ________________ (1) The tax impact of the adjustments to net loss attributable to common stockholders is based on the tax treatment for applicable tax jurisdictions. There was no tax impact related to the amortization of intangible assets as it was incurred in the United States in periods in which we had a net operating loss for which we maintained a full valuation allowance. Components of Our Results of Operations Revenue We generate revenue from subscription arrangements for our software and cloud-based solutions, perpetual licenses, maintenance associated with perpetual licenses and professional services. We begin to recognize revenue when control of our software or services is transferred to the customer, which for sales made through distributors is concurrent with the transfer to the end user. Our subscription arrangements generally have annual or multi-year contractual terms and allow customers to use our software or cloud-based solutions, including ongoing software updates during the contractual period. Revenue is recognized ratably over the subscription term given the critical utility provided by the ongoing updates that are released throughout the contract period. Our perpetual licenses are generally sold with one or more years of maintenance, which includes ongoing software updates. Given the critical utility provided by the ongoing software updates and updated ability to identify network vulnerabilities included in maintenance, we combine the perpetual license and the maintenance into a single performance obligation. Perpetual license arrangements generally contain a material right related to the customer’s ability to renew maintenance at a price that is less than the initial license fee. We apply a practical alternative to allocating a portion of the transaction price to the material right performance obligation and estimate a hypothetical transaction price which includes fees for expected maintenance renewals based on the estimated economic life of perpetual license contracts. We allocate the transaction price between the cybersecurity subscription provided in the initial contract and the material right related to expected contract renewals based on the hypothetical transaction price. We recognize the amount allocated to the combined license and maintenance performance obligation over the initial contractual period, which is generally one year. We recognize the amount allocated to the material right over the expected maintenance renewal period, which begins at the end of the initial contractual term and is generally four years. We have estimated the five-year economic life of perpetual license contracts based on historical contract attrition, expected renewal periods, the lifecycle of our technology and other factors. This estimate may change over time. Professional services and other revenue is primarily comprised of advisory services and training related to the deployment and optimization of our products. These services do not result in significant customization of our products. Professional services and other revenue is recognized as the services are performed. We have historically experienced, and expect in the future to experience, seasonality in entering into agreements with customers. We typically enter into a significantly higher percentage of agreements with new customers, as well as renewal agreements with existing customers, in the third and fourth quarters of the year. The increase in customer agreements in the third quarter is primarily attributable to U.S. government and related agencies, and the increase in the fourth quarter is primarily attributable to large enterprise account buying patterns typical in the software industry. Our recent growth and the ratable nature of our subscription revenue makes this seasonality less apparent in our overall financial results. Cost of Revenue, Gross Profit and Gross Margin Cost of revenue includes personnel costs related to our technical support group that provides assistance to customers, including salaries, benefits, bonuses, payroll taxes and stock-based compensation. Cost of revenue also includes hosting costs for Tenable.io, the costs related to professional services and training, depreciation and amortization and allocated overhead costs, which consist of information technology and facilities. We intend to continue to invest additional resources in our cloud-based platform and our customer support team as we grow our business. The level and timing of investment in these areas could affect our cost of revenue in the future. Gross profit, or revenue less cost of revenue, and gross margin, or gross profit as a percentage of revenue, have been and will continue to be affected by various factors, including the timing of our acquisition of new customers and our renewals of and follow-on sales to existing customers, the costs associated with operating our cloud-based platform, the extent to which we expand our customer support team and the extent to which we can increase the efficiency of our technology and infrastructure through technological improvements. We expect our gross profit to increase in absolute dollars but our gross margin to decrease, as we expect revenue from our cloud-based subscriptions to increase as a percentage of revenue, although our gross margin could fluctuate from period to period depending on the interplay of all of these factors. Operating Expenses Our operating expenses consist of sales and marketing, research and development and general and administrative expenses. Personnel costs are the most significant component of operating expenses and consist of salaries, benefits, bonuses, payroll taxes and stock-based compensation expense. Operating expenses also include depreciation and amortization as well as allocated overhead costs including IT and facilities costs. Sales and Marketing Sales and marketing expense consists of personnel costs, sales commissions, marketing programs, travel and entertainment, expenses for conferences and events and allocated overhead costs. We intend to continue to make significant investments in our sales and marketing teams to grow revenue, further penetrate the market and expand our global customer base. We expect our sales and marketing expense to continue to increase in absolute dollars and to be our largest operating expense category for the foreseeable future. However, as our revenue increases, we expect our sales and marketing expense to decrease as a percentage of our revenue over the long term, although our sales and marketing expense may fluctuate as a percentage of our revenue from period to period due to the timing and extent of these expenses. Research and Development Research and development expense consists of personnel costs, software used to develop our products, travel and entertainment, consulting and professional fees for third-party development resources as well as allocated overhead. Our research and development expense supports our efforts to continue to add capabilities to our existing products and enable the continued detection of new network vulnerabilities. We expect our research and development expense to continue to increase in absolute dollars for the foreseeable future as we continue to invest in research and development efforts to enhance the functionality of our cloud-based platform. However, we expect our research and development expense to decrease as a percentage of our revenue over the long term, although our research and development expense may fluctuate as a percentage of our revenue from period to period due to the timing and extent of these expenses. General and Administrative General and administrative expense consists of personnel costs for our executive, finance, legal, human resources and administrative departments. Additional expenses include travel and entertainment, professional fees, insurance and allocated overhead. We expect our general and administrative expense to continue to increase in absolute dollars for the foreseeable future due to additional costs associated with accounting, compliance, insurance and investor relations as a public company. However, we expect our general and administrative expense to decrease as a percentage of our revenue over the long term, although our general and administrative expense may fluctuate as a percentage of our revenue from period to period due to the timing and extent of these expenses. Other Income (Expense), Net Other income (expense), net consists primarily of interest income earned on cash and cash equivalents and short-term investments, net foreign currency remeasurement and transaction gains and losses and interest expense in connection with unused fees on our revolving credit facility. Provision for Income Taxes Provision for income taxes consists primarily of income taxes in certain foreign jurisdictions in which we conduct business. We have recorded deferred tax assets for which a full valuation allowance has been provided, including net operating loss carryforwards and tax credits. We expect to maintain this full valuation allowance for the foreseeable future as it is more likely than not that some or all of those deferred tax assets may not be realized based on our history of losses. Results of Operations The following tables set forth our consolidated results of operations for the periods presented: _______________ (1) Includes stock-based compensation expense as follows: Comparison of 2018 and 2017 Revenue The increase in revenue of $79.6 million was comprised of increases in subscription revenue of $72.9 million, perpetual license and maintenance revenue of $4.3 million and professional services and other revenue of $2.4 million. Revenue from existing customers comprised 68% of the increase, while the remaining increase was due to revenue from new customers since January 1, 2018. International revenue increased $31.6 million, or 55%. Cost of Revenue, Gross Profit and Gross Margin The increase in cost of revenue of $17.6 million was primarily due to: • a $6.9 million increase in personnel costs, primarily due to increased headcount, including a $1.4 million increase in stock-based compensation; • a $5.3 million increase in third-party cloud infrastructure costs, largely associated with the increased adoption of Tenable.io; • a $3.3 million increase in allocated overhead costs driven by both the increase in headcount and the overall increase in such costs on a year-over-year basis; • a $0.8 million increase in software subscription expenses; and • a $0.5 million increase in depreciation and amortization. Operating Expenses Sales and Marketing The increase in sales and marketing expense of $57.0 million was primarily due to: • a $29.2 million increase in personnel costs, largely associated with an increase in headcount, including a $5.3 million increase in stock-based compensation; • a $14.3 million increase in sales commissions, including sales commission draws, due to increased sales and the amortization of deferred commissions; • a $6.1 million increase in expenses for demand generation programs, including advertising, sponsorships and brand awareness efforts aimed at acquiring new customers; and • a $4.9 million increase in selling expenses, including travel and meeting costs and the costs of software subscriptions. Research and Development The increase in research and development expense of $19.0 million was primarily due to: • a $15.1 million increase in personnel costs, largely associated with an increase in headcount, including a $4.0 million increase in stock-based compensation, and net of $2.4 million of development costs capitalized related to internal use software; • a $1.6 million increase in third-party cloud infrastructure costs related to the development of new and future offerings; • a $0.7 million increase in software subscription expenses; and • a $0.6 million increase in allocated overhead driven by both the increase in headcount and the overall increase in such costs on a year-over-year basis. General and Administrative The increase in general and administrative expense of $17.8 million was primarily due to: • a $11.9 million increase in personnel costs, largely associated with an increase in headcount, including a $4.3 million increase in stock-based compensation; • a $3.3 million increase in professional fees, which includes costs associated with being a public company; and • a $0.8 million increase in software subscription expense. Comparison of 2017 and 2016 Revenue The increase in revenue of $63.4 million was comprised of increases in subscription revenue of $52.5 million, perpetual license and maintenance revenue of $10.0 million and professional services and other revenue of $0.9 million. Revenue from existing customers comprised 68% of the increase, while the remaining increase was due to revenue from new customers since January 1, 2017. The increase in professional services revenue resulted from the growth of our installed customer base. The impact of the ASC 606 adoption on 2017 revenue was a net increase of $3.5 million. International revenue increased $19.3 million, or 50%, consistent with our overall revenue growth rate. Cost of Revenue, Gross Profit and Gross Margin The increase in cost of revenue of $11.4 million was primarily due to: • a $5.4 million increase in third-party cloud infrastructure costs, largely associated with the increased adoption of Tenable.io; • a $4.0 million increase in personnel costs primarily due to increased headcount; • a $0.9 million increase in depreciation and amortization; and • a $0.8 million increase in allocated overhead costs driven by both the increase in headcount and the overall increase in such costs on a year-over-year basis. Operating Expenses Sales and Marketing The increase in sales and marketing expense of $30.6 million was primarily due to: • a $17.3 million increase in personnel costs, largely associated with an increase in headcount; • a $4.0 million increase in expenses for demand generation programs, including advertising, sponsorships and brand awareness efforts aimed at acquiring new customers; • a $3.9 million increase in selling expenses, including travel and meeting costs and the costs of software subscriptions; • a $2.7 million increase in sales commissions, including sales commission draws, due to increased sales and the amortization of deferred commissions, net of an $8.8 million reduction in commissions expense as a result of the adoption of ASC 606; and • a $2.1 million increase in allocated overhead costs, driven by both the increase in headcount and the overall increase in such costs on a year-over-year basis. Research and Development The increase in research and development expense of $17.6 million was primarily due to: • a $12.7 million increase in personnel costs, largely associated with an increase in headcount, including a $1.2 million increase in stock-based compensation; • a $1.7 million increase in third-party cloud infrastructure costs related to the development of new and future offerings; • a $2.0 million increase in other expenses, primarily related to event and travel costs; and • a $1.2 million increase in allocated overhead driven by both the increase in headcount and the overall increase in such costs on a year-over-year basis. General and Administrative The increase in general and administrative expense of $8.8 million was primarily due to: • a $5.6 million increase in personnel costs, largely associated with an increase in headcount, including a $3.4 million increase in stock-based compensation; • a $1.0 million increase in professional fees; and • a $0.6 million increase in allocated overhead driven by both the increase in headcount and the overall increase in such costs on a year-over-year basis. Liquidity and Capital Resources At December 31, 2018, we had cash and cash equivalents consisting of bank deposits and money market funds of $165.1 million and short-term investments consisting of commercial paper, U.S. Treasury and agency obligations, and corporate bonds of $118.1 million. Upon the completion of our IPO in July 2018, we received net proceeds of $264.6 million. Since our inception and prior to our IPO, we financed our operations through cash provided by operations, including payments received from customers using our software products and services, and we did not raise any primary institutional capital prior to our IPO. The proceeds of our Series A and Series B redeemable convertible preferred stock financings were used to repurchase shares of capital stock from former stockholders. We have generated significant operating losses from our operations, as reflected by our accumulated deficit of $466.1 million at December 31, 2018. We typically invoice our customers annually in advance and, to a lesser extent, multi-year in advance. Therefore, a substantial source of our cash is from such prepayments, which are included on our consolidated balance sheets as deferred revenue. Deferred revenue consists primarily of the unearned portion of billed fees for our subscriptions and perpetual licenses, which is subsequently recognized as revenue in accordance with our revenue recognition policy. At December 31, 2018, we had deferred revenue of $289.9 million, of which $213.6 million was recorded as a current liability and is expected to be recorded as revenue in the next 12 months, provided all other revenue recognition criteria are met. Our principal uses of cash in recent periods have been funding our operations, expansion of our sales and marketing and research and development activities and investments in infrastructure. We expect to continue incurring operating losses and generating negative cash flows from operations in the near-term; however, we believe that our existing cash and cash equivalents and short-term investments will be sufficient to fund our operating and capital needs for at least the next 12 months. Our future capital requirements will depend on many factors, including our revenue growth rate, subscription renewal activity, the timing and extent of spending to support further infrastructure and research and development efforts, the timing and extent of additional capital expenditures to invest in new and existing office spaces, such as our new corporate headquarters, the expansion of sales and marketing and international operating activities, the timing of introduction of new product capabilities and enhancements of our platform and the continuing market acceptance of our platform. We may in the future enter into arrangements to acquire or invest in complementary businesses, services and technologies, including intellectual property rights. We may be required to seek equity or debt financing. In the event that financing is required from outside sources, we may not be able to raise it on terms acceptable to us or at all. If we are unable to raise additional capital when desired, or if we cannot expand our operations or otherwise capitalize on our business opportunities because we lack sufficient capital, our business, operating results and financial condition would be adversely affected. Credit Facility In May 2017, we entered into a $25.0 million revolving credit facility with Silicon Valley Bank. Pursuant to the terms of the revolving credit facility, we may issue up to $5.0 million of letters of credit, which reduce the total amount available for borrowing under such facility. The revolving credit facility terminates on May 4, 2020. To date, we have not borrowed any amounts under the revolving credit facility. Interest on borrowings under the revolving credit facility accrues at a variable rate tied to the prime rate or the LIBOR rate, at our election. Interest is payable quarterly in arrears. We are required to pay a quarterly commitment fee that accrues at a rate of 0.25% per annum on the unused portion of the borrowing commitment. The revolving credit facility contains customary conditions to borrowing, events of default and covenants, including restrictions on indebtedness, liens, acquisitions and investments, restricted payments and dispositions. If, as of the last day of any quarter, the outstanding balance of the revolving credit facility exceeds $5.0 million, there are financial covenants that require us to maintain a minimum level of earnings before income taxes, interest, depreciation and amortization adjusted to add changes in deferred revenue in the period and a minimum current ratio level. We were in compliance with all covenants under the revolving credit facility at December 31, 2018. Cash Flows The following table summarizes our cash flows for the periods presented: Operating Activities In 2018, net cash used in operating activities was $2.6 million, which primarily consisted of our $73.5 million net loss, adjusted for stock-based compensation expense of $22.9 million and depreciation and amortization of $6.2 million, as well as a net cash inflow of $41.4 million from changes in operating assets and liabilities. The net inflow from changes in operating assets and liabilities was primarily due to a $64.1 million increase in deferred revenue primarily due to increased subscription sales, as a majority of our customers are invoiced in advance, partially offset by a $17.4 million increase in accounts receivable. In 2017, net cash used in operating activities was $6.3 million, which primarily consisted of our $41.0 million net loss, adjusted for stock-based compensation expense of $7.8 million and depreciation and amortization of $4.7 million, as well as a net cash inflow of $23.1 million from changes in operating assets and liabilities. The net inflow from changes in operating assets and liabilities was primarily due to a $63.4 million increase in deferred revenue, including the cumulative impact of adopting the new revenue recognition guidance, from increased subscription sales as a majority of our customers are invoiced in advance, partially offset by a $14.8 million increase in accounts receivable. In addition, deferred commissions increased $20.1 million, including the cumulative impact of adopting the new revenue recognition guidance. In 2016, net cash used in operating activities was $2.8 million, which primarily consisted of our $37.2 million net loss, adjusted for depreciation and amortization of $3.1 million and stock-based compensation expense of $2.5 million, as well as a net cash inflow of $27.9 million from changes in operating assets and liabilities. The net inflow from operating assets and liabilities was primarily due to an increase of $44.2 million in deferred revenue from increased subscription sales as a majority of our customers are invoiced in advance partially offset by a $13.6 million increase in accounts receivable. Investing Activities From 2017 to 2018, net cash used in investing activities increased by $120.5 million, primarily due to our purchase of short-term investments of commercial paper, U.S. Treasury securities and corporate bonds of $117.5 million. From 2016 to 2017, net cash used in investing activities decreased by $5.1 million, primarily due to a reduction in capital expenditures for infrastructure equipment and leasehold improvements. Financing Activities From 2017 to 2018, net cash provided by financing activities increased by $262.7 million, primarily due to proceeds from our IPO, net of underwriting discounts and commissions, of $268.5 million, less payments of offering costs related to our IPO of $3.9 million. From 2016 to 2017, net cash provided by financing activities increased by $0.7 million, primarily due to an increase of proceeds from the exercise of stock options. Contractual Obligations The following table summarizes our contractual obligations at December 31, 2018: _______________ (1) Consists of future non-cancelable minimum rental payments under operating leases for our offices including $68.2 million of future lease payments related to the lease of our new headquarters, which is currently being constructed. These lease payments are expected to commence in the first quarter of 2021. Not included in the table above is $4.8 million of unrecognized tax benefits and $0.9 million of asset retirement obligations, because the timing of future cash outflows is uncertain. In October 2017, we entered into a new lease agreement for office space in Columbia, Maryland to serve as our new corporate headquarters, and expect to incur approximately $10 million of capital expenditures related to leasehold improvements associated with the build-out. We plan to take possession of the leased office space in mid-2019, at which time we will record a right-of-use asset and corresponding lease liability, and begin to record rent expense. We expect to start making recurring rental payments under the lease in the first quarter of 2021. Included in the operating lease commitments above are total expected minimum obligations under the lease agreement of $68.2 million, which exclude approximately $16.0 million of expected tenant improvement reimbursements and incentives from the landlord and variable operating expenses. We have also excluded a $2.5 million security deposit, which may be increased to $5.0 million, that is expected to be paid in advance of occupancy. At our option, we may deposit cash or provide an unconditional letter of credit, which would reduce the borrowing capacity under our revolving credit facility. We are contractually obligated for our current corporate headquarters through May 2021, and unless we transfer our contractual obligation, we will continue to include the committed lease payments for our current corporate headquarters in the table above. Off-Balance Sheet Arrangements At December 31, 2018, we did not have any relationships with unconsolidated organizations or financial partnerships, such 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. Critical Accounting Policies and Estimates Our financial statements are prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, as well as 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. The critical accounting estimates, assumptions and judgments that we believe have the most significant impact on our consolidated financial statements are described below. Revenue Recognition We early adopted ASC 606 on January 1, 2017 using the modified retrospective method and applying the guidance to all contracts as of January 1, 2017. The core principle of ASC 606 is that revenue should be recognized 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 the core principle of ASC 606, we apply the following steps: • Identify the contract with a customer • Identify the performance obligations in the contract • Determine the transaction price • Allocate the transaction price to the performance obligations in the contract • Recognize revenue when or as performance obligations are satisfied We generate revenue from subscription arrangements for our software and cloud-based solutions, perpetual licenses, maintenance associated with perpetual licenses and professional services and other revenue. Subscription Revenue Our subscription arrangements generally have annual or multi-year contractual terms and allow customers to use our software or cloud solutions, including ongoing software updates and the ability to identify the latest cybersecurity vulnerabilities. Revenue is recognized ratably over the subscription term given the critical utility provided by the ongoing updates that are released throughout the contract period. Perpetual License and Maintenance Revenue Our perpetual licenses are generally sold with one or more years of maintenance, which include ongoing software updates and the ongoing ability to identify the latest cybersecurity vulnerabilities. Given the critical utility provided by the ongoing software updates and updated ability to identify network vulnerabilities included in maintenance, we combine the perpetual license and the maintenance into a single performance obligation. Perpetual license arrangements generally contain a material right related to the customer’s ability to renew maintenance at a price that is less than the initial license fee. We apply a practical alternative to allocating a portion of the transaction price to the material right performance obligation and estimate a hypothetical transaction price which includes fees for expected maintenance renewals based on the estimated economic life of the perpetual license contracts. We allocate the transaction price between the cybersecurity subscription provided in the initial contract and the material right related to expected contract renewals based on the hypothetical transaction price. We recognize the amount allocated to the combined license and maintenance performance obligation over the initial contractual period, which is generally one year. We recognize the amount allocated to the material right over the expected maintenance renewal period, which begins at the end of the initial contractual term and is generally four years. We have estimated the five-year economic life of perpetual license contracts based on historical contract attrition, expected renewal periods, the lifecycle of the our technology and other factors. While we believe that the estimates we have made are reasonable and appropriate, different assumptions and estimates could materially impact our reported financial results. Professional Services and Other Revenue Professional services and other revenue is primarily comprised of advisory services and training related to the deployment and optimization of our products. These services do not result in significant customization of our products. Professional services and other revenue is recognized as the services are performed. Contracts with Multiple Performance Obligations In cases where our contracts with customers contain multiple performance obligations, the contract transaction price is allocated on a relative standalone selling price basis. We typically determine standalone selling price based on observable selling prices of our products and services. Variable Consideration We record revenue from sales at the net sales price, which is the transaction price, including estimates of variable consideration when applicable. Certain of our customers may be entitled to receive credits and in certain circumstances, refunds, if service level commitments are not met. We have not historically experienced significant incidents affecting the ability to meet these service level commitments and any estimated refunds related to these agreements have not been material. Sales through our channel partner network of distributors and resellers are generally discounted as compared to the price that we would sell to an end user. Revenue for sales through our channel network, which is fixed, is recorded net of any distributor or reseller margin. Legacy Revenue Accounting Policies For periods prior to January 1, 2017, we recognized revenue when all the following criteria were met: (1) persuasive evidence of an arrangement exists, (2) delivery has occurred, (3) the fee is fixed or determinable and (4) collectability is reasonably assured. We recognized subscription revenue ratably over the term of the subscription period in accordance with ASC 605, Revenue Recognition. When subscription arrangements involved multiple elements that qualified as separate units of accounting, we allocated arrangement consideration at the inception of the arrangement to all deliverables based on the relative selling price method in accordance with the selling price hierarchy, which included (i) vendor-specific objective evidence, or VSOE, if available, (ii) third-party evidence, or TPE, if VSOE was not available, and (iii) best estimate of selling price, or BESP, if neither VSOE nor TPE were available. When VSOE could not be established for deliverables within subscription arrangements, we utilized BESP in our allocation of arrangement consideration, as it generally could not establish TPE. BESP was determined by considering multiple factors including, but not limited to, prices charged for similar offerings, market conditions, competitive landscape and pricing practices. We recognized perpetual license revenue upon delivery of the license in accordance with ASC 985-605, Software-Revenue Recognition. We established VSOE of fair value for substantially all products and services with the exception of new subscription agreements and perpetual licenses. VSOE was established for maintenance and support based upon actual renewals and historical pricing when sold separately. Revenue from maintenance agreements was deferred and recognized ratably over the term of the maintenance period. The VSOE of fair value for professional services was based on the price for these same services when they were sold separately. Other services revenue was recognized as the services were performed. Deferred Commissions Sales commissions, including related incremental fringe benefit costs, are considered to be incremental costs of obtaining a contract, and therefore are deferred over an estimated period of benefit, which ranges between three and four years for subscription arrangements and five years for perpetual license arrangements. We have estimated the period of benefit based on the expected contract term including renewal periods, the lifecycle of our technology and other factors. Sales commissions on contract renewals are capitalized and amortized ratably over the contract term, with the exception of contracts with renewal periods that are one year or less, in which case the incremental costs are expensed as incurred. While we believe that the estimates we have made are reasonable and appropriate, different assumptions and estimates could materially impact our reported financial results. Prior to January 1, 2017, we capitalized sales commissions for subscriptions and recognized the expense over the corresponding period in which the related revenue was recognized. Commissions on perpetual license sales were recognized upon the delivery of the license. Stock-Based Compensation Stock-based compensation expense related to our stock options, restricted stock, restricted stock units, or RSUs, and purchase rights issued under our 2018 Employee Stock Purchase Plan, or the 2018 ESPP, is calculated based on the fair value of the awards granted and is recognized on a straight-line basis over the requisite service period, which is generally two to four years, with the exception of RSUs that include performance-based vesting conditions and are expensed using the accelerated attribution method. The fair value of stock options and 2018 ESPP purchase rights is estimated on the grant date using the Black-Scholes option pricing model, which requires us to make assumptions and judgments, including the expected term, expected volatility, and risk-free interest rates. Prior to January 1, 2017, we recognized stock-based compensation expense net of estimated forfeitures. Beginning on January 1, 2017, we made an accounting policy election to account for forfeitures as they occur. This election was applied on a modified retrospective basis, resulting in a cumulative-effect adjustment to increase accumulated deficit by $0.1 million. Beginning on January 1, 2017, we recorded excess tax benefits and tax deficiencies in the income statement when the awards vest or are settled. On January 1, 2017, we recorded a $1.9 million deferred tax asset attributable to excess tax benefits from stock-based compensation, which had not been previously recognized, with a corresponding increase to the valuation allowance. Estimating the fair value of stock options and purchase rights under the 2018 ESPP using the Black-Scholes option-pricing model requires assumptions as to the fair value of our underlying common stock, the estimated term of the option, the risk free interest rates, the expected volatility of the price of our common stock and the expected dividend yield. The assumptions used to estimate the fair value of the option awards reflect our best estimates. If any of the assumptions change significantly, stock-based compensation for future awards may differ significantly compared with the awards granted previously. The assumptions and estimates are as follows: • Fair Value of Common Stock. See “Common Stock Valuations” discussion below. • Expected Term. This is the period of time that the options granted are expected to remain unexercised. We employ the simplified method to calculate the average expected term. • Volatility. This is a measure of the amount by which a financial variable, such as a share price, has fluctuated (historical volatility) or is expected to fluctuate (expected volatility) during a period. As we do not yet have sufficient history of our own volatility, we have identified several public entities of similar size, complexity and stage of development and estimate volatility based on the volatility of these companies. • Risk-Free Interest Rate. This is the U.S. Treasury rate, having a term that most closely resembles the expected life of the stock option. • Dividend Yield. We have not and do not expect to pay dividends on our common stock. Common Stock Valuations Following our IPO, we use the market price of our common stock at the date of grant as the fair value. Prior to our IPO, the lack of an active public market for our common stock required our board of directors to exercise reasonable judgment and consider a number of factors in order to make the best estimate of fair value of our common stock, in accordance with the technical practice-aid issued by the American Institute of Certified Public Accountants Practice Aid entitled Valuation of Privately-Held Company Equity Securities Issued as Compensation. Factors considered in connection with estimating the fair value of our common stock underlying our award of restricted stock and stock option awards when performing the fair value calculations with the Black Scholes option-pricing model included: • The results of independent third-party valuations of our common stock • Recent arm’s length transactions involving the sale or transfer of our common stock • The rights, preferences and privileges of our Series A and Series B redeemable convertible preferred stock relative to those of our common stock • Our historical financial results and future financial projections • The market value of equity interests in substantially similar businesses, which equity interests can be valued through nondiscretionary, objective means • The lack of marketability of our common stock • The likelihood of achieving a liquidity event, such as an IPO given prevailing market conditions • Industry outlook • General economic outlook including economic growth, inflation and unemployment, interest rate environment and global economic trends As described above, the exercise price of our stock option awards was determined by our board of directors, with input from management, taking into account the factors described above, using a combination of valuation methodologies with varying weighting applied to each methodology as of the grant date. Application of these approaches involved the use of estimates, judgment and assumptions that were highly complex and subjective, such as those regarding our expected future revenue, expenses and future cash flows, discount rates, market multiples, the selection of comparable companies and the probability of possible future events. Changes in any or all of these estimates and assumptions or the relationships between those assumptions would have impacted our valuations as of each valuation date and may have had a material impact on the valuation of our common stock. The fair value of each stock option was estimated on the grant date based on the following assumptions: The fair value of each 2018 ESPP purchase right was estimated on the grant date based on the following assumptions: Income Taxes We are subject to federal, state and local taxes in the United States as well as numerous international jurisdictions. These foreign jurisdictions have different statutory tax rates than the United States. Earnings generated by our international entities are related to transfer pricing requirements as applicable under local jurisdiction tax laws. We record a provision for income taxes under the asset and liability method, which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial statement carrying amounts and the tax basis of existing assets and liabilities, net operating loss carryforwards and tax credit carryforwards. Deferred tax assets and liabilities are measured using the tax rates that are expected to apply to taxable income for the years in which those tax assets and liabilities are expected to be realized or settled. A valuation allowance is provided if it is more likely than not that some or all of the deferred tax assets will not be realized. We have valuation allowances in all jurisdictions against deferred tax assets net of deferred tax liabilities that will reverse and provide a source of taxable income. Our evaluation of valuation allowances could change in the future and the impact could have a material impact on our financial statements. We recognize tax benefits from an uncertain tax position if it is more likely than not to be sustained upon audit by the relevant taxing authority. Interest and penalties associated with such uncertain tax positions are classified as a component of income tax expense. The Tax Cuts and Jobs Act, or the 2017 Tax Act, was enacted into law, which contains several significant changes to how corporations are taxed in the United States, including the reduction of the corporate income tax rate from 35% to 21% effective January 1, 2018. The new legislation also includes a variety of other changes, such as a one-time repatriation tax on accumulated foreign earnings, or transition tax, acceleration of business asset expensing and reduction in the amount of executive pay that could qualify as a tax deduction. The 2017 Tax Act also included international tax provisions that will affect the Company, including the favorable tax regime for taxing foreign derived intangible income. Additional international provisions include the global intangible low taxed income, or GILTI, regime and the base erosion anti-abuse tax. Depending on the jurisdiction, distributions of earnings could be subject to withholding taxes at rates applicable to the distributing jurisdiction. As we intend to continue to reinvest the earnings of foreign subsidiaries indefinitely, we have not provided for a U.S. income tax liability and foreign withholding taxes on undistributed foreign earnings of foreign subsidiaries. Recently Issued Accounting Pronouncements Refer to Note 1 to our consolidated financial statements contained in this Form 10-K for more information regarding recently issued accounting pronouncements. Emerging Growth Company Status 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 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, we will be subject to the same new or revised accounting standards as other public companies that are not emerging growth companies.
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<s>[INST] Overview We are the first and only provider of solutions for a new category of cybersecurity that we call Cyber Exposure. Cyber Exposure is a discipline for managing and measuring cybersecurity risk in the digital era. Our enterprise platform enables broad visibility into an organization’s cyber exposure across the modern attack surface and deep insights that help organizations translate vulnerability data into business insights to understand and reduce their cybersecurity risk. Our enterprise platform offerings, including Tenable.io, Tenable.sc, and Industrial Security, are built to provide organizations with the breadth of visibility to accurately understand both traditional and modern attack surfaces and the depth of insight that stems from riskbased analytics, prioritization and benchmarking. Our Cyber Exposure platform automatically discovers assets, including those in cloud environments, and assesses these assets for the presence of vulnerabilities, internal and regulatory compliance violations, misconfigurations and other cybersecurity issues, analyzes and prioritizes cybersecurity risks based on the likelihood of a vulnerability being exploited and the business criticality of the asset, and provides an objective way to measure an organization’s cyber exposure. Our enterprise platform offerings are primarily sold on a subscription basis with terms ranging from one to three years, primarily one year. These offerings are typically prepaid in advance. To a lesser extent, we generate ratably recognizable revenue from perpetual licenses and from the related ongoing maintenance. Many of our enterprise platform customers initially use either our free or paid version of Nessus, one of the industry’s most widely deployed vulnerability assessment solutions. Nessus, which is the technology that underpins our enterprise platform offerings, is designed to quickly and accurately identify vulnerabilities, configuration and compliance issues and malware. Our free version of Nessus, Nessus Home, allows for vulnerability assessment over a limited number of IP addresses. We believe many of our Nessus customers begin with Nessus Home and subsequently upgrade to Nessus Professional, the paid version of Nessus; however, we expect many users to continue to use Nessus Home. We have experienced rapid growth in recent years. Revenue in 2018, 2017 and 2016 was $267.4 million, $187.7 million and $124.4 million, respectively, representing yearoveryear growth of 42% and 51%, respectively. Our net loss in 2018, 2017 and 2016 was $73.5 million, $41.0 million and $37.2 million, respectively, as we continue to invest in our business and market opportunity. Initial Public Offering On July 30, 2018, we completed our IPO, in which we issued and sold 12,535,000 shares of common stock at the IPO price of $23.00 for net proceeds to us of $264.6 million, after underwriting discounts and commissions and other offering expenses. Upon the completion of our IPO, all 15,847,500 shares of our Series A Redeemable Convertible Preferred Stock, or Series A, and 39,538,354 shares of our Series B Redeemable Convertible Preferred Stock, or Series B, automatically converted into an aggregate of 55,385,854 shares of our common stock. Financial Highlights Below are our key financial results: Factors Affecting Our Performance Product Leadership We offer the first and only Cyber Exposure platform to provide visibility into the broadest range of traditional and modern IT assets across cloud and onpremises environments. We are intensely focused on continued innovation that empowers organizations to understand and reduce their cyber exposure. This includes ongoing development of our enterprise platform offerings. In February 2017, we released Tenable.io, our SaaS offering that is designed to provide broad visibility and insights across a broad range of traditional and modern IT assets and cloud environments. We continue to expand the capabilities of our enterprise platform offerings, as well as our Nessus products, specifically as it relates to the ability to scan for and detect the rapidly expanding volume of vulnerabilities. We intend to continue to invest in our engineering capabilities and marketing activities to maintain our position in the highlycompetitive market [/INST] Negative. </s>
2,019
9,409
1,660,280
Tenable Holdings, Inc.
2020-02-28
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 our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K, or this Form 10-K. This Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. 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. Such forward-looking statements are subject to a number of risks, uncertainties, assumptions and other factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified herein, and those discussed in the section titled “Risk Factors,” set forth in Part I, Item 1A of this Form 10-K and in our other filings with the SEC. You should not rely upon forward-looking statements as predictions of future events. Furthermore, such forward-looking statements speak only as of the date of this report. Except as required by law, we undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements. On December 2, 2019, we acquired Indegy Ltd. (“Indegy”) to expand our Operational Technology ("OT") specific capabilities. The results of operations of Indegy were not material to our consolidated statement of operations for 2019. Overview We are a leading provider of solutions for a new category of cybersecurity that we call Cyber Exposure. Cyber Exposure is a discipline for managing, measuring and comparing cybersecurity risk in the digital era. Our enterprise platform enables broad visibility into an organization’s cyber exposure across the modern attack surface and deep insights that help organizations translate vulnerability data into business insights to understand and reduce their cybersecurity risk. Our enterprise platform offerings include Tenable.io, which is our software as a service, or SaaS, offering and Tenable.sc, which is our on-premises offering, both of which provide organizations with applications purpose-built for areas of both traditional and modern attack surfaces, including IT infrastructure and applications, cloud environments and Industrial IoT and OT environments. These applications are designed with views, workflows and dashboards to help identify vulnerabilities, internal and regulatory compliance violations, misconfigurations and other cybersecurity issues, prioritize these issues for remediation, and provide insightful remediation guidance. Our enterprise platform offerings are primarily sold on a subscription basis with a one-year term. Our subscription terms are generally not longer than three years. These offerings are typically prepaid in advance. To a lesser extent, we generate ratably recognizable revenue from perpetual licenses and from the related ongoing maintenance. We sell and market our products and services through our field sales force that works closely with our channel partners, which includes a network of distributors and resellers, in developing sales opportunities. We use a two-tiered channel model whereby we sell our enterprise platform offerings to our distributors, which in turn sell to our resellers, which then sell to end users, which we call customers. Many of our enterprise platform customers initially use either our free or paid version of Nessus, one of the industry’s most widely deployed vulnerability assessment solutions. Nessus, which is the technology that underpins our enterprise platform offerings, is designed to quickly and accurately identify vulnerabilities, configuration and compliance issues and malware. Our free version of Nessus, Nessus Essentials, allows for vulnerability assessment over a limited number of IP addresses. We believe many of our Nessus customers begin with Nessus Essentials and subsequently upgrade to Nessus Professional, the paid version of Nessus; however, we expect many users to continue to use Nessus Essentials. We have experienced rapid growth in recent years. Revenue in 2019, 2018 and 2017 was $354.6 million, $267.4 million and $187.7 million, respectively, representing year-over-year growth of 33% and 42%, respectively. Our net loss in 2019, 2018 and 2017 was $99.0 million, $73.5 million and $41.0 million, respectively, as we continue to invest in our business and market opportunity. Financial Highlights Below are our key financial results: Factors Affecting Our Performance Product Leadership Our enterprise platform provides visibility into the broadest range of traditional and modern IT assets across cloud and on-premises environments. We are intensely focused on continued innovation and ongoing development of our enterprise platform offerings that empower organizations to understand and reduce their cyber exposure. Additionally, we continue to expand the capabilities of our Nessus products, specifically as they relate to the ability to scan for and detect the rapidly expanding volume of vulnerabilities. We intend to continue to invest in our engineering capabilities and marketing activities to maintain our position in the highly-competitive market for cybersecurity solutions. Our results of operations may fluctuate as we make these investments to drive increased customer adoption and usage. New Enterprise Platform Customer Acquisition We believe that our customer base provides a significant opportunity to expand sales of our enterprise platform offerings and that our ability to continue to grow our enterprise platform customers will increase future opportunities for renewals and follow-on sales. We believe that we have significant room to increase our market share. We expect to grow our enterprise platform customers by continuing to expand our sales organization and leveraging our channel partner network, which we believe will allow us to identify new enterprise customers, enter new markets, including internationally, as well as to convert more of our existing Nessus Professional customers to enterprise platform customers. We have increased our sales and marketing headcount in recent years and we will continue to invest in our partner network and sales and marketing capability in order to grow domestically and internationally. Retaining and Expanding Revenue from Existing Customers Our enterprise platform offerings utilize IT asset-based or IP address-based pricing models. Once enterprise customers have licensed our platform offerings, they typically seek broader coverage over their traditional IT assets, including networking infrastructure, desktops and on-premises servers. As customers launch new applications or migrate existing applications to the cloud and deploy web applications, containers, internet of things, or IoT, and operational technology, or OT, they often increase the scope of their subscriptions and/or add additional perpetual licenses to our enterprise platforms. We are also focused on upselling customers from Nessus Professional to our enterprise platform offerings. Nessus Professional customers are typically organizations or independent security consultants that use Nessus Professional for a single vulnerability assessment at a point in time. We seek to convert these customers to our enterprise platform offerings, which provide continuous visibility and insights into their attack surface, as their needs develop. Further, we plan to expand existing platform capabilities and launch new products, which we believe will drive new product purchases and follow-on purchases over time, thereby contributing to customer renewals. We believe that there is a significant opportunity to drive additional sales to existing customers, and we expect to invest in sales and marketing and customer success personnel and activities to achieve additional revenue growth from existing customers. However, our ability to increase sales to existing customers will depend on a number of factors, including satisfaction or dissatisfaction with our products and services, competition, pricing, economic conditions or overall changes in our spending levels. We evaluate our ability to expand sales with our existing customers by assessing our dollar-based net expansion rate. We calculate our dollar-based net expansion rate as follows: • Denominator: To calculate our dollar-based net expansion rate as of the end of a reporting period, we first determine the annual recurring revenue, or ARR, from all active subscriptions and maintenance from perpetual licenses as of the last day of the same reporting period in the prior year. This represents recurring payments that we expect to receive in the next 12-month period from the cohort of customers that existed on the last day of the same reporting period in the prior year. • Numerator: We measure the ARR for that same cohort of customers representing all subscriptions and maintenance from perpetual licenses based on customer orders as of the end of the reporting period. We calculate dollar-based net expansion rate by dividing the numerator by the denominator. While our dollar-based net expansion rate may decline or fluctuate from quarter to quarter based on the result of a number of factors, including our existing customers' satisfaction with our solutions, the pricing of our solutions and the ability of competing solutions and the pricing thereof, our dollar-based net expansion rate has historically exceeded, and we expect that it will continue to exceed, 110%. Investing in Business Growth Since our founding, we have invested significantly in growing our business. We intend to continue to invest in sales and marketing to grow our sales team, expand brand and Cyber Exposure awareness and optimize our channel partner network. We also intend to continue to invest in our research and development team to further our technological leadership position in Cyber Exposure and enhance the functionality of our solutions. Any investments we make in our sales and marketing and research and development teams will occur in advance of experiencing the benefits from such investments, so it may be difficult for us to determine if we are efficiently allocating resources in those areas. We may also explore acquisitions of businesses, technology and/or development personnel that will expand and enhance the functionality of our platform offerings. These investment activities could increase our net losses over the short term if our revenue growth does not increase at higher rates. However, we expect that these investments will ultimately benefit our results of operations. Key Operating and Financial Metrics To supplement our consolidated financial statements, which are prepared and presented in accordance with GAAP, we use certain operating metrics and non-GAAP financial measures, as described below, to understand and evaluate our core operating and financial performance. These non-GAAP financial measures, which may be different than similarly titled measures used by other companies, are presented to enhance investors’ overall understanding of our financial performance and should not be considered a substitute for, or superior to, the financial information prepared and presented in accordance with GAAP. We believe that these operating metrics and non-GAAP financial measures provide useful information about our operating and financial performance, enhance the overall understanding of our past performance and future prospects and allow for greater transparency with respect to important metrics used by management for financial and operational decision-making. We present these operating metrics and non-GAAP financial measures to assist investors in seeing our operating and financial performance using a management view and because we believe that these measures provide an additional tool for investors to use in comparing our core operating and financial performance over multiple periods with other companies in our industry. Calculated Current Billings We use the non-GAAP measure of calculated current billings, which we believe is a key metric to measure our periodic performance. Given that most of our customers pay in advance, we typically recognize a majority of the related revenue ratably over time. We use calculated current billings to measure and monitor our ability to provide our business with the working capital generated by upfront payments from our customers. Calculated current billings consists of revenue recognized in a period plus the change in current deferred revenue in the corresponding period. We believe that calculated current billings, which excludes deferred revenue for periods beyond twelve months in a customer’s contractual term, more closely correlates with annual contract value and that the variability in total billings, depending on the timing of large multi-year contracts and the preference for annual billing versus multi-year upfront billing, may distort growth in one period over another. While we believe that calculated current billings provides valuable insight into the cash that will be generated from sales of our subscriptions, this metric may vary from period-to-period for a number of reasons, and therefore has a number of limitations as a quarter-to-quarter or year-over-year comparative measure. For example, calculated current billings include amounts that have not yet been recognized as revenue; an increasing number of large sales transactions, for which the timing has and will continue to vary, may occur in quarters subsequent to or in advance of those that we anticipate; and our calculation of current billings may be different from other companies that report similar financial measures. Additionally, calculated current billings in any one period may be impacted by the timing of customer renewals, including early renewals, which could favorably or unfavorably impact year-over-year comparisons. Because of these and other limitations, you should consider calculated current billings along with revenue and our other GAAP financial results. Our adoption of Accounting Standards Codification Topic 606, Revenue From Contracts With Customers as of January 1, 2017 resulted in a $55.0 million increase in deferred revenue primarily related to the deferral of perpetual license revenue. This cumulative adjustment to deferred revenue at January 1, 2017 increased calculated current billings by $16.7 million in 2017, $11.8 million in 2018 and $5.6 million in 2019 and is expected to increase our calculated current billings by $1.9 million in 2020. The following table presents a reconciliation of revenue, the most directly comparable financial measure calculated in accordance with GAAP, to calculated current billings: _______________ (1) Deferred revenue (current), beginning of period for 2019 includes $0.4 million related to Indegy's deferred revenue at the acquisition date, which is not included in the deferred revenue (current), end of period for 2018. (2) In connection with adopting ASC 606, we recorded $19.0 million of current deferred revenue on January 1, 2017 related to perpetual license revenue recognized in prior periods. Free Cash Flow We use the non-GAAP measure of free cash flow, which we define as GAAP net cash flows from operating activities reduced by purchases of property and equipment. We believe free cash flow is an important liquidity measure of the cash (if any) that is available, after purchases of property and equipment, for investment in our business and to make acquisitions. We believe that free cash flow is useful to investors as a liquidity measure because it measures our ability to generate or use cash. Our use of free cash flow has limitations as an analytical tool and you should not consider it in isolation or as a substitute for an analysis of our results under GAAP. First, free cash flow is not a substitute for net cash flows from operating activities. Second, other companies may calculate free cash flow or similarly titled non-GAAP financial measures differently or may use other measures to evaluate their performance, all of which could reduce the usefulness of free cash flow as a tool for comparison. Additionally, the utility of free cash flow is further limited as it does not reflect our future contractual commitments and does not represent the total increase or decrease in our cash balance for a given period. Because of these and other limitations, you should consider free cash flow along with net cash used in operating activities and our other GAAP financial measures. The following table presents a reconciliation of net cash used in operating activities, the most directly comparable financial measure calculated in accordance with GAAP, to free cash flow: _______________ (1) Free cash flow in 2019 included non-recurring cash payments totaling $13.1 million associated with the Indegy acquisition, including $6.7 million for income taxes on the transfer of acquired intellectual property, $3.1 million for other costs related to the intellectual property transfer, $1.8 million for the settlement of unvested acquiree equity awards, and $1.5 million for acquisition-related expenses. Capital expenditures related to our new headquarters in 2019 were $11.4 million. Contributions to our employee stock purchase plan in 2019 and 2018 impacted free cash flow by $(0.9) million and $6.3 million, respectively. Enterprise Platform Customers We believe that our customer base provides a significant opportunity to expand sales of our enterprise platform offerings. The following tables summarize key components of our customer base: _______________ (1) We define an enterprise platform customer as a customer that has licensed Tenable.io or Tenable.sc for an annual amount of $5,000 or greater. New enterprise platform customers represent new customer logos during the periods presented and do not include customer conversions from Nessus Professional to enterprise platforms. Non-GAAP Loss from Operations and Non-GAAP Operating Margin We use non-GAAP loss from operations along with non-GAAP operating margin as key indicators of our financial performance. We define these non-GAAP financial measures as their respective GAAP measures, excluding the effects of stock-based compensation, acquisition-related expenses and amortization of acquired intangible assets. Acquisition-related expenses include transaction expenses and costs related to the transfer of acquired intellectual property. We believe that these non-GAAP financial measures provide useful information about our core operating results over multiple periods. There are a number of limitations related to the use of the non-GAAP financial measures as compared to GAAP loss from operations and operating margin, including that non-GAAP loss from operations and non-GAAP operating margin exclude stock-based compensation expense, which has been, and will continue to be for the foreseeable future, a significant recurring expense in our business and an important part of our compensation strategy. The following table presents a reconciliation of loss from operations, the most directly comparable financial measure calculated in accordance with GAAP, to non-GAAP loss from operations, and operating margin, the most directly comparable financial measure calculated in accordance with GAAP, to non-GAAP operating margin: Non-GAAP Net Loss, Non-GAAP Net Loss Per Share and Pro Forma Non-GAAP Net Loss Per Share We use non-GAAP net loss, which excludes the effect of the accretion of Series A and B redeemable convertible preferred stock, stock-based compensation, acquisition-related expenses and amortization of acquired intangible assets, as well as the related tax impact, to calculate non-GAAP net loss per share and pro forma non-GAAP net loss per share. Pro forma non-GAAP net loss per share is calculated by giving effect to the conversion of our redeemable convertible preferred stock into common stock as though the conversion occurred at the beginning of each period presented prior to 2019. We believe that these non-GAAP measures provide important information to management and investors because they facilitate comparisons of our core operating results over multiple periods. The following table presents a reconciliation of net loss, and net loss per share attributable to common stockholders, the most comparable financial measures calculated in accordance with GAAP, to non-GAAP net loss, non-GAAP net loss per share and pro forma non-GAAP net loss per share: ________________ (1) The tax impact of the acquisition includes $6.3 million of current tax expense and $4.2 million of deferred tax expense related to the transfer of acquired intellectual property. (2) The tax impact of stock-based compensation is based on the tax treatment for applicable tax jurisdictions. (3) The tax impact of amortization of acquired intangible assets is not material. Components of Our Results of Operations Revenue We generate revenue from subscription arrangements for our software and cloud-based solutions, perpetual licenses, maintenance associated with perpetual licenses and professional services. Our subscription arrangements generally have annual or multi-year contractual terms to use our software or cloud-based solutions, including ongoing software updates during the contractual period. Revenue is recognized ratably over the subscription term given the critical utility provided by the ongoing updates that are released throughout the contract period. Our perpetual licenses are generally sold with one or more years of maintenance, which includes ongoing software updates. Given the critical utility provided by the ongoing software updates and updated ability to identify network vulnerabilities included in maintenance, we combine the perpetual license and the maintenance into a single performance obligation. Perpetual license arrangements generally contain a material right related to the customer’s ability to renew maintenance at a price that is less than the initial license fee. We apply a practical alternative to allocating a portion of the transaction price to the material right performance obligation and estimate a hypothetical transaction price which includes fees for expected maintenance renewals based on the estimated economic life of perpetual license contracts. We allocate the transaction price between the cybersecurity subscription provided in the initial contract and the material right related to expected contract renewals based on the hypothetical transaction price. We recognize the amount allocated to the combined license and maintenance performance obligation over the initial contractual period, which is generally one year. We recognize the amount allocated to the material right over the expected maintenance renewal period, which begins at the end of the initial contractual term and is generally four years. We have estimated the five-year economic life of perpetual license contracts based on historical contract attrition, expected renewal periods, the lifecycle of our technology and other factors. This estimate may change over time. Professional services and other revenue is primarily comprised of advisory services and training related to the deployment and optimization of our products. These services do not result in significant customization of our products. Professional services and other revenue is recognized as the services are performed. We have historically experienced, and expect in the future to experience, seasonality in entering into agreements with customers. We typically enter into a significantly higher percentage of agreements with new customers, as well as renewal agreements with existing customers, in the third and fourth quarters of the year. The increase in customer agreements in the third quarter is primarily attributable to U.S. government and related agencies, and the increase in the fourth quarter is primarily attributable to large enterprise account buying patterns typical in the software industry. Our recent growth and the ratable nature of our subscription revenue makes this seasonality less apparent in our overall financial results. Cost of Revenue, Gross Profit and Gross Margin Cost of revenue includes personnel costs related to our technical support group that provides assistance to customers, including salaries, benefits, bonuses, payroll taxes and stock-based compensation. Cost of revenue also includes cloud infrastructure costs, the costs related to professional services and training, depreciation, amortization of acquired and developed technology and allocated overhead costs, which consist of information technology and facilities. We intend to continue to invest additional resources in our cloud-based platform and customer support team as we grow our business. The level and timing of investment in these areas could affect our cost of revenue in the future. Gross profit, or revenue less cost of revenue, and gross margin, or gross profit as a percentage of revenue, have been and will continue to be affected by various factors, including the timing of our acquisition of new customers and our renewals of and follow-on sales to existing customers, the costs associated with operating our cloud-based platform, the extent to which we expand our customer support team and the extent to which we can increase the efficiency of our technology and infrastructure through technological improvements. We expect our gross profit to increase in absolute dollars but our gross margin to decrease, as we expect revenue from our cloud-based subscriptions to increase as a percentage of revenue, although our gross margin could fluctuate from period to period depending on the interplay of all of these factors. Operating Expenses Our operating expenses consist of sales and marketing, research and development and general and administrative expenses. Personnel costs are the most significant component of operating expenses and consist of salaries, benefits, bonuses, payroll taxes and stock-based compensation expense. Operating expenses also include depreciation and amortization as well as allocated overhead costs including IT and facilities costs. Sales and Marketing Sales and marketing expense consists of personnel costs, sales commissions, marketing programs, travel and entertainment, expenses for conferences and events and allocated overhead costs. We intend to continue to make investments in our sales and marketing teams to grow revenue, further penetrate the market and expand our global customer base. We expect our sales and marketing expense to continue to increase in absolute dollars and to be our largest operating expense category for the foreseeable future. However, as our revenue increases, we expect our sales and marketing expense to decrease as a percentage of our revenue over the long term, although our sales and marketing expense may fluctuate as a percentage of our revenue from period to period due to the timing and extent of these expenses. Research and Development Research and development expense consists of personnel costs, software used to develop our products, travel and entertainment, consulting and professional fees for third-party development resources as well as allocated overhead. Our research and development expense supports our efforts to continue to add capabilities to our existing products and enable the continued detection of new network vulnerabilities. We expect our research and development expense to continue to increase in absolute dollars for the foreseeable future as we continue to invest in research and development efforts to enhance the functionality of our cloud-based platform. However, we expect our research and development expense to decrease as a percentage of our revenue over the long term, although our research and development expense may fluctuate as a percentage of our revenue from period to period due to the timing and extent of these expenses. General and Administrative General and administrative expense consists of personnel costs for our executive, finance, legal, human resources and administrative departments. Additional expenses include travel and entertainment, professional fees, insurance, allocated overhead, and acquisition related costs. We expect our general and administrative expense to continue to increase in absolute dollars for the foreseeable future due to additional costs associated with accounting, compliance, insurance and investor relations as a public company. However, we expect our general and administrative expense to decrease as a percentage of our revenue over the long term, although our general and administrative expense may fluctuate as a percentage of our revenue from period to period due to the timing and extent of these expenses. Interest Income, Net Interest income, net consists primarily of interest income earned on cash and cash equivalents and short-term investments and interest expense in connection with fees for our unused revolving credit facility. Other Expense, Net Other expense, net consists primarily of foreign currency remeasurement and transaction gains and losses. Provision for Income Taxes Provision for income taxes consists of income taxes in certain foreign jurisdictions in which we conduct business and withhold taxes on sales with customers. We have recorded deferred tax assets for which a full valuation allowance has been provided, including net operating loss carryforwards and tax credits. We expect to maintain this full valuation allowance for the foreseeable future as it is more likely than not that some or all of those deferred tax assets may not be realized based on our history of losses. In 2019, the provision for income taxes included the tax impact related to the transfer of acquired intellectual property. Results of Operations The following tables set forth our consolidated results of operations for the periods presented: _______________ (1) Includes stock-based compensation expense as follows: Comparison of 2019 and 2018 Revenue The increase in revenue of $87.2 million was comprised of increases in subscription revenue of $84.7 million and professional services and other revenue of $3.0 million, net of a decrease in perpetual license and maintenance revenue of $0.5 million. Revenue from existing customers comprised 84% of the increase, while the remaining increase was due to revenue from new customers since January 1, 2019. International revenue increased $40.4 million, or 45%. Cost of Revenue, Gross Profit and Gross Margin The increase in cost of revenue of $17.7 million was primarily due to: • a $7.3 million increase in personnel costs, primarily due to increased headcount, including a $1.1 million increase in stock-based compensation; • a $7.0 million increase in third-party cloud infrastructure costs, largely associated with the increased adoption of Tenable.io, as well as the launch of Tenable Lumin; • a $0.9 million increase in allocated overhead costs driven by both the increase in headcount and the overall increase in such costs on a year-over-year basis; • a $0.6 million increase professional fees; • a $0.6 million increase in depreciation and amortization; and • a $0.5 million increase in software subscriptions. Operating Expenses Sales and Marketing The increase in sales and marketing expense of $54.7 million was primarily due to: • a $32.1 million increase in personnel costs, largely associated with an increase in headcount, including a $9.1 million increase in stock-based compensation; • a $10.0 million increase in sales commissions, including sales commission draws, due to increased sales and the amortization of deferred commissions; • a $5.7 million increase in selling expenses, including travel and meeting costs and software subscriptions; • a $3.4 million increase in allocated overhead costs driven by both the increase in headcount and the overall increase in such costs on a year-over-year basis; and • a $3.2 million increase in expenses for demand generation programs, including advertising, sponsorships, and brand awareness efforts aimed at acquiring new customers. Research and Development The increase in research and development expense of $10.4 million was primarily due to: • an $8.1 million increase in personnel costs, largely associated with an increase in headcount, including a $3.3 million increase in stock-based compensation, and net of $1.7 million of development costs and stock-based compensation capitalized related to internal use software; • a $2.0 million increase in third-party cloud infrastructure costs related to the development of new and future offerings; • a $0.9 million increase in software subscriptions; and • a $0.7 million increase in allocated overhead driven by both the increase in headcount and the overall increase in such costs on a year-over-year basis, partially offset by • a $0.9 million decrease in travel and meeting costs. General and Administrative The increase in general and administrative expense of $22.7 million was primarily due to: • a $12.3 million increase in personnel costs, largely associated with an increase in headcount, including a $6.4 million increase in stock-based compensation; • a $4.0 million increase in acquisition-related expenses, including $2.1 million related to the transfer of acquired intellectual property; • a $3.7 million increase in professional fees, which includes costs associated with being a public company; and • a $1.1 million increase in allocated overhead driven by both the increase in headcount and the overall increase in such costs on a year-over-year basis. Comparison of 2018 and 2017 Revenue The increase in revenue of $79.6 million was comprised of increases in subscription revenue of $72.9 million, perpetual license and maintenance revenue of $4.3 million and professional services and other revenue of $2.4 million. Revenue from existing customers comprised 68% of the increase, while the remaining increase was due to revenue from new customers since January 1, 2018. International revenue increased $31.6 million, or 55%. Cost of Revenue, Gross Profit and Gross Margin The increase in cost of revenue of $17.6 million was primarily due to: • a $6.9 million increase in personnel costs, primarily due to increased headcount, including a $1.4 million increase in stock-based compensation; • a $5.3 million increase in third-party cloud infrastructure costs, largely associated with the increased adoption of Tenable.io; • a $3.3 million increase in allocated overhead costs driven by both the increase in headcount and the overall increase in such costs on a year-over-year basis; • a $0.8 million increase in software subscription expenses; and • a $0.5 million increase in depreciation and amortization. Operating Expenses Sales and Marketing The increase in sales and marketing expense of $57.0 million was primarily due to: • a $29.2 million increase in personnel costs, largely associated with an increase in headcount, including a $5.3 million increase in stock-based compensation; • a $14.3 million increase in sales commissions, including sales commission draws, due to increased sales and the amortization of deferred commissions; • a $6.1 million increase in expenses for demand generation programs, including advertising, sponsorships and brand awareness efforts aimed at acquiring new customers; and • a $4.9 million increase in selling expenses, including travel and meeting costs and the costs of software subscriptions. Research and Development The increase in research and development expense of $19.0 million was primarily due to: • a $15.1 million increase in personnel costs, largely associated with an increase in headcount, including a $4.0 million increase in stock-based compensation, and net of $2.4 million of development costs capitalized related to internal use software; • a $1.6 million increase in third-party cloud infrastructure costs related to the development of new and future offerings; • a $0.7 million increase in software subscription expenses; and • a $0.6 million increase in allocated overhead driven by both the increase in headcount and the overall increase in such costs on a year-over-year basis. General and Administrative The increase in general and administrative expense of $17.8 million was primarily due to: • a $11.9 million increase in personnel costs, largely associated with an increase in headcount, including a $4.3 million increase in stock-based compensation; • a $3.3 million increase in professional fees, which includes costs associated with being a public company; and • a $0.8 million increase in software subscription expense. Liquidity and Capital Resources At December 31, 2019, we had cash and cash equivalents consisting of bank deposits, money market funds and commercial paper of $74.4 million and short-term investments consisting of commercial paper, U.S. Treasury and agency obligations and corporate bonds of $137.9 million. Since inception and prior to our IPO, we financed our operations through cash provided by operations, including payments received from customers using our software products and services, and we did not raise any primary institutional capital. The proceeds of our Series A and Series B redeemable convertible preferred stock financings were used to repurchase shares of capital stock from former stockholders. Upon the completion of our IPO in July 2018, we received net proceeds of $264.6 million. We have generated significant operating losses from our operations, as reflected by our accumulated deficit of $565.1 million at December 31, 2019. We typically invoice our customers annually in advance and, to a lesser extent, multi-year in advance. Therefore, a substantial source of our cash is from such prepayments, which are included on our consolidated balance sheets as deferred revenue. Deferred revenue consists primarily of the unearned portion of billed fees for our subscriptions and perpetual licenses, which is subsequently recognized as revenue in accordance with our revenue recognition policy. At December 31, 2019, we had deferred revenue of $363.1 million, of which $274.3 million was recorded as a current liability and is expected to be recorded as revenue in the next 12 months, provided all other revenue recognition criteria are met. Our principal uses of cash in recent periods have been funding our operations, expansion of our sales and marketing and research and development activities, investments in infrastructure and acquiring complementary businesses and technology. We expect to continue incurring operating losses and generating negative cash flows from operations in the near-term; however, we believe that our existing cash and cash equivalents and short-term investments will be sufficient to fund our operating and capital needs for at least the next 12 months. Our future capital requirements will depend on many factors, including our revenue growth rate, subscription renewal activity, the timing and extent of spending to support further infrastructure and research and development efforts, the timing and extent of additional capital expenditures to invest in new and existing office spaces, the expansion of sales and marketing and international operating activities, the timing of introduction of new product capabilities and enhancements of our platform and the continuing market acceptance of our platform. Capital expenditures related to our new corporate headquarters were $11.4 million in 2019. In 2020, we expect capital expenditures related to our new corporate headquarters to be approximately $16.0 million and we expect to receive $12.5 million in tenant improvement reimbursements. We may in the future enter into arrangements to acquire or invest in complementary businesses, services and technologies, including intellectual property rights. We may be required to seek equity or debt financing. In the event that financing is required from outside sources, we may not be able to raise it on terms acceptable to us or at all. If we are unable to raise additional capital when desired, or if we cannot expand our operations or otherwise capitalize on our business opportunities because we lack sufficient capital, our business, operating results and financial condition would be adversely affected. Credit Facility In May 2017, we entered into a $25.0 million revolving credit facility with Silicon Valley Bank. Pursuant to the terms of the revolving credit facility, we may issue up to $5.0 million of letters of credit, which reduce the total amount available for borrowing under such facility. The revolving credit facility terminates on May 4, 2020. To date, we have not borrowed any amounts under the revolving credit facility. Interest on borrowings under the revolving credit facility accrues at a variable rate tied to the prime rate or the LIBOR rate, at our election. Interest is payable quarterly in arrears. We are required to pay a quarterly commitment fee that accrues at a rate of 0.25% per annum on the unused portion of the borrowing commitment. The revolving credit facility contains customary conditions to borrowing, events of default and covenants, including restrictions on indebtedness, liens, acquisitions and investments, restricted payments and dispositions. If, as of the last day of any quarter, the outstanding balance of the revolving credit facility exceeds $5.0 million, there are financial covenants that require us to maintain a minimum level of earnings before income taxes, interest, depreciation and amortization adjusted to add changes in deferred revenue in the period and a minimum current ratio level. We were in compliance with all covenants under the revolving credit facility at December 31, 2019. Letter of Credit On January 9, 2020, we entered into a $2.5 million standby letter of credit ("Letter of Credit") for the security deposit on our new headquarters lease. The Letter of Credit bears interest at 2% per annum and expires one year from the issue date, with automatic renewals for additional one year terms until the final expiration date of February 2032. The Letter of Credit reduces the amount available for borrowing under our revolving credit facility. Cash Flows The following table summarizes our cash flows for the periods presented: Operating Activities In 2019, net cash used in operating activities was $10.7 million, which primarily consisted of our $99.0 million net loss, adjusted for stock-based compensation expense of $41.6 million and depreciation and amortization of $6.9 million, as well as a net cash inflow of $36.3 million from changes in operating assets and liabilities. The net inflow from changes in operating assets and liabilities was primarily due to a $72.8 million increase in deferred revenue primarily due to increased subscription sales, as a majority of our customers are invoiced in advance, partially offset by a $25.9 million increase in accounts receivable and a $12.8 million increase in deferred commissions. In 2018, net cash used in operating activities was $2.6 million, which primarily consisted of our $73.5 million net loss, adjusted for stock-based compensation expense of $22.9 million and depreciation and amortization of $6.2 million, as well as a net cash inflow of $41.4 million from changes in operating assets and liabilities. The net inflow from changes in operating assets and liabilities was primarily due to a $64.1 million increase in deferred revenue, primarily due to increased subscription sales, as a majority of our customers are invoiced in advance, partially offset by a $17.4 million increase in accounts receivable. In 2017, net cash used in operating activities was $6.3 million, which primarily consisted of our $41.0 million net loss, adjusted for stock-based compensation expense of $7.8 million and depreciation and amortization of $4.7 million, as well as a net cash inflow of $23.1 million from changes in operating assets and liabilities. The net inflow from operating assets and liabilities was primarily due to an increase of $63.4 million in deferred revenue, including the cumulative impact of adopting ASC 606, from increased subscription sales as a majority of our customers are invoiced in advance, partially offset by a $14.8 million increase in accounts receivable. In addition, deferred commissions increased $20.1 million, including the cumulative impact of adopting ASC 606. Investing Activities From 2018 to 2019, net cash used in investing activities decreased by $10.2 million, primarily due to a decrease in our purchase, net of sales, of investments of $100.0 million, partially offset by cash paid for acquisitions of $74.9 million and capital expenditures for our new corporate headquarters of $11.4 million. From 2017 to 2018, net cash used in investing activities increased by $120.5 million, primarily due to our purchase of short-term investments of commercial paper, U.S. Treasury securities and corporate bonds of $117.5 million. Financing Activities From 2018 to 2019, net cash provided by financing activities decreased by $230.6 million, primarily due to proceeds from our IPO, net of underwriting discounts and commissions, of $268.5 million, less payments of offering costs related to our IPO of $3.9 million in 2018, partially offset by proceeds from the exercise of stock options of $19.0 million and stock issued in connection with the employee stock purchase plan of $15.1 million in 2019. From 2017 to 2018, net cash provided by financing activities increased by $262.7 million, primarily due to proceeds from our IPO, net of underwriting discounts and commissions, less payments of offering costs related to our IPO. Contractual Obligations The following table summarizes our contractual obligations at December 31, 2019: Not included in the table above is $7.2 million of unrecognized tax benefits and $1.2 million of asset retirement obligations, because the timing of future cash outflows is uncertain. Off-Balance Sheet Arrangements At December 31, 2019, we did not have any relationships with unconsolidated organizations or financial partnerships, such 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. Critical Accounting Policies and Estimates Our financial statements are prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, as well as 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. The critical accounting estimates, assumptions and judgments that we believe have the most significant impact on our consolidated financial statements are described below. Revenue Recognition We early adopted ASC 606 on January 1, 2017 using the modified retrospective method and applying the guidance to all contracts as of January 1, 2017. The core principle of ASC 606 is that revenue should be recognized 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 the core principle of ASC 606, we apply the following steps: • Identify the contract with a customer • Identify the performance obligations in the contract • Determine the transaction price • Allocate the transaction price to the performance obligations in the contract • Recognize revenue when or as performance obligations are satisfied In situations where we enter into a contractual arrangement that includes non-standard terms and conditions, such as acceptance provisions and options to purchase additional products and services, as well as contract modifications, we apply judgment in identifying and assessing the impact on revenue recognition. We generate revenue from subscription arrangements for our software and cloud-based solutions, perpetual licenses, maintenance associated with perpetual licenses and professional services and other revenue. Subscription Revenue Our subscription arrangements generally have annual or multi-year contractual terms and allow customers to use our software or cloud solutions, including ongoing software updates and the ability to identify the latest cybersecurity vulnerabilities. Revenue is recognized ratably over the subscription term given the critical utility provided by the ongoing updates that are released throughout the contract period. Perpetual License and Maintenance Revenue Our perpetual licenses are generally sold with one or more years of maintenance, which include ongoing software updates and the ongoing ability to identify the latest cybersecurity vulnerabilities. Given the critical utility provided by the ongoing software updates and updated ability to identify network vulnerabilities included in maintenance, we combine the perpetual license and the maintenance into a single performance obligation. Perpetual license arrangements generally contain a material right related to the customer’s ability to renew maintenance at a price that is less than the initial license fee. We apply a practical alternative to allocating a portion of the transaction price to the material right performance obligation and estimate a hypothetical transaction price which includes fees for expected maintenance renewals based on the estimated economic life of the perpetual license contracts. We allocate the transaction price between the cybersecurity subscription provided in the initial contract and the material right related to expected contract renewals based on the hypothetical transaction price. We recognize the amount allocated to the combined license and maintenance performance obligation over the initial contractual period, which is generally one year. We recognize the amount allocated to the material right over the expected maintenance renewal period, which begins at the end of the initial contractual term and is generally four years. We have estimated the five-year economic life of perpetual license contracts based on historical contract attrition, expected renewal periods, the lifecycle of the our technology and other factors. While we believe that the estimates we have made are reasonable and appropriate, different assumptions and estimates could materially impact our reported financial results. Professional Services and Other Revenue Professional services and other revenue is primarily comprised of advisory services and training related to the deployment and optimization of our products. These services do not result in significant customization of our products. Professional services and other revenue is recognized as the services are performed. Contracts with Multiple Performance Obligations In cases where our contracts with customers contain multiple performance obligations, the contract transaction price is allocated on a relative standalone selling price basis. We typically determine standalone selling price based on observable selling prices of our products and services. Variable Consideration We record revenue from sales at the net sales price, which is the transaction price, including estimates of variable consideration when applicable. Certain of our customers may be entitled to receive credits and in certain circumstances, refunds, if service level commitments are not met. We have not historically experienced significant incidents affecting the ability to meet these service level commitments and any estimated refunds related to these agreements have not been material. Sales through our channel partner network of distributors and resellers are generally discounted as compared to the price that we would sell to an end user. Revenue for sales through our channel network, which is fixed, is recorded net of any distributor or reseller margin. Deferred Commissions Sales commissions, including related incremental fringe benefit costs, are considered to be incremental costs of obtaining a contract, and therefore are deferred over an estimated period of benefit, which ranges between three and four years for subscription arrangements and five years for perpetual license arrangements. We have estimated the period of benefit based on the expected contract term including renewal periods, the lifecycle of our technology and other factors. Sales commissions on contract renewals are capitalized and amortized ratably over the contract term, with the exception of contracts with renewal periods that are one year or less, in which case the incremental costs are expensed as incurred. While we believe that the estimates we have made are reasonable and appropriate, different assumptions and estimates could materially impact our reported financial results. Stock-Based Compensation Stock-based compensation expense related to our stock options, restricted stock, restricted stock units, or RSUs, and purchase rights issued under our 2018 Employee Stock Purchase Plan, or the 2018 ESPP, is calculated based on the fair value of the awards granted and is recognized on a straight-line basis over the requisite service period, which is generally two to four years, with the exception of RSUs that include performance-based vesting conditions and are expensed using the accelerated attribution method. We account for forfeitures as they occur. Estimating the fair value of stock options and purchase rights under the 2018 ESPP using the Black-Scholes option-pricing model requires assumptions as to the fair value of our underlying common stock, the estimated term of the option, the risk free interest rates, the expected volatility of the price of our common stock and the expected dividend yield. The assumptions used to estimate the fair value of the option awards reflect our best estimates. If any of the assumptions change significantly, stock-based compensation for future awards may differ significantly compared with the awards granted previously. The assumptions and estimates are as follows: • Fair Value of Common Stock. See “Common Stock Valuations” discussion below. • Expected Term. This is the period of time that the options granted are expected to remain unexercised. We employ the simplified method to calculate the average expected term. • Volatility. This is a measure of the amount by which a financial variable, such as a share price, has fluctuated (historical volatility) or is expected to fluctuate (expected volatility) during a period. As we do not yet have sufficient history of our own volatility, we have identified several public entities of similar size, complexity and stage of development and estimate volatility based on the volatility of these companies. • Risk-Free Interest Rate. This is the U.S. Treasury rate, having a term that most closely resembles the expected life of the stock option. • Dividend Yield. We have not and do not expect to pay dividends on our common stock. Common Stock Valuations Following our IPO, we use the market price of our common stock at the date of grant as the fair value. Prior to our IPO, the lack of an active public market for our common stock required our board of directors to exercise reasonable judgment and consider a number of factors in order to make the best estimate of fair value of our common stock, in accordance with the technical practice-aid issued by the American Institute of Certified Public Accountants Practice Aid entitled Valuation of Privately-Held Company Equity Securities Issued as Compensation. Factors considered in connection with estimating the fair value of our common stock underlying our award of restricted stock and stock option awards when performing the fair value calculations with the Black Scholes option-pricing model included: • The results of independent third-party valuations of our common stock • Recent arm’s length transactions involving the sale or transfer of our common stock • The rights, preferences and privileges of our Series A and Series B redeemable convertible preferred stock relative to those of our common stock • Our historical financial results and future financial projections • The market value of equity interests in substantially similar businesses, which equity interests can be valued through nondiscretionary, objective means • The lack of marketability of our common stock • The likelihood of achieving a liquidity event, such as an IPO given prevailing market conditions • Industry outlook • General economic outlook including economic growth, inflation and unemployment, interest rate environment and global economic trends As described above, the exercise price of our stock option awards was determined by our board of directors, with input from management, taking into account the factors described above, using a combination of valuation methodologies with varying weighting applied to each methodology as of the grant date. Application of these approaches involved the use of estimates, judgment and assumptions that were highly complex and subjective, such as those regarding our expected future revenue, expenses and future cash flows, discount rates, market multiples, the selection of comparable companies and the probability of possible future events. Changes in any or all of these estimates and assumptions or the relationships between those assumptions would have impacted our valuations as of each valuation date and may have had a material impact on the valuation of our common stock. The fair value of each stock option was estimated on the grant date based on the following assumptions: The fair value of each 2018 ESPP purchase right was estimated on the offering or modification dates based on the following assumptions: Business Combinations We account for business combinations by recognizing the fair value of acquired assets and liabilities. The excess purchase consideration over the fair value of acquired assets and liabilities is recorded as goodwill. When determining the fair value of assets acquired and liabilities assumed, we make estimates and assumptions, especially with respect to intangible assets. Estimates in valuing certain identifiable intangible assets require significant judgment and include, but are not limited to, expected long-term market growth, future expected operating expenses, costs of capital, and appropriate discount rates. Our estimate of fair value is based upon assumptions we believe to be reasonable, but which are inherently uncertain and, as a result, actual results may differ from estimates. During the measurement period, we may make adjustments to the fair value of assets acquired and liabilities assumed, with offsetting adjustments to goodwill. Any adjustments made after the measurement period will be reflected in the consolidated statements of operations. Acquisition-related transaction costs are expensed as incurred. Income Taxes We are subject to federal, state and local taxes in the United States as well as numerous international jurisdictions. These foreign jurisdictions have different statutory tax rates than the United States. Earnings generated by our international entities are related to transfer pricing requirements as applicable under local jurisdiction tax laws. We record a provision for income taxes under the asset and liability method, which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial statement carrying amounts and the tax basis of existing assets and liabilities, net operating loss carryforwards and tax credit carryforwards. Deferred tax assets and liabilities are measured using the tax rates that are expected to apply to taxable income for the years in which those tax assets and liabilities are expected to be realized or settled. A valuation allowance is provided if it is more likely than not that some or all of the deferred tax assets will not be realized. We have valuation allowances in all jurisdictions against deferred tax assets net of deferred tax liabilities that will reverse and provide a source of taxable income. Our evaluation of valuation allowances could change in the future and the impact could have a material impact on our financial statements. We recognize tax benefits from an uncertain tax position if it is more likely than not to be sustained upon audit by the relevant taxing authority. Interest and penalties associated with such uncertain tax positions are classified as a component of income tax expense. In December 2019, subsequent to our acquisition of Indegy Ltd. we transferred the acquired Indegy intellectual property through an intercompany transaction. The valuation of Indegy's intellectual property for tax purposes resulted in $6.3 million of current tax expense and $4.2 million of deferred tax expense in Israel. The valuation of the intellectual property for tax purposes required significant judgment and assumptions with respect to forecasted operating results and discount rates. The Tax Cuts and Jobs Act, or the 2017 Tax Act, was enacted into law, which contains several significant changes to how corporations are taxed in the United States, including the reduction of the corporate income tax rate from 35% to 21% effective January 1, 2018. The new legislation also includes a variety of other changes, such as a one-time repatriation tax on accumulated foreign earnings, or transition tax, acceleration of business asset expensing and reduction in the amount of executive pay that could qualify as a tax deduction. The 2017 Tax Act also included international tax provisions that will affect the Company, including the favorable tax regime for taxing foreign derived intangible income. Additional international provisions include the global intangible low taxed income, or GILTI, regime and the base erosion anti-abuse tax. Depending on the jurisdiction, distributions of earnings could be subject to withholding taxes at rates applicable to the distributing jurisdiction. As we intend to continue to reinvest the earnings of foreign subsidiaries indefinitely, we have not provided for a U.S. income tax liability and foreign withholding taxes on undistributed foreign earnings of foreign subsidiaries. Recently Issued Accounting Pronouncements Refer to Note 1 to our consolidated financial statements in this Annual Report on Form 10-K for more information regarding recently issued accounting pronouncements.
-0.02272
-0.022522
0
<s>[INST] On December 2, 2019, we acquired Indegy Ltd. (“Indegy”) to expand our Operational Technology ("OT") specific capabilities. The results of operations of Indegy were not material to our consolidated statement of operations for 2019. Overview We are a leading provider of solutions for a new category of cybersecurity that we call Cyber Exposure. Cyber Exposure is a discipline for managing, measuring and comparing cybersecurity risk in the digital era. Our enterprise platform enables broad visibility into an organization’s cyber exposure across the modern attack surface and deep insights that help organizations translate vulnerability data into business insights to understand and reduce their cybersecurity risk. Our enterprise platform offerings include Tenable.io, which is our software as a service, or SaaS, offering and Tenable.sc, which is our onpremises offering, both of which provide organizations with applications purposebuilt for areas of both traditional and modern attack surfaces, including IT infrastructure and applications, cloud environments and Industrial IoT and OT environments. These applications are designed with views, workflows and dashboards to help identify vulnerabilities, internal and regulatory compliance violations, misconfigurations and other cybersecurity issues, prioritize these issues for remediation, and provide insightful remediation guidance. Our enterprise platform offerings are primarily sold on a subscription basis with a oneyear term. Our subscription terms are generally not longer than three years. These offerings are typically prepaid in advance. To a lesser extent, we generate ratably recognizable revenue from perpetual licenses and from the related ongoing maintenance. We sell and market our products and services through our field sales force that works closely with our channel partners, which includes a network of distributors and resellers, in developing sales opportunities. We use a twotiered channel model whereby we sell our enterprise platform offerings to our distributors, which in turn sell to our resellers, which then sell to end users, which we call customers. Many of our enterprise platform customers initially use either our free or paid version of Nessus, one of the industry’s most widely deployed vulnerability assessment solutions. Nessus, which is the technology that underpins our enterprise platform offerings, is designed to quickly and accurately identify vulnerabilities, configuration and compliance issues and malware. Our free version of Nessus, Nessus Essentials, allows for vulnerability assessment over a limited number of IP addresses. We believe many of our Nessus customers begin with Nessus Essentials and subsequently upgrade to Nessus Professional, the paid version of Nessus; however, we expect many users to continue to use Nessus Essentials. We have experienced rapid growth in recent years. Revenue in 2019, 2018 and 2017 was $354.6 million, $267.4 million and $187.7 million, respectively, representing yearoveryear growth of 33% and 42%, respectively. Our net loss in 2019, 2018 and 2017 was $99.0 million, $73.5 million and $41.0 million, respectively, as we continue to invest in our business and market opportunity. Financial Highlights Below are our key financial results: Factors Affecting Our Performance Product Leadership Our enterprise platform provides visibility into the broadest range of traditional and modern IT assets across cloud and onpremises environments. We are intensely focused on continued innovation and ongoing development of our enterprise platform offerings that empower organizations to understand and reduce their cyber exposure. Additionally, we continue to expand the capabilities of our Nessus products, specifically as they relate to the ability to scan for and detect the rapidly expanding volume of vulnerabilities. We intend to continue to invest in our engineering capabilities and marketing activities to maintain our position in the highlycompetitive market for cybersecurity solutions. Our results of operations may fluctuate as we make these investments to drive increased customer adoption and usage. New Enterprise Platform Customer Acquisition We believe that our customer base provides a significant opportunity to expand sales of our enterprise platform offerings and that our ability to continue to grow our enterprise platform customers will increase future opportunities for renewals and followon sales. We believe that we have significant room to increase our market share. We expect to grow our enterprise platform customers by continuing to expand our sales organization and leveraging our channel partner network [/INST] Negative. </s>
2,020
9,467
1,603,756
Axonics Modulation Technologies, Inc.
2019-03-05
2018-12-31
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. Overview We are a medical technology company that has developed and is commercializing an innovative and minimally invasive implantable neurostimulation system. SNM therapy is primarily used to treat patients with OAB, including UUI and UUF, FI, and UR. OAB affects an estimated 87 million adults in the United States and Europe. Another estimated 40 million adults are reported to suffer from FI. SNM therapy is an effective and durable treatment that has been widely used and reimbursed in Europe and the United States for the past two decades. SNM is the only OAB treatment with proven clinical superiority to standard medical therapy and OAB patients who receive SNM report significantly higher quality of life than patients undergoing drug treatment. We believe our proprietary r-SNM System offers significant advantages, including being the first and only rechargeable SNM system that is designed to be 60% smaller than existing technology and to last approximately 15 years. We believe our r-SNM System has the potential to disrupt and grow the estimated $650 million global SNM market in 2018, which is currently controlled by a single participant. We currently have marketing approvals in Europe, Canada, and Australia for OAB, FI, and UR. On December 3, 2018, we submitted a literature-based PMA application to the FDA for OAB and UR. This literature-based PMA was based on reasonable safety and effectiveness data from a literature review. In this PMA filing, we submitted existing literature reporting on InterStim II. In addition to the technical specifications, testing data and published literature, we included one-year follow-up data from our 51-patient RELAX-OAB European post-market clinical follow-up study to support the PMA, and subsequently provided the FDA with the clinical results on the first 60 patients to reach their six-month primary endpoint from our ARTISAN-SNM pivotal study. Since the original PMA submission in December 2018, we have submitted various amendments to the PMA. These amendments include data in support of conditional full-body magnetic resonance imaging (“MRI”) labeling and complete three-month and six-month clinical data from the ARTISAN-SNM study. On March 1, 2019, we submitted a new literature-based PMA seeking approval for FI. This PMA is also based on an existing literature review of Interstim II. Typically, the PMA review process takes six to 18 months, with the duration depending on a variety of factors. We will continue to maintain our core strategy of pursuing what is, in our view, the most expeditious pathway within the PMA processes to achieving FDA clearance to market the Axonics r-SNM system in the United States. Specifically, it is our understanding that the literature-based PMA submission did not impact the ARTISAN-SNM pivotal study, nor, in our understanding, did the submission of the complete data from our ARTISAN-SNM pivotal study impact the schedule of the literature-based PMA process. The literature-based PMA filing now includes the data from all 129 subjects treated in the ARTISAN-SNM pivotal study and we believe that the question-response process between us and the FDA will prove beneficial in the overall PMA review process. We have retained the option to file a PMA submission at any time based on the ARTISAN-SNM pivotal study data and additional required information, or to rely solely on the literature-based application currently under review, whichever appears to represent, in our judgment, the most efficient and timely pathway to approval. Since we commenced operations in late 2013, we have generated minimal revenue, as our activities have consisted primarily of developing our r-SNM System, conducting our RELAX-OAB post-market clinical follow-up study in Europe and our ARTISAN-SNM pivotal study in the United States and Europe, and filing for regulatory approvals. In the future, if our r-SNM System is approved in the United States, we expect to generate revenue from product sales. Our ability to generate revenue and become profitable will depend on our ability to successfully commercialize our r-SNM System and any product enhancements we may advance in the future. Although we have begun limited commercial activities in Europe, our main priority is the United States, where we expect to begin to commercialize and market our r-SNM System and generate revenue from product sales if and when approved by the FDA. We plan to establish a significant commercial infrastructure in anticipation of potential FDA approval of our r-SNM System and make significant investments to build our sales and marketing organization by hiring dedicated sales personnel, including sales representatives, sales managers and clinical support personnel to market our product in markets throughout United States and Canada. In addition, we plan to strategically expand into certain international markets in Europe. If we are unable to accomplish any of these objectives, it could have a significant negative impact on our future revenue. If we fail to generate revenue in the future, our business, results of operations, financial condition, cash flows, and future prospects would be materially and adversely affected. We also intend to continue to make investments in research and development efforts to develop our next generation r-SNM System and support our future regulatory submissions for expanded labeling. We expect to derive future revenue by increasing patient and physician awareness of our r-SNM System and obtaining additional regulatory approvals. In the United States, the cost required to treat each patient is reimbursed through various third-party payors, such as commercial payors and government agencies. Most large insurers have established coverage policies in place to cover SNM therapy. Certain commercial payors have a patient-by-patient prior authorization process that must be followed before they will provide reimbursement for SNM therapy. Outside the United States, reimbursement levels vary significantly by country and by region, particularly based on whether the country or region at issue maintains a single-payor system. SNM therapy is eligible for reimbursement in Canada, Australia, and certain countries in the EU, such as Germany, France, and the United Kingdom. Annual healthcare budgets generally determine the number of SNM systems that will be paid for by the payor in these single-payor system countries and regions. We currently outsource the manufacture of all components of our r-SNM System. We plan to continue with an outsourced manufacturing arrangement for certain of our r-SNM System components for the foreseeable future. We believe that our contract manufacturers are recognized in their field for their competency to manufacture the respective portions of our r-SNM System and have quality systems established that meet FDA requirements. We believe the manufacturers we currently utilize have sufficient capacity to meet our launch requirements and are able to scale up their capacity relatively quickly with limited capital investment. We have devoted substantially all of our resources to research and development activities related to our r-SNM System, including clinical and regulatory initiatives to obtain marketing approvals. In anticipation of potential FDA approval, we expect to continue to spend a significant amount of our resources on sales and marketing activities as we begin to commercialize and market our r-SNM System in the United States. We incurred net losses of $32.5 million and $18.1 million for the years ended December 31, 2018 and 2017, and had an accumulated deficit of $99.6 million as of December 31, 2018. As of December 31, 2018, we had available cash, cash equivalents and short-term investments of approximately $157.5 million, current liabilities of approximately $5.9 million, and long-term liabilities of approximately $22.7 million. Prior to our IPO, we financed our operations primarily through preferred stock financings and amounts borrowed under the Loan Agreement. We have invested heavily in product development and continuous improvement to our r-SNM System. We have also made significant investments in clinical studies to demonstrate the safety and effectiveness of our r-SNM System and to support regulatory submissions. Because of these and other factors, we expect to continue to incur net losses for the next few years and we may require additional funding, which may include future equity and debt financings. 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 and adverse effect on our business, financial condition, and results of operations. Initial Public Offering On November 2, 2018, we completed our IPO by issuing 9,200,000 shares of common stock, at an offering price of $15.00 per share, inclusive of 1,200,000 shares of our common stock issued upon the exercise by the underwriters of their option to purchase additional shares. The gross proceeds from the IPO were $138.0 million and the net proceeds were approximately $126.0 million, after deducting underwriting discounts, commissions and estimated offering expenses payable by us. In connection with the IPO, our outstanding shares of convertible preferred stock were automatically converted into an aggregate of 15,813,297 shares of common stock, and our outstanding warrants to purchase shares of Series C convertible preferred stock were automatically converted into warrants to purchase up to an aggregate of 80,000 shares of common stock. AMF License Agreement On October 1, 2013, we entered into the License Agreement pursuant to which AMF granted us a royalty-bearing, sublicensable license to the AMF IP. The license to the AMF IP allows Axonics to make, have made, lease, offer to lease, use, sell, offer for sale, market, promote, advertise, import, research, develop and commercialize the AMF Licensed Products worldwide for the treatment of: (i) urinary and fecal dysfunction in humans through the application of electrical energy anywhere in or on the human body; (ii) chronic pain in humans through the application of electrical energy to the nervous system; and (iii) inflammatory conditions of the human body through the application of electrical energy to the vagus nerve, excluding, in each case, any product or method that involves the placement of electrodes or the administration of electrical stimulation inside the cranial cavity or to the ocular nervous system or the auditory nervous system. We have the right to expand the field of use for the AMF Licensed Products to modulation of digestive process and treatment of digestive conditions in humans through the application of electrical energy anywhere in or on the body, subject to the exclusions described above. Generally, the license is non-transferable without the prior written consent of AMF, except to an affiliate of our company or in connection with the acquisition of our company (whether by merger, consolidation, sale or otherwise) or the part of our business to which the License Agreement relates, provided that the assignee agrees in writing to be bound to the terms of the License Agreement to which we are bound. We granted to AMF a royalty-free, worldwide, sublicensable, perpetual, exclusive license to the Axonics Licensed IP. This license granted by us to AMF explicitly excludes uses of the Axonics Licensed IP that are within the scope of the exclusive license of the AMF IP granted by AMF to us. Such license is irrevocable unless we terminate the License Agreement and AMF does not agree to pay us compensation for such license mutually agreed between us and AMF or determined by arbitration in accordance with the terms of the License Agreement. To date, we have not made any improvements to the inventions claimed in the AMF IP that constitute Axonics Licensed IP. In addition, the License Agreement provides AMF with the AMF Option, to license from us any intellectual property owned by us or otherwise in our control, that is related to electrical stimulation of human tissue, separate from the Axonics Licensed IP and AMF IP, on terms that are materially consistent with the terms upon which we license the AMF IP pursuant to the License Agreement, and subject to field of use restrictions that would be determined upon the exercise of the AMF Option. AMF has expressly declined in writing to exercise the AMF Option. Under the License Agreement, for each calendar year beginning in 2018, we are obligated to pay AMF the greater of (i) 4% of all net revenue derived from the AMF Licensed Products, and (ii) the Minimum Royalty, payable quarterly. As of December 31, 2018, we have accrued $0.1 million toward the Minimum Royalty. The Minimum Royalty will automatically increase each year after 2018, subject to a maximum amount of $200,000 per year. We have 60 days to pay AMF the royalty amount due under the License Agreement, and if we fail to pay AMF within such 60-day period, AMF may, at its election, convert the exclusive license to a non-exclusive license or terminate the License Agreement. The initial term of the License Agreement is from October 1, 2013 to October 1, 2033, and will automatically continue until all patents are no longer in force. Upon completion of the initial term, the license granted pursuant to the License Agreement will be fully paid-up and perpetual except that if we wish to continue to practice any of the patents licensed to us by AMF that remain in force after such initial term, then we will have to continue to pay a reduced royalty for so long as such patent remains in force. Each party may terminate the License Agreement if the other party commits a material breach of any obligation under the License Agreement and such breach is not cured within 90 days following receipt of notice of such breach from the other party. AMF may terminate the License Agreement upon (i) notice to us in the event we challenge or assist any other person or entity in challenging the patentability, enforceability or validity of any of the AMF patents licensed to us under the License Agreement, subject to certain exceptions including challenges that we are not infringing any such AMF patent, and (ii) upon our filing of or the institution of bankruptcy, reorganization, liquidation or receivership proceedings, or upon an assignment of a substantial portion of our assets for the benefit of creditors, and in the case of involuntary bankruptcy, in the event we consent to such bankruptcy and it is not dismissed within 90 days. Lastly, we may terminate the License Agreement in full for any reason effective upon 60 days written notice to AMF. The License Agreement was amended twice in February 2014 in order to, among other things, include the field of the treatment of urinary and fecal dysfunction in humans through the application of electrical energy anywhere in or on the human body, within the scope of the licenses granted therein. The agreement allows for AMF the right to use the AMF IP for non-commercial research, educational and scholarly purposes. As of December 31, 2018, AMF holds 2,102,970 shares of our common stock. John Petrovich, a former member of our board of directors who retired from the board in early March 2019, is the President, Chief Executive Officer, Senior Vice President, Business Development and General Counsel of AMF. Components of Our Results of Operations Net Revenue Since we commenced operations in late 2013, we have generated minimal revenue, as our activities have consisted primarily of developing our r-SNM System, conducting our RELAX-OAB post-market clinical follow up study in Europe and our ARTISAN-SNM pivotal study in the United States and Europe, and filing for regulatory approvals. In the future, if our r-SNM System is approved in the United States, we expect to generate revenue from product sales. Our ability to generate revenue and become profitable will depend on our ability to successfully commercialize our r-SNM System and any product enhancements we may advance in the future. Although we have begun limited commercial activities in Europe, our main priority is the United States, where we expect to begin to commercialize and market our r-SNM System and generate revenue from product sales if and when approved by the FDA. We plan to establish a significant commercial infrastructure in anticipation of potential FDA approval of our r-SNM System. We expect to derive future revenue by increasing patient and physician awareness of our r-SNM System, hiring our own dedicated sales force, and obtaining additional regulatory approvals. In addition, we plan to strategically expand into favorable international markets. If we are unable to accomplish any of these objectives, it could have a significant negative impact on our future revenue. If we fail to generate revenue in the future, our business, results of operations, financial condition, cash flows, and future prospects would be materially and adversely affected. Cost of Goods Sold and Gross Margin Cost of goods sold consists primarily of acquisition costs of the components of our r-SNM System, third-party contract labor costs, overhead costs, as well as distribution-related expenses such as logistics and shipping costs, net of costs charged to customers. The overhead costs include the cost of material procurement and operations supervision and management personnel. We expect overhead costs as a percentage of revenue to decrease as our sales volume increases, if our product is approved in the United States. In the future, our cost of goods sold will include expenses associated with our payment of royalties to AMF when we exceed the Minimum Royalty threshold, as well as scrap and inventory obsolescence. The Minimum Royalty amounts are currently included in research and development expenses. We expect cost of goods sold to increase in absolute dollars primarily as, and to the extent, our revenue grows. We expect gross margin to vary based on regional differences in pricing and discounts negotiated by customers. We calculate gross margin as gross profit divided by revenue. Revenues have been insignificant to date with prices based on evaluation agreements with one-time discounts offered. We expect future gross margin will be affected by a variety of factors, including manufacturing costs, the average selling price of our r-SNM System, the implementation of cost-reduction strategies, inventory obsolescence costs, which may occur when new generations of our r-SNM System are introduced, and to a lesser extent, the sales mix between the United States, Canada, Europe and Australia as our average selling price in the United States is expected to be higher than in Canada, Europe and Australia. Our gross margin may increase over the long term to the extent our production volumes increase and we receive discounts on the costs charged by our contract manufacturers, thereby reducing our per unit costs. Additionally, our gross margin may fluctuate from quarter to quarter due to seasonality. Research and Development Expenses The largest component of our total operating expenses has historically been research and development expenses. Research and development expenses consist primarily of employee compensation, including stock-based compensation, product development, including testing and engineering, and clinical studies to develop and support our r-SNM System, including clinical study management and monitoring, payments to clinical investigators, and data management. Other research and development expenses include consulting and advisory fees, travel expenses, and equipment-related expenses and other miscellaneous office and facilities expenses related to research and development programs. Research and development costs are expensed as incurred. We expect research and development expenses to increase in the future as we develop next generation versions of our r-SNM System and continue to expand our clinical studies to potentially add additional indications and expand to new markets. We expect research and development expenses as a percentage of revenue to vary over time depending on the level and timing of initiating new product development efforts and new clinical development activities. The following table summarizes our research and development expenses by functional area for the years ended December 31, 2018 and 2017 (in thousands): General and Administrative Expenses General and administrative expenses consist primarily of employee compensation, including stock-based compensation, and spending related to finance, information technology, human resource functions, consulting, legal, and professional service fees. Other general and administrative expenses include office-related expenses, facilities and equipment rentals, and travel expenses. We expect our general and administrative expenses will significantly increase in absolute dollars 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. Additionally, we anticipate increased expenses related to audit, legal, and tax-related services associated with maintaining compliance with regulations, exchange listing and SEC requirements, director and officer insurance premiums and investor relations costs associated with being a public company. These expenses may further increase when we no longer qualify as an “emerging growth company” under the Jumpstart Our Business Startups (JOBS) Act, which will require us to comply with certain reporting requirements from which we are currently exempt. We expect general and administrative expenses to decrease as a percentage of revenue primarily as, and to the extent, our revenue grows. Sales and Marketing Expenses Sales and marketing expenses consist primarily of trade shows, booth exhibition costs, and the related travel for these events. Other sales and marketing expenses include consulting and advisory fees, market access personnel and employee compensation, including stock-based compensation. In anticipation of potential FDA approval, we expect sales and marketing expenses to continue to increase in absolute dollars as we expand our commercial infrastructure to both drive and support our expected growth in revenue. In particular, we are in the process of hiring a specialty sales force of approximately 100 sales professionals, regional sales managers and clinical specialists in advance of the anticipated commercial launch of our r-SNM System in the United States, which will significantly increase our sales and marketing expense. However, we expect sales and marketing expenses to decrease as a percentage of revenue primarily as, and to the extent, our revenue grows. Other Income (Expense), Net Other income (expense), net consists primarily of interest income earned on cash equivalents and short-term investments, net of interest expense payable under the Loan Agreement with Silicon Valley Bank, and loss on disposal of property and equipment. Other income (expense), net also includes net unrealized mark-to-market gains (losses) on our preferred stock warrant liabilities. Income Tax Expense Income tax expense consists of state income taxes in California. We maintain a full valuation allowance for deferred tax assets including net operating loss carryforwards and research and development credits and other tax credits. Results of Operations Comparison of the Years Ended December 31, 2018 and 2017 The following table shows our results of operations for the years ended December 31, 2018 and 2017 (in thousands, except percentages): Net Revenue Net revenue was $0.7 million in fiscal year 2018 and was derived from the sale of our r-SNM Systems to customers in Europe and Canada. Net revenue was $0.1 million in fiscal year 2017 and consisted of a sale to a single customer in Canada. Cost of Goods Sold and Gross Margin We incurred $0.4 million of cost of goods sold in fiscal year 2018, compared to $0.1 million in fiscal year 2017. Gross margin was 49.7% in fiscal year 2018, compared to 7.9% gross margin in fiscal year 2017. The increase in gross margin is primarily due to country and product mix, and the lower gross margin in the prior year period is due to a one-time evaluation agreement with a hospital in Canada. Research and Development Expenses Research and development expenses increased $7.1 million, or 57.3%, to $19.4 million in fiscal year 2018, compared to $12.3 million in fiscal year 2017. The increase in research and development expenses was primarily attributable to an increase of $3.0 million in clinical development costs to demonstrate the safety and effectiveness of our r-SNM System and to support regulatory submissions, an increase of $2.4 million in personnel costs including $1.4 million in salaries and wages and $0.6 million in forgiveness of stock subscriptions receivable, and an increase of $1.4 million in contract fabrication and manufacturing costs. For more information on forgiveness of stock subscriptions receivable, see Note 6 to the Consolidated Financial Statements in Part II, Item 8 of this Report. General and Administrative Expenses General and administrative expenses increased $4.5 million, or 94.1%, to $9.4 million in fiscal year 2018, compared to $4.8 million in fiscal year 2017, primarily as a result of an increase of $2.6 million related to personnel costs including $1.2 million of forgiveness of stock subscriptions receivable and $0.9 million of salaries and wages, and an increase of $1.1 million in legal and consulting costs. For more information on forgiveness of stock subscriptions receivable, see Note 6 to the Consolidated Financial Statements in Part II, Item 8 of this Report. Sales and Marketing Expenses Sales and marketing expenses increased $2.7 million, or 261.6%, to $3.7 million in fiscal year 2018, compared to $1.0 million in fiscal year 2017. The increase in sales and marketing expenses was primarily due to an increase of $1.5 million related to personnel costs and costs of initial hiring of the sales force and an increase of $0.8 million related to expenses for general marketing expenses, conferences and tradeshows. Other Income (Expense), Net Other expense, net was $0.3 million in fiscal year 2018, consisting primarily of interest expense incurred related to the Loan Agreement with Silicon Valley Bank, partially offset by interest income earned on cash equivalents and short-term investments. Other income, net was $0.1 million in fiscal year 2017, which was primarily interest income earned on cash equivalents and short-term investments. Income Tax Expense Income tax expense was minimal in fiscal year 2018 and 2017. Liquidity and Capital Resources Since we commenced operations in late 2013, we have devoted substantially all of our resources to research and development activities related to our r-SNM System, including clinical and regulatory initiatives to obtain marketing approvals. Additionally, to date, we have generated minimal revenue from product sales and have never been profitable. While we have received regulatory approval in Europe, Canada, and Australia for OAB, FI, and UR, our main commercial priority is the United States, where we expect to begin to commercialize and market our r-SNM System initially for the treatment of OAB and UR, and generate revenue from product sales if and when approved by the FDA. In addition to the United States, we expect to expend capital resources pursuing commercial operations in Europe, Canada, and Australia, the amount and timing of which will depend on a variety of factors, including the size of the developed market for SNM therapy, burdens to entry in any such country or region, and other factors specific to certain respective countries and regions. We incurred net losses of $32.5 million and $18.1 million for the years ended December 31, 2018 and 2017, respectively, and had an accumulated deficit of $99.6 million as of December 31, 2018. In anticipation of potential FDA approval, we expect to spend a significant amount of our existing resources on sales and marketing activities as we begin to commercialize and market our r-SNM System in the United States. In particular, we are in the process of hiring a specialty sales force of approximately 100 sales professionals, regional sales managers and clinical specialists in advance of the anticipated commercial launch of our r-SNM System in the United States, which will significantly increase our sales and marketing expense. As of December 31, 2018, we had cash, cash equivalents and short-term investments of $157.5 million. Since inception and prior to our IPO, we raised an aggregate of $114.2 million in gross proceeds from private placements of our preferred stock. On October 30, 2018, we completed our IPO by issuing 9,200,000 shares of common stock, at an offering price of $15.00 per share, for net proceeds of approximately $126.0 million after deducting underwriting discounts and commissions and estimated offering expenses payable by us. Prior to the IPO, our primary sources of capital were from equity financings and amounts borrowed under the Loan Agreement with Silicon Valley Bank. In February 2018, we received $10.0 million from the first tranche (“Tranche A”) of the Term Loan simultaneously with our entry in the Loan Agreement. In October 2018, we received the full $5.0 million from the second tranche (“Tranche B”) and the full $5.0 million from (“Tranche C”). As of December 31, 2018, we had $21.5 million in outstanding borrowings, as discussed below under “Indebtedness.” We believe that our existing cash resources will be sufficient to meet our forecasted requirements for operating liquidity, capital expenditure and debt repayments for at least the next 12 months from the issuance of this Annual Report. If these sources are insufficient to satisfy our liquidity requirements, however, we may seek to sell additional equity, increase the availability under the Loan Agreement or enter into an additional loan agreement. If we raise additional funds by issuing equity securities, our stockholders could experience dilution. Debt financing, if available, may involve covenants further restricting our operations or our ability to incur additional debt. Any 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 acceptable to us. If we are unable to obtain additional financing when needed to satisfy our liquidity requirements, we may be required to delay the development, commercialization and marketing of our r-SNM System. Cash Flows The following table presents a summary of our cash flow for the periods indicated (in thousands): Net cash used in operating activities Net cash used in operating activities was $31.4 million in fiscal year 2018 and consisted primarily of a net loss of $32.5 million, a decrease in net operating assets of $2.9 million, partially offset by non-cash charges of $4.0 million. Net operating assets consisted primarily of inventory to support the planned launch of our commercial operations. Non-cash charges consisted primarily of forgiveness of receivables for stock subscriptions, depreciation and amortization, and stock-based compensation. Net cash used in operating activities was $18.2 million in fiscal year 2017 and consisted primarily of a net loss of $18.1 million, a decrease in net operating assets of $1.4 million, partially offset by non-cash charges of $1.3 million. Net operating assets consisted primarily of inventory to support the planned launch of our commercial operations. Non-cash charges consisted primarily of depreciation and amortization and stock-based compensation. Net cash used in investing activities Net cash used in investing activities was $60.1 million in fiscal year 2018 and consisted primarily of purchases and sales of short-term investments. Net cash used in investing activities was $1.0 million in fiscal year 2017 and consisted of purchases of property and equipment. Net cash provided by financing activities Net cash provided by financing activities was $165.3 million in fiscal year 2018 and consisted primarily of $126.0 million in net proceeds received in the IPO, $20.0 million of proceeds from our Term Loan with Silicon Valley Bank, and $20.1 million of proceeds from the issuance of shares of our Series C preferred stock. Net cash provided by financing activities was $34.8 million in fiscal year 2017 and consisted primarily of $35.0 million of proceeds from the issuance and sale of our Series C preferred stock. Indebtedness In February 2018, we entered into a Loan and Security Agreement with Silicon Valley Bank, which we and Silicon Valley Bank amended in October 2018, providing for the Term Loan. Pursuant to the Loan Agreement, we have drawn $20.0 million in three tranches of term loans, with such drawn obligations maturing on December 1, 2021. The Loan Agreement provides for monthly interest payments through December 31, 2019. On the first day of the end of the interest only period, we will be required to repay the Term Loan in equal monthly installments of principal plus interest through maturity. Outstanding principal balances under the Term Loan bear interest at the prime rate plus 1.75%. We may prepay amounts outstanding under the Term Loan in increments of $5.0 million at any time with 30 days prior written notice to Silicon Valley Bank. However, all prepayments of the Term Loan prior to maturity, whether voluntary or mandatory (acceleration or otherwise), are also subject to the payment of a prepayment fee equal to (i) for a prepayment made on or after the closing date through and including the first anniversary of the closing date, 3.00% of the principal amount of the Term Loan being prepaid, (ii) for a prepayment made after the date which is the first anniversary of the closing date through and including the second anniversary of the closing date, 2.00% of the principal amount of the Term Loan being prepaid, and (iii) for a prepayment made after the date which is the second anniversary of the closing date and before the maturity date, 1.00% of the principal amount of the Term Loan being prepaid. Additionally, on the earliest to occur of (i) the maturity date of the Term Loan, (ii) the acceleration of the Term Loan, or (iii) the prepayment of the Term Loan, we will be required to make a final payment equal to the original principal amount of such Tranche multiplied by 7.50%. We are currently accruing the portion of the final payment calculated based on the amount outstanding under the Term Loan. All obligations under the Term Loan are secured by a first priority lien on substantially all of our assets, excluding intellectual property assets and more than 65% of the shares of voting capital stock of any of our foreign subsidiaries. We have agreed with Silicon Valley Bank not to encumber our intellectual property assets without its prior written consent unless a security interest in the underlying intellectual property is necessary to have a security interest in the accounts and proceeds that are part of the assets securing the Term Loan, in which case our intellectual property shall automatically be included within the assets securing the Term Loan. The Loan Agreement contains certain covenants that limit our ability to engage in certain transactions that may be in our long-term best interest. Subject to certain limited exceptions, these covenants limit our ability to or prohibit us to permit any of our subsidiaries to, as applicable, among other things: • pay cash dividends on, make any other distributions in respect of, or redeem, retire or repurchase, any shares of our capital stock; • convey, sell, lease, transfer, assign, or otherwise dispose of all or any part of our business or property; • effect certain changes in our business, management, ownership or business locations; • merge or consolidate with, or acquire all or substantially all of the capital stock or property of any other company; • create, incur, assume, or be liable for any additional indebtedness, or create, incur, allow, or permit to exist any additional liens; • make certain investments; and • enter into transactions with our affiliates. While we have not previously breached and are currently in compliance with the covenants contained in the Loan Agreement, we may breach these covenants in the future. Our ability to comply with these covenants may be affected by events and factors beyond our control. In the event that we breach one or more covenants, Silicon Valley Bank may choose to declare an event of default and require that we immediately repay all amounts outstanding under the Loan Agreement, terminate any commitment to extend further credit and foreclose on the collateral. The occurrence of any of these events could have a material adverse effect on our business, financial condition and results of operations. An event of default includes, but is not limited to, the following: if we fail to make any payment under the Loan Agreement when due, if we fail or neglect to perform certain obligations under the Loan Agreement, if we violate certain covenants under the Loan Agreement, if certain material adverse changes occur, if we are unable to pay our debts as they become due or otherwise become insolvent, or if we begin an insolvency proceeding. In addition, we issued warrants to Silicon Valley Bank and Life Science Loans II, LLC, its counterparty. Each warrant entitles the holder thereof to purchase 40,000 shares of our common stock at an exercise price of $7.50 per share. Each warrant will expire on February 6, 2028. We have no further indebtedness arrangements. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements, as defined by applicable regulations of the SEC, 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. Critical Accounting Policies and Estimates The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States (“GAAP”) requires our management to make estimates and judgments that affect the amounts reported in our consolidated financial statements and accompanying notes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable and supportable under the circumstances. The results of this evaluation then 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, and such differences may be material to our consolidated financial statements. While our significant accounting policies are more fully described in Note 1 to the Consolidated Financial Statements in Part II, Item 8 of 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 the portrayal of our financial condition and results of operations and require our most difficult, subjective and complex judgments. Revenue Recognition Since we commenced operations in late 2013, we have recognized minimal revenue. Although we have begun limited commercial activities in the EU, our main priority is the United States where we expect to begin to commercialize and market our r-SNM System and generate revenue from product sales if and when approved by the FDA. In addition, we plan to strategically expand into favorable international markets. If we are unable to accomplish any of these objectives, it could have a significant negative impact on our future revenue. If we fail to generate revenue in the future, our business, results of operations, financial condition, cash flows and future prospects would be materially and adversely affected. Revenue recognized during the years ended December 31, 2018 and 2017 relates entirely to the sale of our r-SNM System. In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-09 “Revenue from Contracts with Customers” (“ASU 2014-09”) as Accounting Standards Codification (“ASC”) Topic 606. The objective of Topic 606 is to establish a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and superseded most of the existing revenue recognition guidance, including industry-specific guidance. The core principle is that a company 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. Topic 606 applies to all contracts with customers except those that are within the scope of other topics in the FASB ASC. Effective January 1, 2018, we early adopted the comprehensive new revenue recognition standard using the modified retrospective method. We make reasonable assumptions regarding the future collectability of amounts receivable from customers to determine whether the revenue recognition criteria have been met. Taxes assessed by a governmental authority that are directly imposed on revenue-producing transactions between a seller and a customer are not recorded as revenue. In general, our standard terms and conditions of sale do not allow for product returns. We expense shipping and handling costs as incurred and include them in the cost of goods sold. In those cases where shipping and handling costs are billed to customers, we classify the amounts billed as a component of cost of goods sold. Fair Value of Financial Instruments Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. A three-level fair value hierarchy prioritizes the inputs used to measure fair value. The hierarchy requires entities to maximize the use of observable inputs and minimize the use of unobservable inputs. The three levels of inputs used to measure fair value are as follows: • Level 1: Inputs are unadjusted quoted prices in active markets for identical assets or liabilities. • Level 2: Inputs are quoted prices for similar assets and liabilities in active markets or quoted prices for identical or similar instruments in markets that are not active and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets. • Level 3: Inputs are unobservable inputs based on our assumptions and valuation techniques used to measure assets and liabilities at fair value. The inputs require significant management judgment or estimation. Our assessment of the significance of an input to the fair value measurement requires judgment, which may affect the valuation of fair value assets and liabilities and their placement within the fair value hierarchy levels. The carrying amounts reported in the consolidated financial statements approximate the fair value for cash and cash equivalents, accounts receivable, accounts payables, and accrued expenses, due to their short-term nature. The carrying amount of our term loan, which is described below, approximates fair value, considering the interest rates are based on the prime interest rate. Investment Securities We classify our investment securities as available-for-sale. Those investments in debt securities with maturities less than 12 months at the date of purchase are considered short-term investments. Those investments in debt securities with maturities greater than 12 months at the date of purchase are considered long-term investments. Our investment securities classified as available-for-sale are recorded at fair value based on the fair value hierarchy (Level 1 and Level 2 inputs in the fair value hierarchy), and consists primarily of commercial paper, corporate notes and U.S. government and agency securities. Unrealized gains or losses, deemed temporary in nature, are reported as interest income within the consolidated statement of comprehensive income (loss). Inventory Inventories are stated at the lower of cost or net realizable value, with cost computed on a first-in, first-out basis. We capitalize inventory produced for commercial sale. Costs associated with developmental products prior to satisfying our inventory capitalization criteria are charged to research and development expense as incurred. Products that have been approved by certain regulatory authorities are also used in clinical programs to assess the safety and efficacy of the products for usage that have not been approved by the FDA or other regulatory authorities. The form of product utilized for both commercial and clinical programs is identical and, as a result, the inventory has an “alternative future use” as defined in authoritative guidance. Component materials and purchased products associated with clinical development programs are included in inventory and charged to research and development expense when the product enters the research and development process and no longer can be used for commercial purposes and, therefore, does not have an “alternative future use.” For products that are under development and have not yet been approved by regulatory authorities, purchased component materials are charged to research and development expense when the inventory ownership transfers to us. We analyze inventory levels to identify inventory that may expire prior to sale, inventory that has a cost basis in excess of its net realizable value, or inventory in excess of expected sales requirements. Although the manufacturing of the r-SNM System is subject to strict quality control, certain batches or units of product may no longer meet quality specifications or may expire, which would require adjustments to our inventory values. We also apply judgment related to the results of quality tests that are performed throughout the production process, as well as the understanding of regulatory guidelines, to determine if it is probable that inventory will be saleable. These quality tests are performed throughout the pre- and post-production processes, and we continually gather information regarding product quality for periods after the manufacturing date. The r-SNM System currently has a maximum estimated shelf life range of 12 to 27 months and, based on sales forecasts, we expect to realize the carrying value of the product inventory. In the future, reduced demand, quality issues, or excess supply beyond those anticipated by management may result in a material adjustment to inventory levels, which would be recorded as an increase to cost of sales. The determination of whether or not inventory costs will be realizable requires estimates by our management. A critical input in this determination is future expected inventory requirements based on internal sales forecasts. Management then compares these requirements to the expiry dates of inventory on hand. To the extent that inventory is expected to expire prior to being sold, management will write down the value of inventory. We began capitalizing the r-SNM System manufacturing costs as inventory following both the receipt of regulatory approval from the European and Canadian regulatory bodies and the Company’s intent to commercialize, which occurred in 2017. As of December 31, 2018, we had $0.9 million and $2.7 million of finished goods inventory and raw materials inventory, respectively, on hand. As of December 31, 2017, we had $0.2 million and $1.3 million of finished goods inventory and raw materials inventory, respectively, on hand. As of December 31, 2018 and 2017, there were minimal work-in-process inventory on hand. Intangible Asset The intangible asset represents exclusive rights to an additional field-of-use on the patent suite within the License Agreement with AMF. The additional field-of-use was provided in exchange for 50,000 shares of Series A preferred stock, the fair value of which was $1.0 million in 2013. The intangible asset was recorded at its fair value of $1.0 million at the date contributed. Amortization of this asset is recorded over the shorter of the patent or legal life on a straight-line basis. The weighted-average amortization period is 8.71 years. We will review the intangible asset for impairment whenever an impairment indicator exists. There have been no intangible asset impairment charges to date. Impairment of Long-Lived Assets We review our long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability is measured by comparing the carrying amount to the future net cash flows that the assets are expected to generate. If said assets are considered to be impaired, the impairment that would be recognized is measured by the amount by which the carrying amount of the assets exceeds the projected discounted future net cash flows arising from the asset. There have been no such impairments of long-lived assets to date. Leases We determine if an arrangement is a lease at inception and include operating leases on our consolidated balance sheets. The operating lease right-of-use (“ROU”) asset is included within our other non-current assets, and lease liabilities are included in current or noncurrent liabilities on our consolidated balance sheets. Operating lease ROU asset and operating lease liabilities are recognized based on the present value of the future minimum lease payments over the lease term at commencement date. As our lease does not provide an implicit rate, we use our incremental borrowing rate based on the information available at commencement date in determining the present value of future payments. The operating lease ROU asset also includes any lease payments made and excludes lease incentives and initial direct costs incurred. The lease terms may include options to extend or terminate the lease when it is reasonably certain that we will exercise that option. Lease expense for minimum lease payments is recognized on a straight-line basis over the lease term. Research and Development Research and development costs are charged to operations as incurred. Research and development costs include salary and personnel-related costs, costs of clinical studies and testing, supplies and materials, and outside consultant costs. Costs of clinical studies and testing include fees paid to hospitals and physicians for the enrollment and treatment of patients, related product manufacturing expenses for the products used in the studies, fees paid to CROs, other consultants, and other outside expenses. Our research and development team focuses on our r-SNM System, including our clinical studies, as well as evaluations of improvements and enhancements to our r-SNM System. For the years ended December 31, 2018 and 2017, we incurred research and development expenses of $19.4 million and $12.3 million, respectively. Income Taxes We account for income taxes using the asset and liability method to compute the difference between the tax basis of assets and liabilities and the related financial amounts, using currently enacted tax rates. We have deferred tax assets. The realization of these deferred tax assets is dependent upon our ability to generate sufficient taxable income in future years. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount that more likely than not will be realized. We evaluate the recoverability of the deferred tax assets annually. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by taxing authorities, based on the technical merits of the position. We have determined that we have no uncertain tax positions. Stock-Based Compensation We maintain an equity incentive plan to provide long-term incentives for employees and certain advisors and consultants. The plan allows for the issuance of nonstatutory and incentive stock options to employees and nonstatutory stock options to consultants and non-employee directors. We measure the cost of employee services in exchange for an award of equity instruments based on the grant-date fair value of the award and recognize compensation cost over the requisite service period (typically the vesting period), generally four years. We account for equity instruments issued to non-employees based on the fair value of the award, which is periodically re-measured as they vest over the performance period. The related expense is recognized over the performance period. 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. The Black-Scholes option pricing model requires the input of certain subjective assumptions, including (i) the expected share price volatility, (ii) the expected term of the award, (iii) the risk-free interest rate, and (iv) 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 the estimate of expected volatility on the historical volatility of a group of similar companies that are publicly traded. Similarities with such companies include being at the stage of product development and focused on the medical technology industry. The historical volatility is calculated based on a period of time commensurate with the expected term assumption. 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. Internal Controls and Procedures We will be required, pursuant to Section 404(a) of the Sarbanes-Oxley Act, to furnish a report by management on, among other things, the effectiveness of our internal control over financial reporting for the year following our first annual report required to be filed with the SEC. This assessment will need to include disclosure of any material weaknesses identified by management over our internal control over financial reporting. However, our independent registered public accounting firm will not be required to report on the effectiveness of our internal control over financial reporting pursuant to Section 404(b) until the later of the year following our first annual report required to be filed with the SEC, or the date we are no longer an “emerging growth company” if we take advantage of the exemptions contained in the JOBS Act. We are in the very early stages of the costly and challenging process of compiling the system and processing documentation necessary to perform the evaluation needed to comply with Section 404. We may not be able to complete our evaluation, testing or any required remediation in a timely fashion. During the evaluation and testing process, if we identify one or more material weaknesses in our internal control over financial reporting, we will be unable to assert that our internal controls are designed and operating effectively, which could result in a loss of investor confidence in the accuracy and completeness of our financial reports. This could cause the price of our common stock to decline, and we may be subject to investigation or sanctions by the SEC. Recent Accounting Pronouncements For recent accounting pronouncements, see Note 1, Nature of Operations and Summary of Significant Accounting Policies, of Notes to Consolidated Financial Statements in Part II, Item 8 of this Annual Report. JOBS Act As a company with less than $1.07 billion in revenue during our last fiscal year, we qualify as an “emerging growth company,” as defined in the JOBS Act. An emerging growth company may take advantage of reduced reporting requirements that are otherwise applicable to public companies. These provisions include: • an exemption from compliance with the auditor attestation requirement in the assessment of our internal control over financial reporting pursuant to the Sarbanes-Oxley Act; • reduced disclosure about executive compensation arrangements in our periodic reports, registration statements and proxy statements; • exemptions from the requirements to seek non-binding advisory votes on executive compensation or golden parachute arrangements; and • delay implementing new accounting standards until such time as those standards apply to private companies. We may take advantage of these provisions until the last day of our fiscal year following the fifth anniversary of the completion of our IPO. However, if certain events occur prior to the end of such five-year period, including if we become a “large accelerated filer,” our annual gross revenue is $1.07 billion or more or we issue more than $1.0 billion of non-convertible debt in any three-year period, we will cease to be an emerging growth company prior to the end of such five-year period. We have elected to take advantage of certain of the reduced disclosure obligations in this Annual Report on Form 10-K and may elect to take advantage of other reduced reporting requirements in future filings. As a result, the information that we provide to our stockholders may be different from what you might receive from other public reporting companies in which you hold equity interests. We have elected not to delay implementing new accounting standards until such time as those standards apply to private companies. Section 107 of the JOBS Act provides that we can elect to opt out of the extended transition period at any time, which election is irrevocable.
-0.063577
-0.063515
0
<s>[INST] We are a medical technology company that has developed and is commercializing an innovative and minimally invasive implantable neurostimulation system. SNM therapy is primarily used to treat patients with OAB, including UUI and UUF, FI, and UR. OAB affects an estimated 87 million adults in the United States and Europe. Another estimated 40 million adults are reported to suffer from FI. SNM therapy is an effective and durable treatment that has been widely used and reimbursed in Europe and the United States for the past two decades. SNM is the only OAB treatment with proven clinical superiority to standard medical therapy and OAB patients who receive SNM report significantly higher quality of life than patients undergoing drug treatment. We believe our proprietary rSNM System offers significant advantages, including being the first and only rechargeable SNM system that is designed to be 60% smaller than existing technology and to last approximately 15 years. We believe our rSNM System has the potential to disrupt and grow the estimated $650 million global SNM market in 2018, which is currently controlled by a single participant. We currently have marketing approvals in Europe, Canada, and Australia for OAB, FI, and UR. On December 3, 2018, we submitted a literaturebased PMA application to the FDA for OAB and UR. This literaturebased PMA was based on reasonable safety and effectiveness data from a literature review. In this PMA filing, we submitted existing literature reporting on InterStim II. In addition to the technical specifications, testing data and published literature, we included oneyear followup data from our 51patient RELAXOAB European postmarket clinical followup study to support the PMA, and subsequently provided the FDA with the clinical results on the first 60 patients to reach their sixmonth primary endpoint from our ARTISANSNM pivotal study. Since the original PMA submission in December 2018, we have submitted various amendments to the PMA. These amendments include data in support of conditional fullbody magnetic resonance imaging (“MRI”) labeling and complete threemonth and sixmonth clinical data from the ARTISANSNM study. On March 1, 2019, we submitted a new literaturebased PMA seeking approval for FI. This PMA is also based on an existing literature review of Interstim II. Typically, the PMA review process takes six to 18 months, with the duration depending on a variety of factors. We will continue to maintain our core strategy of pursuing what is, in our view, the most expeditious pathway within the PMA processes to achieving FDA clearance to market the Axonics rSNM system in the United States. Specifically, it is our understanding that the literaturebased PMA submission did not impact the ARTISANSNM pivotal study, nor, in our understanding, did the submission of the complete data from our ARTISANSNM pivotal study impact the schedule of the literaturebased PMA process. The literaturebased PMA filing now includes the data from all 129 subjects treated in the ARTISANSNM pivotal study and we believe that the questionresponse process between us and the FDA will prove beneficial in the overall PMA review process. We have retained the option to file a PMA submission at any time based on the ARTISANSNM pivotal study data and additional required information, or to rely solely on the literaturebased application currently under review, whichever appears to represent, in our judgment, the most efficient and timely pathway to approval. Since we commenced operations in late 2013, we have generated minimal revenue, as our activities have consisted primarily of developing our rSNM System, conducting our RELAXOAB postmarket clinical followup study in Europe and our ARTISANSNM pivotal study in the United States and Europe, and filing for regulatory approvals. In the future, if our rSNM System is approved in the United States, we expect to generate revenue from product sales. Our ability to generate revenue and become profitable will depend on our ability to successfully commercialize our rSNM System and any product enhancements we may advance in the future. Although we have begun limited commercial activities in Europe, our main priority is the United States, where we expect to begin to commercialize and market our rSNM System and generate revenue from product sales [/INST] Negative. </s>
2,019
9,161
1,603,756
Axonics Modulation Technologies, Inc.
2020-03-04
2019-12-31
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. Overview We are a medical technology company that has developed and is commercializing innovative and minimally invasive implantable SNM used to treat patients with UUI and UUF, together referred to as OAB, as well as FI, and non-obstructive UR. OAB affects an estimated 87 million adults in the United States and Europe. Another estimated 40 million adults are reported to suffer from FI. SNM therapy is an effective and durable treatment that has been widely used and reimbursed in Europe and the United States for the past two decades. SNM is the only OAB treatment with proven clinical superiority to standard medical therapy and OAB patients who receive SNM report significantly higher quality of life than patients undergoing drug treatment. We believe our proprietary r-SNM System offers significant advantages, including being the first and only rechargeable SNM system. It is designed to last approximately 15 years and is 60% smaller than existing technology. We believe our r-SNM System has the potential to disrupt and grow the approximately $650 million, as of 2018, global SNM market, which has historically been served by Medtronic, as a single participant. Since we commenced operations in late 2013, our activities have consisted primarily of developing our r-SNM System, conducting our RELAX-OAB post-market clinical follow up study in Europe and our ARTISAN-SNM pivotal clinical study in the United States and Europe, filing for regulatory approvals and hiring and training our U.S. commercial team. We have marketing approvals in Europe, Canada, and Australia for all relevant clinical indications and initiated limited commercial efforts in Europe and Canada in late 2018. Revenue in 2019 from international operations in select markets, including England, the Netherlands and Canada, was $5.4 million. On September 6, 2019, our PMA application for our r-SNM System for the treatment of FI was approved by the FDA and on November 13, 2019, our PMA application for our r-SNM System for the treatment of OAB and UR was approved by the FDA. Accordingly, we began U.S. commercialization of our r-SNM System in the middle of the fourth quarter of 2019 and generated $8.4 million in revenue during that period. Our ability to generate revenue and become profitable will depend on our ability to successfully commercialize our r-SNM System and any product enhancements we may advance in the future. Although we have limited commercial activities in Europe and Canada, our main priority is the United States, where we began to commercialize and market our r-SNM System in the fourth quarter of 2019. During the first half of 2019, we established a significant commercial infrastructure in advance of FDA approval of our r-SNM System and we continued to make significant investments to build our sales and marketing organization by hiring dedicated sales and clinical personnel to market and support our product in the United States and Canada. Specifically, we hired and trained a dedicated direct sales organization, comprised of approximately 100 sales professionals, 11 regional sales managers and 48 clinical specialists. We hired and trained sales representatives and clinical specialists with strong sales backgrounds and experience in SNM therapy and other neurostimulation applications, and with relationships with urologists and urogynecologists. If we are unable to accomplish any of these objectives, it could have a significant negative impact on our future revenue. If we fail to generate revenue in the future, our business, results of operations, financial condition, cash flows, and future prospects would be materially and adversely affected. We also intend to continue to make investments in research and development efforts to develop improvements and enhancements to our r-SNM System. We expect to derive future revenue by increasing patient and physician awareness of our r-SNM System. In the United States, the cost required to treat each patient is reimbursed through various third-party payors, such as commercial payors and government agencies. Most large insurers have established coverage policies in place to cover SNM therapy. Certain commercial payors have a patient-by-patient prior authorization process that must be followed before they will provide reimbursement for SNM therapy. Outside the United States, reimbursement levels vary significantly by country and by region, particularly based on whether the country or region at issue maintains a single-payor system. SNM therapy is eligible for reimbursement in Canada, Australia, and certain countries in Europe, such as Germany, France, and the United Kingdom. Annual healthcare budgets generally determine the number of SNM systems that will be paid for by the payor in these single-payor system countries and regions. We currently outsource the manufacture of the implantable components of our r-SNM System. We plan to continue with an outsourced manufacturing arrangement for the foreseeable future. Our contract manufacturers are all recognized in their field for their competency to manufacture the respective portions of our r-SNM System and have quality systems established that meet FDA requirements. We believe the manufacturers we currently utilize have sufficient capacity to meet our launch requirements and are able to scale up their capacity relatively quickly with limited capital investment. Prior to obtaining FDA approval, we devoted substantially all of our resources to research and development activities related to our r-SNM System, including clinical and regulatory initiatives to obtain marketing approvals. We expect to spend a significant amount of our resources on sales and marketing activities as we begin to commercialize and market our r-SNM System in the United States. We incurred net losses of $79.9 million and $32.5 million for the years ended December 31, 2019 and 2018, and had an accumulated deficit of $179.6 million as of December 31, 2019 compared to $99.6 million at December 31, 2018. As of December 31, 2019, we had available cash, cash equivalents and short-term investments of approximately $183.7 million, current liabilities of approximately $12.0 million, and long-term liabilities of approximately $24.8 million. Prior to our IPO, we financed our operations primarily through preferred stock financings and amounts borrowed under the Loan Agreement. We have invested heavily in product development and continuous improvement to our r-SNM System. We have also made significant investments in clinical studies to demonstrate the safety and effectiveness of our r-SNM System and to support regulatory submissions. Because of these and other factors, we expect to continue to incur net losses for the next few years and we may require additional funding, which may include future equity and debt financings. 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 and adverse effect on our business, financial condition, and results of operations. Initial Public Offering On November 2, 2018, we completed our IPO by issuing 9,200,000 shares of common stock, at an offering price of $15.00 per share, inclusive of 1,200,000 shares of our common stock issued upon the exercise by the underwriters of their option to purchase additional shares. The gross proceeds from the IPO were $138.0 million and the net proceeds were approximately $126.0 million, after deducting underwriting discounts, commissions and estimated offering expenses payable by us. In connection with the IPO, our outstanding shares of convertible preferred stock were automatically converted into an aggregate of 15,813,297 shares of common stock, and our outstanding warrants to purchase shares of Series C convertible preferred stock were automatically converted into warrants to purchase up to an aggregate of 80,000 shares of common stock. Follow-On Offering On November 22, 2019, we completed a follow-on offering by issuing 5,345,000 shares of common stock, at an offering price of $22.00 per share, inclusive of 750,000 shares of our common stock issued upon the exercise by the underwriters of their option to purchase additional shares. The gross proceeds to us from this follow-on offering were $117.6 million and the net proceeds were approximately $110.4 million, after deducting underwriting discounts, commissions and estimated offering expenses payable by us. AMF License Agreement On October 1, 2013, we entered into the License Agreement, pursuant to which AMF granted us a royalty-bearing, sublicensable license to the AMF IP. The license to the AMF IP allows us to make, have made, lease, offer to lease, use, sell, offer for sale, market, promote, advertise, import, research, develop and commercialize the AMF Licensed Products worldwide for the treatment of (i) chronic pain in humans through the application of electrical energy to the nervous system, (ii) inflammatory conditions of the human body through the application of electrical energy to the vagus nerve, a nerve that interfaces with parasympathic control of the heart, lungs and digestive tract and (iii) bladder and bowel dysfunction in humans through the application of electrical energy anywhere in or on the human body, excluding, in each case, any product or method that involves the placement of electrodes or the administration of electrical stimulation inside the cranial cavity or to the ocular nervous system or the auditory nervous system. We have the right to expand the field of use for the AMF Licensed Products to the modulation of digestive process and treatment of digestive conditions in humans through the application of electrical energy anywhere in or on the body, subject to the exclusions described above. Generally, the license is non-transferable without the prior written consent of AMF, except to an affiliate of our company or in connection with the acquisition of our company (whether by merger, consolidation, sale or otherwise) or the part of our business to which the License Agreement relates, provided that the assignee agrees in writing to be bound to the terms of the License Agreement to which we are bound. The license is co-exclusive with AMF solely with respect to (i) AMF IP resulting from AMF’s performance of any engineering services rendered under the License Agreement, and (ii) AMF’s right to use AMF IP for non-commercial research, educational and scholarly purposes. We granted to AMF a royalty-free, worldwide, sublicensable, perpetual, exclusive license to the Axonics Licensed IP. This license granted by us to AMF explicitly excludes uses of the Axonics Licensed IP that are within the scope of the exclusive license of the AMF IP granted by AMF to us. Such license is irrevocable unless we terminate the License Agreement and AMF does not agree to pay us compensation for such license mutually agreed between us and AMF or determined by arbitration in accordance with the terms of the License Agreement. Any and all improvements to AMF IP made by us will be owned by AMF and licensed to us under the License Agreement. To date, we have not made any improvements to the inventions claimed in the AMF IP that constitute Axonics Licensed IP. In addition, the License Agreement provides AMF with the AMF Option to license from us any intellectual property owned by us or otherwise in our control that is related to electrical stimulation of human tissue, separate from the Axonics Licensed IP and AMF IP, on terms that are materially consistent with the terms upon which we license the AMF IP pursuant to the License Agreement, and subject to field of use restrictions that would be determined upon the exercise of the AMF Option. AMF has expressly declined in writing to exercise the AMF Option. Under the License Agreement, for each calendar year beginning in 2018, we are obligated to pay AMF a royalty on an AMF Licensed Product-by-AMF Licensed Product basis if one of the following conditions applies: (i) one or more valid claims within any of the patents licensed to us by AMF covers such AMF Licensed Products or the manufacture of such AMF Licensed Products or (ii) for a period of 12 years from the first commercial sale anywhere in the world of such AMF Licensed Product, in each case. The foregoing royalty is calculated as the greater of (a) 4% of all net revenue derived from the AMF Licensed Products, and (b) the Minimum Royalty, payable quarterly. The Minimum Royalty automatically increases each year, subject to a maximum amount of $200,000 per year. During the years ended December 31, 2019 and 2018, we have recorded related royalties of $0.6 million and $0.1 million, respectively. We have 60 days to pay AMF the royalty amount due under the License Agreement, and if we fail to pay AMF within such 60-day period, AMF may, at its election, convert the exclusive license to a non-exclusive license or terminate the License Agreement. Each party may terminate the License Agreement if the other party commits a material breach of any obligation under the License Agreement and such breach is not cured within 90 days following receipt of notice of such breach from the other party. AMF may terminate the License Agreement upon (i) notice to us in the event we challenge or assist any other person or entity in challenging the patentability, enforceability or validity of any of the AMF patents licensed to us under the License Agreement, subject to certain exceptions including challenges that we are not infringing any such AMF patent, and (ii) upon our filing of or the institution of bankruptcy, reorganization, liquidation or receivership proceedings, or upon an assignment of a substantial portion of our assets for the benefit of creditors, and in the case of involuntary bankruptcy, in the event we consent to such bankruptcy and it is not dismissed within 90 days. Lastly, we may terminate the License Agreement in full for any reason effective upon 60 days written notice to AMF. The License Agreement was amended twice in February 2014 in order to, among other things, include the field of the treatment of bladder and bowel dysfunction in humans through the application of electrical energy anywhere in or on the human body, within the scope of the licenses granted therein. The License Agreement allows AMF the right to use the AMF IP for non-commercial research, educational and scholarly purposes. Components of Our Results of Operations Net Revenue Since we commenced operations in late 2013, our activities have consisted primarily of developing our r-SNM System, conducting our RELAX-OAB post-market clinical follow up study in Europe and our ARTISAN-SNM pivotal clinical study in the United States and Europe, filing for regulatory approvals and hiring and training our U.S. commercial team. We have marketing approvals in Europe, Canada, and Australia for all relevant clinical indications and initiated limited commercial efforts in Europe and Canada in late 2018. Revenue in 2019 from international operations in select markets, including England, the Netherlands and Canada, was $5.4 million. On September 6, 2019, our PMA application for our r-SNM System for the treatment of FI was approved by the FDA and on November 13, 2019, our PMA application for our r-SNM System for the treatment of OAB and UR was approved by the FDA. Accordingly, we began U.S. commercialization of our r-SNM System in the middle of the fourth quarter of 2019 and generated $8.4 million in revenue during that period. Our ability to generate revenue and become profitable will depend on our ability to successfully commercialize our r-SNM System and any product enhancements we may advance in the future. Although we have limited commercial activities in Europe and Canada, our main priority is the United States, where we began to commercialize and market our r-SNM System and generate revenue from product sales in the fourth quarter of 2019. We have established a significant commercial infrastructure to support our product launch in the United States. We expect to derive future revenue by increasing patient and physician awareness of our r-SNM System. If we are unable to accomplish any of these objectives, it could have a significant negative impact on our future revenue. If we fail to generate revenue in the future, our business, results of operations, financial condition, cash flows, and future prospects would be materially and adversely affected. Cost of Goods Sold and Gross Margin Cost of goods sold consists primarily of acquisition costs of the components of our r-SNM System, third-party contract labor costs, overhead costs, as well as distribution-related expenses such as logistics and shipping costs, net of costs charged to customers. The overhead costs include the cost of material procurement and operations supervision and management personnel. We expect overhead costs as a percentage of revenue to decrease as our sales volume increases. In the future, our cost of goods sold will include other expenses such as scrap and inventory obsolescence. We expect cost of goods sold to increase in absolute dollars primarily as, and to the extent, our revenue grows. We expect gross margin to vary based on regional differences in pricing and discounts negotiated by customers. We calculate gross margin as gross profit divided by revenue. Revenues have been insignificant to date with prices based on evaluation agreements with one-time discounts offered. We expect future gross margin will be affected by a variety of factors, including manufacturing costs, the average selling price of our r-SNM System, the implementation of cost-reduction strategies, inventory obsolescence costs, which may occur when new generations of our r-SNM System are introduced, and to a lesser extent, the sales mix between the United States, Canada, Europe and Australia as our average selling price in the United States is expected to be higher than in Canada, Europe and Australia. Our gross margin may increase over the long term to the extent our production volumes increase and we receive discounts on the costs charged by our contract manufacturers, thereby reducing our per unit costs. Additionally, our gross margin may fluctuate from quarter to quarter due to seasonality. Research and Development Expenses Research and development expenses consist primarily of employee compensation, including stock-based compensation, product development, including testing and engineering, and clinical studies to develop and support our r-SNM System, including clinical study management and monitoring, payments to clinical investigators, and data management. Other research and development expenses include consulting and advisory fees, royalty expense, travel expenses, and equipment-related expenses and other miscellaneous office and facilities expenses related to research and development programs. Research and development costs are expensed as incurred. We expect to continue incurring research and development expenses in the future as we develop next generation versions of our r-SNM System and expand to new markets. We expect research and development expenses as a percentage of revenue to vary over time depending on the level and timing of initiating new product development efforts and new clinical development activities. The following table summarizes our research and development expenses by functional area for the years ended December 31, 2019 and 2018 (in thousands): General and Administrative Expenses General and administrative expenses consist primarily of employee compensation, including stock-based compensation, and spending related to finance, information technology, human resource functions, consulting, legal, and professional service fees. Other general and administrative expenses include office-related expenses, facilities and equipment rentals, and travel expenses. We expect our general and administrative expenses will significantly increase in absolute dollars 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. Additionally, we anticipate increased expenses related to audit, legal, and tax-related services associated with maintaining compliance with regulations, exchange listing and SEC requirements, director and officer insurance premiums and investor relations costs associated with being a public company. These expenses may further increase when we no longer qualify as an “emerging growth company” under the Jumpstart Our Business Startups (JOBS) Act, which will require us to comply with certain reporting requirements from which we are currently exempt. We expect general and administrative expenses to decrease as a percentage of revenue primarily as, and to the extent, our revenue grows. Sales and Marketing Expenses Sales and marketing expenses consist primarily of employee compensation, including stock-based compensation, trade shows, booth exhibition costs, and the related travel for these events. Other sales and marketing expenses include consulting and advisory fees. We expect sales and marketing expenses to continue to increase in absolute dollars as we expand our commercial infrastructure to both drive and support our expected growth in revenue. Specifically, we hired and trained a dedicated direct sales organization, comprised of approximately 100 sales professionals, 11 regional sales managers and 48 clinical specialists. However, we expect sales and marketing expenses to decrease as a percentage of revenue in the long term primarily as, and to the extent, our revenue grows. Other Income (Expense), Net Other income (expense), net consists primarily of interest income earned on cash equivalents and short-term investments, net of interest expense payable under the Loan Agreement with Silicon Valley Bank. Other income (expense), net also includes net unrealized mark-to-market gains (losses) on our preferred stock warrant liabilities. Income Tax Expense Income tax expense consists of state income taxes in California. We maintain a full valuation allowance for deferred tax assets including net operating loss carryforwards and research and development credits and other tax credits. Results of Operations Comparison of the Years Ended December 31, 2019 and 2018 The following table shows our results of operations for the years ended December 31, 2019 and 2018 (in thousands, except percentages): Net Revenue Net revenue was $13.8 million in fiscal year 2019 and was derived from the sale of our r-SNM Systems to customers in the United States, Europe and Canada. Net revenue was $0.7 million in fiscal year 2018 and was derived from the sale of our r-SNM Systems to customers in Europe and Canada. The increase in net revenue is primarily due to $8.4 million attributable to our commercial launch in the United States. Cost of Goods Sold and Gross Margin We incurred $6.5 million of cost of goods sold in fiscal year 2019, compared to $0.4 million in fiscal year 2018. Gross margin was 53.0% in fiscal year 2019, compared to 49.7% gross margin in fiscal year 2018. The increase in gross margin is primarily due to country and product mix. Research and Development Expenses Research and development expenses increased $0.8 million, or 4.0%, to $20.2 million in fiscal year 2019, compared to $19.4 million in fiscal year 2018. The increase in research and development expenses was primarily attributable to an increase of $3.5 million in personnel costs including salaries and wages, stock-based compensation and other employee-related benefits, an increase of $3.1 million in contract research and development and consulting expenses, partially offset by a decrease of $3.2 million in clinical development costs to demonstrate the safety and effectiveness of our r-SNM System and to support regulatory submissions and a decrease of $2.9 million in contract fabrication and manufacturing costs. General and Administrative Expenses General and administrative expenses increased $9.7 million, or 103.8%, to $19.1 million in fiscal year 2019, compared to $9.4 million in fiscal year 2018, primarily as a result of an increase of $4.5 million in personnel costs including salaries and wages, stock-based compensation and other employee-related benefits, an increase of $3.6 million in legal and consulting costs, and an increase of $0.7 million in rent expense. Sales and Marketing Expenses Sales and marketing expenses increased $44.9 million, or 1,207.0%, to $48.7 million in fiscal year 2019, compared to $3.7 million in fiscal year 2018. The increase in sales and marketing expenses was primarily due to an increase of $35.0 million related to personnel costs including salaries and wages, stock-based compensation and other employee-related benefits, as we increased headcount by hiring and training our U.S. commercial team, an increase of $5.1 million in travel expenses, and an increase of $2.8 million related to expenses for general marketing expenses, conferences and tradeshows. Other Income (Expense), Net Other income, net was $0.7 million in fiscal year 2019, consisting primarily of interest income earned on cash equivalents and short-term investments, partially offset by interest expense incurred related to the Loan Agreement with Silicon Valley Bank. Other expense, net was $0.3 million in fiscal year 2018, consisting primarily of interest expense incurred related to the Loan Agreement with Silicon Valley Bank, partially offset by interest income earned on cash equivalents and short-term investments. Income Tax Expense Income tax expense was minimal in fiscal year 2019 and 2018. Liquidity and Capital Resources Since we commenced operations in late 2013, we have devoted substantially all of our resources to research and development activities related to our r-SNM System, including clinical and regulatory initiatives to obtain marketing approvals, and hiring and training our sales organization. Additionally, to date, revenue generated from product sales has had minimal impact on our operations, and we have never been profitable. We have marketing approvals in Europe, Canada, and Australia for all relevant clinical indications and initiated limited commercial efforts in Europe and Canada in late 2018. On September 6, 2019, our PMA application for our r-SNM System for the treatment of FI was approved by the FDA and on November 13, 2019, our PMA application for our r-SNM System for the treatment of OAB and UR was approved by the FDA. Our main commercial priority is the United States, where we began to commercialize and market our r-SNM System and generate revenue from product sales in the fourth quarter of 2019. In addition to the United States, we expect to expend capital resources pursuing commercial operations in Europe, Canada, and Australia, the amount and timing of which will depend on a variety of factors, including the size of the developed market for SNM therapy, burdens to entry in any such country or region, and other factors specific to certain respective countries and regions. We incurred net losses of $79.9 million and $32.5 million for the years ended December 31, 2019 and 2018, respectively, and had an accumulated deficit of $179.6 million as of December 31, 2019 compared to $99.6 million at December 31, 2018. We expect to continue to spend a significant amount of our existing resources on sales and marketing activities as we begin to commercialize and market our r-SNM System in the United States. Specifically, we hired and trained a dedicated direct sales organization, comprised of approximately 100 sales professionals, 11 regional sales managers and 48 clinical specialists. As of December 31, 2019, we had cash, cash equivalents and short-term investments of $183.7 million compared to $157.5 million at December 31, 2018. Since inception and prior to our IPO, we raised an aggregate of $114.2 million in gross proceeds from private placements of our preferred stock. On October 30, 2018, we completed our IPO by issuing 9,200,000 shares of common stock, at an offering price of $15.00 per share, for net proceeds of approximately $126.0 million after deducting underwriting discounts and commissions and estimated offering expenses payable by us. On November 18, 2019, we completed a follow-on offering by issuing 5,345,000 shares of common stock, at an offering price of $22.00 per share, for net proceeds to us of approximately $110.4 million after deducting underwriting discounts and commissions and estimated offering expenses payable by us. Prior to our IPO, our primary sources of capital were equity financings and amounts borrowed under the Loan Agreement with Silicon Valley Bank. In February 2018, we received $10.0 million from the first tranche of the Term Loan simultaneously with our entry in the Loan Agreement. In October 2018, we received the full $5.0 million from the second tranche and the full $5.0 million from the third tranche. Effective December 30, 2019, we amended our term loan agreement whereas the interest-only period was extended through December 31, 2020. As of December 31, 2019, we had $21.5 million in outstanding borrowings, as discussed below under “Indebtedness.” We believe that our existing cash resources will be sufficient to meet our forecasted requirements for operating liquidity, capital expenditure and debt repayments for at least the next 12 months from the issuance of this Annual Report. If these sources are insufficient to satisfy our liquidity requirements, however, we may seek to sell additional equity, increase the availability under the Loan Agreement or enter into an additional loan agreement. If we raise additional funds by issuing equity securities, our stockholders could experience dilution. Debt financing, if available, may involve covenants further restricting our operations or our ability to incur additional debt. Any 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 acceptable to us. If we are unable to obtain additional financing when needed to satisfy our liquidity requirements, we may be required to delay the commercialization and marketing of our r-SNM System. Cash Flows The following table presents a summary of our cash flow for the periods indicated (in thousands): Net cash used in operating activities Net cash used in operating activities was $83.5 million in fiscal year 2019 and consisted primarily of a net loss of $79.9 million, a decrease in net operating assets of $14.4 million, partially offset by non-cash charges of $10.9 million. Net operating assets consisted primarily of inventory to support the commercial launch of our r-SNM System in the United States. Non-cash charges consisted primarily of stock-based compensation. Net cash used in operating activities was $31.4 million in fiscal year 2018 and consisted primarily of a net loss of $32.5 million, a decrease in net operating assets of $2.9 million, partially offset by non-cash charges of $4.0 million. Net operating assets consisted primarily of inventory to support the planned launch of our commercial operations. Non-cash charges consisted primarily of forgiveness of receivables for stock subscriptions, depreciation and amortization, and stock-based compensation. Net cash provided by (used in) investing activities Net cash provided by investing activities was $45.3 million in fiscal year 2019 and consisted primarily of sales and maturities of short-term investments, partially offset by purchases of short-term investments. Net cash used in investing activities was $60.1 million in fiscal year 2018 and consisted primarily of purchases and sales of short-term investments. Net cash provided by financing activities Net cash provided by financing activities was $111.0 million in fiscal year 2019 and consisted primarily of $110.4 million in net proceeds received in the follow-on offering. Net cash provided by financing activities was $165.3 million in fiscal year 2018 and consisted primarily of $126.0 million in net proceeds received in the IPO, $20.0 million of proceeds from our Term Loan with Silicon Valley Bank, and $20.1 million of proceeds from the issuance of shares of our Series C preferred stock. Indebtedness In February 2018, we entered into a Loan and Security Agreement with Silicon Valley Bank, which we and Silicon Valley Bank amended in October 2018 and in December 2019, providing for the Term Loan. Pursuant to the Loan Agreement, we have drawn $20.0 million in three tranches of term loans, with such drawn obligations maturing on December 1, 2021. The Loan Agreement provides for monthly interest payments but no principal amortization through December 31, 2020. On the first day of the end of the interest only period, we will be required to repay the Term Loan in equal monthly installments of principal plus interest through maturity. Outstanding principal balances under the Term Loan bear interest at the prime rate plus 1.75%. We may prepay amounts outstanding under the Term Loan in increments of $5.0 million at any time with 30 days prior written notice to Silicon Valley Bank. However, all prepayments of the Term Loan prior to maturity, whether voluntary or mandatory (acceleration or otherwise), are also subject to the payment of a prepayment fee equal to (i) for a prepayment made on or after the closing date through and including the first anniversary of the closing date, 3.00% of the principal amount of the Term Loan being prepaid, (ii) for a prepayment made after the date which is the first anniversary of the closing date through and including the second anniversary of the closing date, 2.00% of the principal amount of the Term Loan being prepaid, and (iii) for a prepayment made after the date which is the second anniversary of the closing date and before the maturity date, 1.00% of the principal amount of the Term Loan being prepaid. Additionally, on the earliest to occur of (i) the maturity date of the Term Loan, (ii) the acceleration of the Term Loan, or (iii) the prepayment of the Term Loan, we will be required to make a final payment equal to the original principal amount of such tranche multiplied by 7.50%. We are currently accruing the portion of the final payment calculated based on the amount outstanding under the Term Loan. All obligations under the Term Loan are secured by a first priority lien on substantially all of our assets, excluding intellectual property assets and more than 65% of the shares of voting capital stock of any of our foreign subsidiaries. We have agreed with Silicon Valley Bank not to encumber our intellectual property assets without its prior written consent unless a security interest in the underlying intellectual property is necessary to have a security interest in the accounts and proceeds that are part of the assets securing the Term Loan, in which case our intellectual property shall automatically be included within the assets securing the Term Loan. The Loan Agreement contains certain covenants that limit our ability to engage in certain transactions that may be in our long-term best interest. Subject to certain limited exceptions, these covenants limit our ability to or prohibit us to permit any of our subsidiaries to, as applicable, among other things: • pay cash dividends on, make any other distributions in respect of, or redeem, retire or repurchase, any shares of our capital stock; • convey, sell, lease, transfer, assign, or otherwise dispose of all or any part of our business or property; • effect certain changes in our business, management, ownership or business locations; • merge or consolidate with, or acquire all or substantially all of the capital stock or property of any other company; • create, incur, assume, or be liable for any additional indebtedness, or create, incur, allow, or permit to exist any additional liens; • make certain investments; and • enter into transactions with our affiliates. As of December 31, 2019, we were in compliance with all debt covenant requirements under the Term Loan. While we have not previously breached and are currently in compliance with the covenants contained in the Loan Agreement, we may breach these covenants in the future. Our ability to comply with these covenants may be affected by events and factors beyond our control. In the event that we breach one or more covenants, Silicon Valley Bank may choose to declare an event of default and require that we immediately repay all amounts outstanding under the Loan Agreement, terminate any commitment to extend further credit and foreclose on the collateral. The occurrence of any of these events could have a material adverse effect on our business, financial condition and results of operations. An event of default includes, but is not limited to, the following: if we fail to make any payment under the Loan Agreement when due, if we fail or neglect to perform certain obligations under the Loan Agreement, if we violate certain covenants under the Loan Agreement, if certain material adverse changes occur, if we are unable to pay our debts as they become due or otherwise become insolvent, or if we begin an insolvency proceeding. In addition, we issued warrants to Silicon Valley Bank and Life Science Loans II, LLC, its counterparty. Each warrant entitles the holder thereof to purchase 40,000 shares of our common stock at an exercise price of $7.50 per share. In May 2019, Life Science Loans II, LLC exercised all of its outstanding warrants at an exercise price of $7.50 per share. In July 2019, Silicon Valley Bank exercised all of its outstanding warrants at an exercise price of $7.50 per share. We have no further indebtedness arrangements. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements, as defined by applicable regulations of the SEC, 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. Critical Accounting Policies and Estimates The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States (“GAAP”) requires our management to make estimates and judgments that affect the amounts reported in our consolidated financial statements and accompanying notes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable and supportable under the circumstances. The results of this evaluation then 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, and such differences may be material to our consolidated financial statements. While our significant accounting policies are more fully described in Note 1 to the Consolidated Financial Statements in Part II, Item 8 of 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 the portrayal of our financial condition and results of operations and require our most difficult, subjective and complex judgments. Revenue Recognition Since we commenced operations in late 2013, we have recognized minimal revenue. Although we have limited commercial activities in Europe and Canada, our main priority is the United States where we began to commercialize and market our r-SNM System and generate revenue from product sales in the fourth quarter of 2019. If we are unable to accomplish any of these objectives, it could have a significant negative impact on our future revenue. If we fail to generate revenue in the future, our business, results of operations, financial condition, cash flows and future prospects would be materially and adversely affected. Revenue recognized during the years ended December 31, 2019 and 2018 relates entirely to the sale of our r-SNM System. In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-09 “Revenue from Contracts with Customers” (“ASU 2014-09”) as Accounting Standards Codification (“ASC”) Topic 606. The objective of Topic 606 is to establish a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and superseded most of the existing revenue recognition guidance, including industry-specific guidance. The core principle is that a company 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. Topic 606 applies to all contracts with customers except those that are within the scope of other topics in the FASB ASC. We have revenue arrangements that consist of a single performance obligation. We recognize revenue at the point in time when it transfers control of promised goods to its customers. Revenue is measured as the amount of consideration it expects to receive in exchange for transferring goods. The amount of revenue that is recognized is based on the transaction price, which represents the invoiced amount and includes estimates of variable consideration such as discounts, where applicable. We do not offer rights of return or price protection. The amount of variable consideration included in the transaction price may be constrained and is included only to the extent that it is probable that a significant reversal in the amount of the cumulative revenue recognized under the contract will not occur in a future period. Payment terms, typically less than three months, are offered to our customers and do not include a significant financing component. We extend credit to our customers based upon an evaluation of the customer’s financial condition and credit history and generally require no collateral. We do not have any contract balances related to product sales. We also do not have significant contract acquisition costs related to product sales. In accordance with our policy, no allowance for product returns has been provided. Damaged or defective products are replaced at no charge under our standard warranty. Allowance for Doubtful Accounts We make estimates of the collectability of accounts receivable. In doing so, we analyze historical bad debt trends, customer credit worthiness, current economic trends and changes in customer payment patterns when evaluating the adequacy of the allowance for doubtful accounts. Fair Value of Financial Instruments Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. A three-level fair value hierarchy prioritizes the inputs used to measure fair value. The hierarchy requires entities to maximize the use of observable inputs and minimize the use of unobservable inputs. The three levels of inputs used to measure fair value are as follows: • Level 1: Inputs are unadjusted quoted prices in active markets for identical assets or liabilities. • Level 2: Inputs are quoted prices for similar assets and liabilities in active markets or quoted prices for identical or similar instruments in markets that are not active and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets. • Level 3: Inputs are unobservable inputs based on our assumptions and valuation techniques used to measure assets and liabilities at fair value. The inputs require significant management judgment or estimation. Our assessment of the significance of an input to the fair value measurement requires judgment, which may affect the valuation of fair value assets and liabilities and their placement within the fair value hierarchy levels. The carrying amounts reported in the consolidated financial statements approximate the fair value for cash and cash equivalents, accounts receivable, accounts payables, and accrued expenses, due to their short-term nature. The carrying amount of our term loan, which is described below, approximates fair value, considering the interest rates are based on the prime interest rate. Investment Securities We classify our investment securities as available-for-sale. Those investments in debt securities with maturities less than 12 months at the date of purchase are considered short-term investments. Those investments in debt securities with maturities greater than 12 months at the date of purchase are considered long-term investments. Our investment securities classified as available-for-sale are recorded at fair value based on the fair value hierarchy (Level 1 and Level 2 inputs in the fair value hierarchy), and consists primarily of commercial paper, corporate notes and U.S. government and agency securities. Unrealized gains or losses, deemed temporary in nature, are reported as other comprehensive income within the consolidated statement of comprehensive income (loss). Foreign Currency Translation The functional currencies of the Company’s subsidiaries are currencies other than the U.S. dollar. The Company translates assets and liabilities of the foreign subsidiaries into U.S. dollars at the exchange rate in effect on the balance sheet date. Costs and expenses of the subsidiaries are translated into U.S. dollars at the average exchange rate during the period. Gains or losses from these translation adjustments are reported as a separate component of stockholders’ equity in accumulated other comprehensive loss until there is a sale or complete or substantially complete liquidation of the Company’s investment in the foreign subsidiary at which time the gains or losses will be realized and included in net income (loss). Inventory, Net Inventories are stated at the lower of cost or net realizable value, with cost computed on a first-in, first-out basis. We reduce the carrying value of inventories for items that are potentially excess, obsolete, or slow-moving based on changes in customer demand, technology developments, or other economic factors. We capitalize inventory produced for commercial sale. We capitalize manufacturing costs as inventory following both the receipt of regulatory approval from regulatory bodies and our intent to commercialize. Costs associated with developmental products prior to satisfying our inventory capitalization criteria are charged to research and development expense as incurred. Products that have been approved by certain regulatory authorities are also used in clinical programs to assess the safety and efficacy of the products for usage that have not been approved by the FDA or other regulatory authorities. The form of product utilized for both commercial and clinical programs is identical and, as a result, the inventory has an “alternative future use” as defined in authoritative guidance. Component materials and purchased products associated with clinical development programs are included in inventory and charged to research and development expense when the product enters the research and development process and no longer can be used for commercial purposes and, therefore, does not have an “alternative future use.” For products that are under development and have not yet been approved by regulatory authorities, purchased component materials are charged to research and development expense when the inventory ownership transfers to us. We analyze inventory levels to identify inventory that may expire prior to sale, inventory that has a cost basis in excess of its net realizable value, or inventory in excess of expected sales requirements. Although the manufacturing of the r-SNM System is subject to strict quality control, certain batches or units of product may no longer meet quality specifications or may expire, which would require adjustments to our inventory values. We also apply judgment related to the results of quality tests that are performed throughout the production process, as well as the understanding of regulatory guidelines, to determine if it is probable that inventory will be saleable. These quality tests are performed throughout the pre- and post-production processes, and we continually gather information regarding product quality for periods after the manufacturing date. The r-SNM System currently has a maximum estimated shelf life range of 12 to 27 months and, based on sales forecasts, we expect to realize the carrying value of the product inventory. In the future, reduced demand, quality issues, or excess supply beyond those anticipated by management may result in a material adjustment to inventory levels, which would be recorded as an increase to cost of sales. The determination of whether or not inventory costs will be realizable requires estimates by our management. A critical input in this determination is future expected inventory requirements based on internal sales forecasts. Management then compares these requirements to the expiry dates of inventory on hand. To the extent that inventory is expected to expire prior to being sold, management will write down the value of inventory. Intangible Asset The intangible asset represents exclusive rights to an additional field-of-use on the patent suite within the License Agreement with AMF. The additional field-of-use was provided in exchange for 50,000 shares of Series A preferred stock, the fair value of which was $1.0 million in 2013. The intangible asset was recorded at its fair value of $1.0 million at the date contributed. In connection with our IPO, such shares of Series A preferred stock were converted into common stock. Amortization of this asset is recorded over the shorter of the patent or legal life on a straight-line basis. The weighted-average amortization period is 8.71 years. We will review the intangible asset for impairment whenever an impairment indicator exists. There have been no intangible asset impairment charges to date. Impairment of Long-Lived Assets We review our long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability is measured by comparing the carrying amount to the future net cash flows that the assets are expected to generate. If said assets are considered to be impaired, the impairment that would be recognized is measured by the amount by which the carrying amount of the assets exceeds the projected discounted future net cash flows arising from the asset. There have been no such impairments of long-lived assets to date. Leases We determine if an arrangement is a lease at inception and include operating leases on our consolidated balance sheets. The operating lease right-of-use (“ROU”) asset is included within our other non-current assets, and lease liabilities are included in current or noncurrent liabilities on our consolidated balance sheets. We have made certain policy elections to apply to our leases executed post-adoption, or subsequent to January 1, 2018. In accordance with Topic 842, components of a lease should be split into three categories: lease components, non-lease components, and non-components. The fixed and in-substance fixed contract consideration (including any consideration related to non-components) must be allocated based on the respective relative fair values to the lease components and non-lease components. Entities may elect not to separate lease and non-lease components. Rather, entities would account for each lease component and related non-lease component together as a single lease component. We have elected to account for lease and non-lease components together as a single lease component for all underlying assets and allocate all of the contract consideration to the lease component only. Topic 842 allows for the use of judgment in determining whether the assumed lease term is for a major part of the remaining economic life of the underlying asset and whether the present value of lease payments represents substantially all of the fair value of the underlying asset. We apply the bright line thresholds referenced in Topic 842 to assist in evaluating leases for appropriate classification. The aforementioned bright lines are applied consistently to our entire portfolio of leases. Operating lease ROU asset and operating lease liabilities are recognized based on the present value of the future minimum lease payments over the lease term at commencement date. As our lease does not provide an implicit rate, we use our incremental borrowing rate based on the information available at commencement date in determining the present value of future payments. The operating lease ROU asset also includes any lease payments made and excludes lease incentives and initial direct costs incurred. The lease terms may include options to extend or terminate the lease when it is reasonably certain that we will exercise that option. Lease expense for minimum lease payments is recognized on a straight-line basis over the lease term. Research and Development Research and development costs are charged to operations as incurred. Research and development costs include salary and personnel-related costs, costs of clinical studies and testing, supplies and materials, and outside consultant costs. Costs of clinical studies and testing include fees paid to hospitals and physicians for the enrollment and treatment of patients, related product manufacturing expenses for the products used in the studies, fees paid to CROs, other consultants, and other outside expenses. Our research and development team focuses on our r-SNM System, including our clinical studies, as well as evaluations of improvements and enhancements to our r-SNM System. For the years ended December 31, 2019 and 2018, we incurred research and development expenses of $20.2 million and $19.4 million, respectively. Income Taxes We account for income taxes using the asset and liability method to compute the difference between the tax basis of assets and liabilities and the related financial amounts, using currently enacted tax rates. We have deferred tax assets. The realization of these deferred tax assets is dependent upon our ability to generate sufficient taxable income in future years. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount that more likely than not will be realized. We evaluate the recoverability of the deferred tax assets annually, and maintain a full valuation allowance on our deferred tax assets. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by taxing authorities, based on the technical merits of the position. We have determined that we have no uncertain tax positions. Stock-Based Compensation We maintain an equity incentive plan to provide long-term incentives for employees and certain advisors and consultants. The plan allows for the issuance of nonstatutory and incentive stock options to employees and nonstatutory stock options to consultants and non-employee directors. We measure the cost of employee and non-employee services in exchange for an award of equity instruments based on the grant-date fair value of the award and recognize compensation cost over the requisite service period (typically the vesting period), generally four years. Forfeitures are estimated at the time of the grant and revised in subsequent periods to reflect differences between the estimates and the number of shares that actually become exercisable. We use the Black-Scholes option pricing model to determine the fair value of stock options (as of the date of grant) that have service conditions for vesting. Stock options and restricted shares awards vest based on service conditions, typically over four years. We also grant shares of performance-based restricted stock units that typically cliff vest after one year only if we have also achieved certain performance objectives as defined and approved by our board of directors. Performance awards are expensed over the performance period based on the probability of achieving the performance objectives. In addition, we also grant market-based restricted stock units that have combined market conditions and service conditions for vesting, for which we use the Monte Carlo valuation model to value equity awards (as of the date of grant). The Black-Scholes option pricing model requires the input of certain subjective assumptions, including (i) the expected share price volatility, (ii) the expected term of the award, (iii) the risk-free interest rate, and (iv) 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 the estimate of expected volatility on the historical volatility of a group of similar companies that are publicly traded. Similarities with such companies include being at the stage of product development and focused on the medical technology industry. The historical volatility is calculated based on a period of time commensurate with the expected term assumption. 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. Emerging Growth Company We are an “emerging growth company” under the JOBS Act. For as long as we are an “emerging growth company,” we are not required to: (i) comply with any new or revised financial accounting standards that have different effective dates for public and private companies until those standards would otherwise apply to private companies, (ii) provide an auditor’s attestation report on management’s assessment of the effectiveness of internal control over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act, (iii) comply with any new requirements adopted by the Public Company Accounting Oversight Board (“PCAOB”) requiring mandatory audit firm rotation or a supplement to the auditor’s report in which the auditor would be required to provide additional information about the audit and the financial statements of the issuer or (iv) comply with any new audit rules adopted by the PCAOB after April 5, 2012, unless the SEC determines otherwise. However, we have elected to “opt out” of the extended transition period discussed in (i), and will therefore comply with new or revised accounting standards on the applicable dates on which the adoption of such standards are required for non-emerging growth companies. Section 107 of the JOBS Act provides that our decision to opt out of such extended transition period for compliance with new or revised accounting standards is irrevocable. Recent Accounting Pronouncements For recent accounting pronouncements, see Note 1, Nature of Operations and Summary of Significant Accounting Policies, of Notes to Consolidated Financial Statements in Part II, Item 8 of this Annual Report. JOBS Act As a company with less than $1.07 billion in revenue during our last fiscal year, we qualify as an “emerging growth company,” as defined in the JOBS Act. An emerging growth company may take advantage of reduced reporting requirements that are otherwise applicable to public companies. These provisions include: • an exemption from compliance with the auditor attestation requirement in the assessment of our internal control over financial reporting pursuant to the Sarbanes-Oxley Act; • reduced disclosure about executive compensation arrangements in our periodic reports, registration statements and proxy statements; • exemptions from the requirements to seek non-binding advisory votes on executive compensation or golden parachute arrangements; and • delay implementing new accounting standards until such time as those standards apply to private companies. We may take advantage of these provisions until the last day of our fiscal year following the fifth anniversary of the completion of our IPO. However, if certain events occur prior to the end of such five-year period, including if we become a “large accelerated filer,” our annual gross revenue is $1.07 billion or more or we issue more than $1.0 billion of non-convertible debt in any three-year period, we will cease to be an emerging growth company prior to the end of such five-year period. We have elected to take advantage of certain of the reduced disclosure obligations in this Annual Report on Form 10-K and may elect to take advantage of other reduced reporting requirements in future filings. As a result, the information that we provide to our stockholders may be different from what you might receive from other public reporting companies in which you hold equity interests. We have elected not to delay implementing new accounting standards until such time as those standards apply to private companies. Section 107 of the JOBS Act provides that we can elect to opt out of the extended transition period at any time, which election is irrevocable.
0.006457
0.006682
0
<s>[INST] We are a medical technology company that has developed and is commercializing innovative and minimally invasive implantable SNM used to treat patients with UUI and UUF, together referred to as OAB, as well as FI, and nonobstructive UR. OAB affects an estimated 87 million adults in the United States and Europe. Another estimated 40 million adults are reported to suffer from FI. SNM therapy is an effective and durable treatment that has been widely used and reimbursed in Europe and the United States for the past two decades. SNM is the only OAB treatment with proven clinical superiority to standard medical therapy and OAB patients who receive SNM report significantly higher quality of life than patients undergoing drug treatment. We believe our proprietary rSNM System offers significant advantages, including being the first and only rechargeable SNM system. It is designed to last approximately 15 years and is 60% smaller than existing technology. We believe our rSNM System has the potential to disrupt and grow the approximately $650 million, as of 2018, global SNM market, which has historically been served by Medtronic, as a single participant. Since we commenced operations in late 2013, our activities have consisted primarily of developing our rSNM System, conducting our RELAXOAB postmarket clinical follow up study in Europe and our ARTISANSNM pivotal clinical study in the United States and Europe, filing for regulatory approvals and hiring and training our U.S. commercial team. We have marketing approvals in Europe, Canada, and Australia for all relevant clinical indications and initiated limited commercial efforts in Europe and Canada in late 2018. Revenue in 2019 from international operations in select markets, including England, the Netherlands and Canada, was $5.4 million. On September 6, 2019, our PMA application for our rSNM System for the treatment of FI was approved by the FDA and on November 13, 2019, our PMA application for our rSNM System for the treatment of OAB and UR was approved by the FDA. Accordingly, we began U.S. commercialization of our rSNM System in the middle of the fourth quarter of 2019 and generated $8.4 million in revenue during that period. Our ability to generate revenue and become profitable will depend on our ability to successfully commercialize our rSNM System and any product enhancements we may advance in the future. Although we have limited commercial activities in Europe and Canada, our main priority is the United States, where we began to commercialize and market our rSNM System in the fourth quarter of 2019. During the first half of 2019, we established a significant commercial infrastructure in advance of FDA approval of our rSNM System and we continued to make significant investments to build our sales and marketing organization by hiring dedicated sales and clinical personnel to market and support our product in the United States and Canada. Specifically, we hired and trained a dedicated direct sales organization, comprised of approximately 100 sales professionals, 11 regional sales managers and 48 clinical specialists. We hired and trained sales representatives and clinical specialists with strong sales backgrounds and experience in SNM therapy and other neurostimulation applications, and with relationships with urologists and urogynecologists. If we are unable to accomplish any of these objectives, it could have a significant negative impact on our future revenue. If we fail to generate revenue in the future, our business, results of operations, financial condition, cash flows, and future prospects would be materially and adversely affected. We also intend to continue to make investments in research and development efforts to develop improvements and enhancements to our rSNM System. We expect to derive future revenue by increasing patient and physician awareness of our rSNM System. In the United States, the cost required to treat each patient is reimbursed through various thirdparty payors, such as commercial payors and government agencies. Most large insurers have established coverage policies in place to cover SNM therapy. Certain commercial payors have a patientbypatient prior authorization process that must be followed before they will provide reimbursement for SNM therapy. Outside the United States, reimbursement levels vary significantly by country and by region, particularly based on whether the country or region [/INST] Positive. </s>
2,020
9,651
1,733,186
Veoneer, Inc.
2019-02-22
2018-12-31
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Introduction The following MD&A is intended to help you understand the business operations and financial condition of the Company. This MD&A is presented in the following sections: • Executive Overview • Trends, Uncertainties and Opportunities • Market Overview • Non-U.S. GAAP Financial Measures • Results of Operations • Liquidity and Capital Resources • Off-Balance Sheet Arrangements • Contractual Obligations and Commitments • Significant Accounting Policies and Critical Accounting Estimates Veoneer is a Delaware corporation with its principal executive offices in Stockholm, Sweden. The Company functions as a holding corporation and owns two principal operating subsidiaries, Veoneer AB and Veoneer US, Inc. On June 29, 2018 the Spin-Off of Veoneer from Autoliv, Inc. ("Autoliv") was completed through the distribution by Autoliv of all the outstanding shares of common stock of Veoneer to Autoliv’s stockholders as of the close of business on June 12, 2018, the common stock record date for the distribution, in a tax-free, pro rata distribution (the "Spin-Off"). On July 2, 2018, the shares of Veoneer common stock commenced trading on the New York Stock Exchange under the symbol “VNE” and the Veoneer Swedish Depository Receipts representing shares of Veoneer common stock commenced trading on Nasdaq Stockholm under the symbol “VNE SDB.” Veoneer is a global leader in the design, development, manufacture, and sale of automotive safety electronics with a focus on innovation, quality and manufacturing excellence. Prior to the Spin-Off, Veoneer operated for almost four years as an operating segment within Autoliv. Veoneer's Safety Systems are designed to make driving safer and easier, more comfortable and convenient for the end consumer and to intervene before a collision. Veoneer endeavors to prevent vehicle accidents or reduce the severity of impact in the event a crash is unavoidable. Through our customer focus, being an expert partner with our customers, we intend to develop human centric systems that benefit vehicle occupants. Veoneer’s current product offering includes automotive radars, mono-and stereo-vision cameras, night driving assist systems, positioning systems, ADAS (advanced driver assist systems) electronic control units, passive safety electronics (airbag control units and crash sensors), brake control systems and a complete ADAS software offering towards highly automated driving (HAD) and eventually autonomous driving (AD). In addition, we offer driver monitoring systems, LiDAR sensors, RoadScape positioning and other technologies critical for HAD and AD solutions by leveraging our partnership network and internally developed intellectual property. Executive Overview The environment around us is rapidly changing and we currently see a shift across the automotive and autotech industries. New technologies, creating new levels of interaction and driver support are starting to revolutionize driving, but we also see the driver being actively involved for years to come. We call this Collaborative Driving; the industry also calls it “Level 2+” driver support. At the same time there is also a growing realization that the introduction of truly self-driving cars will likely take longer and be more expensive than previously anticipated. This fundamental insight opens up new opportunities for companies, including Veoneer, but it also requires a reprioritization of resources. In the near term there is also an increased uncertainty regarding the development of global light vehicle production (LVP). During the fourth quarter of 2018 we saw a sharp decline in the LVP in China and Western Europe and we anticipate that these markets will continue to show weakness in the first half of this year. We expect the situation to improve in the second half, but we currently expect a slight decline in the global LVP for the full year 2019. In response to the larger role in the market for Collaborative Driving, the expected delay of self-driving, and the weaker LVP trend, we are actively reviewing our investment priorities and the focus of our product portfolio. Our purpose is to identify the most effective way to allocate talent and capital to meet these new market realities. In December we refined our organization to create a more agile and focused company, and during 2019 we expect our renewed organization, combined with other initiatives to gradually start delivering efficiency gains and stronger customer engagement. We expect the combined effects of a stronger LVP and new program launches in the second half of the year combined with our own efficiency and prioritization initiatives to start to lead to improved cash-flow in the latter part of the year. Assuming successful execution of these initiatives, we expect our net cash to cover our funding requirements until the Company reaches positive cash flow. However, additional funding may be required if order intake increases beyond our expectations, if the underlying near-term business conditions deteriorate further, or if we make acquisitions. We build our 2019 plan on a strong base. In 2018, our order intake grew strongly to a record lifetime order value of close to $6 billion. Active Safety orders almost doubled, and we expanded our Active Safety customer base from 9 to 12 car manufacturers. From a product perspective, I am particularly pleased with the strong market and customer reception of our vision products based on Veoneer’s internally developed software algorithms and the fact that we won our first major commercial LiDAR order with a global OEM. We move forward in 2019 with a strong focus on capturing the opportunities in a new industry situation. By balancing growth, cost, and effective capital allocation we are building a focused, industry leading product portfolio, all with the objective to make Veoneer the leading company in our chosen business segments. 2019 Outlook Looking ahead into 2019 we are planning for a complex business environment. We are responding to light vehicle production fluctuations and uncertainties even as we prepare for a heavy new program launch schedule beginning in late 2019 and extending into 2020. Our current customer call-offs and deliveries reflect a weak demand situation in China and Western Europe, which leads us to anticipate a decline in LVP during the first six months of 2019. At this time, we expect this demand to stabilize and return to growth during the second half of the year, resulting in the estimated full year LVP being slightly down in 2019 as compared to 2018. Our sales during the first half of 2019 are expected to remain relatively flat sequentially from the second half of 2018, albeit a decline year over year, and then improve sequentially in the second half of 2019. Consequently, we estimate our organic sales will be flat to decline slightly for the full year 2019 while we estimate the currency translation impact to be approximately (2)% as compared to 2018. As a result of our sales and RD&E development, in combination with the implementation of our market adjustment initiatives during 2019, we expect a weak operating margin and cash flow during the first half of the year. The first quarter in 2019 is expected to be weaker than the fourth quarter in 2018, with an anticipated improvement during the second half of 2019. Based on the market opportunities ahead of us, we expect our 2019 order intake to be at least as strong as our performance in 2018. Financial Results Significant aspects of the Company's financial results for the year ended December 31, 2018, include the following. Sales - Net sales for the full year of 2018 decreased by $95 million to $2,228 million as compared to 2017. Gross Profit - The gross profit of $430 million for the full year of 2018 was $36 million lower as compared to 2017. The volume and product mix effect causing the lower organic sales was partially offset by a net favorable currency benefit of around $10 million. Operating Loss - The operating loss of $197 million for the full year of 2018 decreased by $86 million as compared to 2017, including a net favorable currency benefit of $4 million. In 2017 the operating loss included a goodwill impairment charge related to VNBS of $234 million. Net Loss - The net loss for the full year of 2018 of $294 million decreased by $50 million as compared to 2017. In addition to the operating loss impact, the Veoneer net loss from Zenuity increased by $32 million. The Zenuity net loss increase is mainly due to the higher net cost run-rate related to the hiring of software engineers and an additional quarter of cost in 2018, since the JV was formed in April 2017. Interest income net increased by $6 million as compared to 2017. Income tax expense for 2018 was $42 million as compared to $30 million in 2017. The change in tax expense was primarily impacted by the change in mix of pre-tax earnings in our profitable subsidiaries and a non-cash, one-time discrete tax item of $23 million in 2018. The non-controlling interest loss in the VNBS JV was $19 million for 2018 as compared to $127 million loss in 2017 which included the goodwill impairment charge of $113 million. The pie charts below highlight the sales breakdown for Veoneer for the year ended December 31, 2018. Trends, Uncertainties and Opportunities Europe continues to take a pro-active role in promoting or requiring active safety technologies. The European New Car Assessment Program (“NCAP”) continuously updates its test rating program to include more active safety technologies to help the European Union reach its target of cutting road fatalities by 50% by 2030, as compared to 2020. On May 17, 2018, the European Commission proposed a new mandate, as party of the EU general Safety Regulation road-map till 2028 to make certain active safety features compulsory in light vehicles by 2022. Such a mandate should significantly expand demand for our active safety products. If passed as proposed, certain safety features could be mandated in 2022 as new vehicle models are introduced to the European market. In any case, General Safety Regulation (GSR) would have a positive influence on other market regulators as they evaluate their respective vehicle test rating programs and safety legislations. In China, the Ministry of Industry and Information Technology issued the Key Working Points of Intelligent Connected Vehicle Standardization for 2018 to promote and facilitate the development of the intelligent connected vehicles industry, and advance the development of fundamental standards and those that are in urgent demand. The guideline has pointed out that more than 30 key standards will be defined by 2020 to fund the systems for ADAS and low-level autonomous driving, and a system of over 100 standards will be set up by 2025 for higher level autonomous driving. During the third quarter of 2018 the Chinese government commenced testing of new vehicles according to the new China New Car Assessment Program (CNAP) where active safety features like Autonomous Emergency Braking (AEB) are required to achieve the maximum safety rating. In 2017 a consortium of Original Equipment Manufacturers (OEM's) in the United States voluntarily agreed to make AEB standard equipment on all new vehicles produced no later than 2023. On October 4, 2018 the U.S. Department of Transportation (DoT) issued new voluntary guidelines on automated driving systems (ADS) under its “Preparing for the Future of Transportation: Automated Vehicles 3.0” initiative, building on its “Vision for Safety 2.0” from September 2017 which prioritized aligning federal guidance around twelve safety design elements of interest to the auto industry. This initiative should have a positive impact on the adoption of Advanced Driver Assistance Systems (ADAS) and Highly Automated Driving (HAD) on the road towards Autonomous Vehicles. The UN ECE created the new Working Party to deal with regulations for Automated Vehicles (GRVA). In addition to the EU and Japan who started to work closely for ADAS regulations in the last 3 years, the U.S. and China indicated a willingness to be active in several working groups towards harmonization of future regulations for ADAS and AV. This would create a common umbrella for countries which follow type-approval rules (EU, Japan, Australia) and countries which are outside of type-approval system e.g., under self-certification regimes (U.S., Korea) or specific national rules (China). Key future working fields for regulations are expected for (i) safety critical ADAS-features (e.g. AEB); (ii) Highway AV-features (Physical Tests + Real World Test Drive + Audit); (iii) Cybersecurity & SW-Updates; and (iv) Connected Vehicles. On one hand, the agreement on minimal common base requirements will take longer time and therefore may postpone introduction of regulations. On the other hand, the harmonization would help the industry while a more active position from China may help to pull forward some safety critical ADAS technologies which are not yet considered as relevant for regulation in EU and Japan (e.g. Blind Spot or Night Vision). Market Overview During 2018 the global light vehicle production decreased by around 1% as compared to 2017 mainly due to the production declines in Western Europe (4%), partially attributable to the introduction of the Worldwide Harmonized Light Vehicle Procedure ("WLTP"), China (4%), likely attributable to weaker consumer demand and record volumes in 2017 when tax incentive on 1.6 liter vehicles were in place, along with South Korea (2%) likely attributable to fewer NAFTA exports due to production localization. Light vehicle demand in Japan and the Americas remained relatively flat, where South America increased 3% and North America declined slightly (1)% while India, included in Rest of Asia, increased 7% during the year as compared with 2017. During 2017 the global light vehicle production increased by around 2% as compared to 2016 mainly due to the production declines in Western Europe (1%), North America (5%) and South Korea (3%) which was more than offset by increases in China of 2%, partially attributable to the tax incentive on 1.6 liter vehicles which were still in place in 2017, along with South America, Japan, Eastern Europe and India all with increases of 20%, 6%, 9% and 7%, respectively. Non-U.S. GAAP Financial Measures Non-U.S. GAAP financial measures are reconciled throughout this report. In this report we refer to organic sales or changes in organic sales growth, a non-U.S. GAAP financial measure that we, investors and analysts use to analyze the Company's sales trends and performance. We believe that this measure assists investors and management in analyzing trends in the Company's business because the Company generates approximately 65% of sales, a significant amount of sales, in currencies other than in U.S. dollars (its reporting currency) and currency rates have been and can be rather volatile. Additionally, the Company has historically made several acquisitions and divestitures. Organic sales and organic sales growth presents the increase or decrease in the overall U.S. dollar net sales on a comparable basis, allowing separate discussions of the impact of acquisitions/divestitures and exchange rates on the Company’s performance. The tables in this report present reconciliation of changes in the total U.S. GAAP net sales changes in organic sales growth. For any forward-looking statements contained in this report or any other document, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, and we assume no obligation to revise or publicly release the results of any revision to these forward-looking statements, except as required by law. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. The Company also uses in this report EBITDA, a non-U.S. GAAP financial measure, which represents the Company’s net income excluding interest expense, income taxes, depreciation and amortization. The Company also uses Segment EBITDA, a non-U.S. GAAP financial measure, which represents the Company’s EBITDA which has been further adjusted on a segment basis to exclude certain corporate and other items. We believe that EBITDA and Segment EBITDA are useful measures for management, analysts and investors to evaluate operating performance on a consolidated and reportable segment basis, because it assists in comparing our performance on a consistent basis. The tables below provide reconciliations of net income (loss) to EBITDA and Segment EBITDA. The Company also uses in this report net working capital, a non-U.S. GAAP financial measure, which is defined as current assets (excluding cash and cash equivalents) less current liabilities. Management uses this measure to improve its ability to assess liquidity at a point in time. The table below provides a reconciliation of current assets and liabilities to net working capital. Investors should not consider these non-U.S. GAAP measures as substitutes, but rather as additions, to financial reporting measures prepared in accordance with U.S. GAAP. It should be noted that these measures, as defined, may not be comparable to similarly titled measures used by other companies. The forward looking non-U.S. GAAP financial measure used in this report is provided on a non-U.S. GAAP basis. Veoneer has not provided a U.S. GAAP reconciliation of this measure because items that impact this measure, such as foreign currency exchange rates, cannot be reasonably predicted or determined. As a result, such reconciliation is not available without unreasonable efforts and Veoneer is unable to determine the probable significance of the unavailable information. Results of Operations Fiscal Year 2018 compared to 2017 The following tables show Veoneer’s performance by segment for the year ended December 31, 2018 and 2017 along with components of change compared to the prior year. 1 Non-U.S. GAAP measure reconciliation for Organic Sales and EBITDA Sales - Net sales in the Electronics segment for the full year of 2018 decreased by $51 million to $1,799 million as compared to 2017. The difference was attributable to organic sales decline in Restraint Control Systems of approximately $120 million which was partially offset by Active Safety organic sales growth of around $52 million. The quantities delivered for the full year 2018 were 18.7 million and 10 million units for Restraint Controls Systems and Active Safety, respectively. Operating Loss - The operating loss in the Electronics segment increased by $102 million to $116 million for the full year of 2018 as compared to 2017. The increase is mainly due to the volume and product mix effect causing the lower organic sales and a planned increase in RD&E costs to support future sales growth. EBITDA - For the full year of 2018 the Electronics segment EBITDA of negative $43 million declined by $110 million as compared to 2017, which was partially offset by lower amortization of intangibles, mainly related to the effects of the MACOM acquisition. Associates - The number of associates in the Electronics segment increased by approximately 1,207 since December 31, 2017 to 7,105 mainly due to increases in RD&E to support future organic sales growth and current development programs. 1 Non-U.S. GAAP measure reconciliation for Organic Sales and EBITDA Sales - The net sales of $428 million in the Brake Systems segment for the full year of 2018 decreased by $48 million as compared to 2017. The decline was mainly attributable to lower volumes on certain Honda models, primarily in North America and lower LVP in China which was partially offset by higher volumes in Japan. The quantity delivered for the full year 2018 was 1.9 million units for the Brake Systems segment. Operating Loss - The operating loss in the Brake Systems segment decreased by $217 million to $30 million for the full year of 2018 as compared to 2017 which included the goodwill impairment charge of $234 million. In addition, the volume and product mix effect causing the lower organic sales was partially offset by reduced overhead costs. EBITDA - For the full year of 2018, the Brake Systems segment EBITDA of $7 million increased by $217 million as compared to 2017. This was mainly due to the goodwill impairment charge in 2017 of $234 million, which was partially offset by an increase in underlying operating loss. Associates - The number of associates in the Brake Systems segment declined by 134 since December 31, 2017 to 1,452 mainly due to the reductions in direct manufacturing as well as production overhead and SG&A due to the decline in organic sales. 1 Non-U.S. GAAP measure reconciliation for EBITDA Operating Loss and EBITDA - The operating loss and EBITDA for Corporate and other for the full year of 2018 increased to $51 million from $22 million and $21 million, respectively, as compared to 2017 mainly due to the additional costs associated with being a standalone listed company. Associates - The number of associates in Corporate and other increased to 43 as compared to December 31, 2017 mainly related to the hiring of additional personnel for being a standalone listed company. The associate and financial figures are not comparable since the 2017 financial reports are based on carve-out basis accounting rules. Net Sales by Product The following tables show Veoneer’s consolidated net sales by product for the year ended December 31, 2018 and 2017 along with components of change compared to the prior year. 1 Non-U.S. GAAP measure reconciliation for Organic Sales Sales - Net sales for the full year of 2018 decreased by $95 million to $2,228 million as compared to 2017. The organic sales decline of 5% was partially offset by positive currency translation effects of 1%. The sales decline in Restraint Control Systems and Brake Systems, was mitigated by the Active Safety organic sales growth. We expect the sales trend in all three product areas to rebound starting in the latter part of 2019 and increasing in 2020. Restraint Control Systems - Net sales of $974 million for the full year of 2018 declined by 9% as compared to 2017. The 11% organic sales decline was mainly driven by the phase-out of certain models in North America and lower LVP in China and Western Europe in the second half of 2018. Active Safety - Net sales of $825 million for the full year of 2018 increased by 6% as compared to 2017 due to an increase in organic sales of 7%. Strong demand for vision systems and ADAS ECUs on multiple models accounted for most of the organic sales growth together with night vision systems to PSA and Audi. This strong growth was partially offset by the continued ramp-down of current GPS business with Ford and an underlying weaker LVP environment, particularly in Western Europe. Brake Systems - Net sales of $428 million for the full year of 2018 decreased by 9% as compared to 2017, mainly due to an organic sales decline of 11%, mostly due to lower volumes on certain Honda vehicle models, primarily in North America, and lower LVP in China. Veoneer Performance The following table shows Veoneer’s performance for the year ended December 31, 2018 and 2017 along with components of change compared to the prior year. 1 Including Corporate and other sales. Basic number of shares used to compute net loss per share. Participating share awards with right to receive dividend equivalents are (under the two class method) excluded from EPS calculation. 2017 and first half of 2018 are according to Carve-out reporting from Autoliv Spin-Off of Veoneer. Gross Profit - The gross profit of $430 million for the full year of 2018 was $36 million lower as compared to 2017. The volume and product mix effect causing the lower organic sales was partially offset by a net favorable currency benefit of around $10 million. Operating Loss - The operating loss of $197 million for the full year of 2018 decreased by $86 million as compared to 2017, including a net favorable currency benefit of $4 million. In 2017 the operating loss included a goodwill impairment charge related to VNBS of $234 million. The planned increase in RD&E investments of $91 million, mainly related to the increase in engineers for future sales growth and current development programs, as well as $46 million higher SG&A, mainly resulting from the additional costs associated with being a standalone listed company, accounted for most of the change as compared to 2017. These effects were partially offset by a decrease of $14 million in the amortization of intangibles related to historical acquisitions, and a $10 million increase in other income, both as compared to 2017. Net Loss - The net loss for the full year of 2018 of $294 million decreased by $50 million as compared to 2017. In addition to the operating loss impact, the Veoneer net loss from Zenuity increased by $32 million. The Zenuity net loss increase is mainly due to the higher net cost run-rate related to the hiring of software engineers and an additional quarter of cost in 2018, since the JV was formed in April 2017. Interest income net increased by $6 million as compared to 2017. Income tax expense for 2018 was $42 million as compared to $30 million in 2017. The change in tax expense was primarily impacted by the change in mix of pre-tax earnings in our profitable subsidiaries and a non-cash, one-time discrete tax item of $23 million in 2018. The non-controlling interest loss in the VNBS JV was $19 million for 2018 as compared to $127 million loss in 2017 which included the goodwill impairment charge of $113 million. Loss per Share - The loss per share for the full year of 2018 increased to $3.17 as compared to a loss of $2.49 per share in 2017 due to the increased net loss. The share count was virtually unchanged. Reconciliations of U.S. GAAP to non U.S. GAAP Results of Operations Full Year 2017 compared with 2016 The following tables show Veoneer’s performance by segment for the year ended 2017 and 2016 along with components of change. 1 Non-U.S. GAAP measure reconciliation for Organic Sales and EBITDA Net Sales - The net sales in the Electronics segment for the full year 2017 increased by $14 million to $1,850 million as compared to 2016. The difference was attributable to organic sales1 increase in Active Safety of approximately $38 million and favorable currency translation effects of around $4 million was partially offset by a decline in Restraint Controls Systems organic sales growth of around $27 million. The quantities delivered for the full year 2017 were approximately 20 million and 10 million for Restraint Controls Systems and Active Safety, respectively. Operating Loss - The operating loss in the Electronics segment increased by $25 million to $14 million for 2017 as compared to 2016. The increase is mainly due to the planned increase in RD&E costs to support future sales growth. EBITDA1 - The Electronics segment EBITDA of $67 million in 2017 declined by $14 million as compared to 2016. In addition to the increased operating loss, amortization of intangibles declined mainly related to the effects of the MACOM acquisition. Associates - The number of associates in the Electronics segment increased by approximately 853 since December 31, 2016 to 5,898 mainly due to increases in RD&E to support future organic sales growth and current development programs. 1 Non-U.S. GAAP measure reconciliation for Organic Sales and EBITDA Net Sales - The net sales of $476 million in the Brake Systems segment for the full year 2017 increased by $85 million as compared to 2016. The increase was mainly attributable to the additional quarter of sales in 2017 since the joint venture was formed in April 2016 which was partially offset by lower volumes on certain Honda models, primarily in North America which was partially offset by higher volumes in Japan. The quantities delivered for the full year 2017 were 2 million for Brake Systems. Operating Loss - The operating loss in the Brake Systems segment decreased by $235 million to $247 million in 2017 as compared to 2016. This is mainly due to the volume and product mix impact due to lower organic sales and slight increase in RD&E costs to support sales growth which was more than offset by reduced overhead costs and the goodwill impairment charge of $234 million in 2017. EBITDA1 - For 2017, the Brake Systems segment EBITDA of $(210) million decreased by $234 million compared to 2016. Associates - The number of associates in the Brake Systems segment declined by 147 since December 31, 2016 to 1,586 mainly due to the reductions in direct manufacturing as well as production overhead and SG&A due to the sales decline. 1 Non-U.S. GAAP measure reconciliation for EBITDA Operating Loss - The operating loss and EBITDA1 for Corporate and other for 2017 decreased to negative $22 million and $21 million, respectively, from negative $24 million as compared to 2016 mainly resulting from lower SG&A which is tied to the carve-out basis rules of reporting Veoneer related to the Spin-Off from Autoliv. Associates - There were no associates in Corporate and other during 2017 and 2016. The associate and financial figures are not comparable since the financial results are based on carve-out basis accounting rules. Net Sales by Product The following tables show Veoneer’s consolidated net sales by product for the year ended December 31, 2017 and 2016 along with components of change compared to the prior year. 1 Non-U.S. GAAP measure reconciliation for Organic Sales Sales - Net sales for 2017 increased by 5% to $2,322 million as compared to 2016. The organic sales1 decline of 1% was more than offset by acquisition effects of the VNBS joint venture of 5% or $121 million as the currency translation effects were negligible. Restraint Control Systems - Restraint Control Systems sales declined by 2% in 2017 as compared to 2016. The decrease in organic sales of 3% or $27 million was mainly driven by declines in North America, Japan and South Korea which were partially mitigated by increase in China and India. Active Safety - Active Safety sales increased by 5% or $38 million as compared to 2016, driven essentially by an increase in organic sales. The Active Safety growth was positively impacted by double digit organic sales in core active safety products (including radars, cameras including night driving assist and ADAS ECU's). However, this growth was negatively impacted by sales declines for positioning systems in North America as well as the ramp-down in our internally developed brake systems in China. Brake Systems - Brake Systems sales increased by 23% in 2017 as compared to 2016. This positive change was mainly driven by the full year operations impact of $121 million in the VNBS joint venture which was formed on April 1, 2016. The organic sales decline of 6% or $24 million was mainly attributable to product changes on certain vehicle models where Honda did not retain VNBS as the incumbent. Veoneer Performance The following table shows Veoneer’s performance for the year ended December 31, 2017 and 2016 along with components of change compared to the prior year. Including Corporate and other sales. Basic number of shares used to compute net loss per share. Participating share awards with right to receive dividend equivalents are (under the two-class method) excluded from EPS calculation. 2016 and 2017 are according to Carve-out reporting from Autoliv Spin-Off of Veoneer. Gross Profit - The gross profit for the full year 2017 increased by $43 million to $466 million as compared to 2016. This increase was primarily driven by the sales increase in Active Safety and the VNBS joint venture. In addition, lower material costs were partly offset by higher costs related to investments for capacity and growth. Operating Loss - The operating loss of $283 million for 2017 increased by $258 million as compared to 2016, mainly due to the goodwill impairment charge of $234 million in 2017 due to lower than originally anticipated sales development in the VNBS joint venture. In addition, planned higher RD&E investments of $75 million, in engineering resources to support future growth as illustrated by our strong order intake, more than offset the improvement in gross profit while SG&A remained relatively unchanged as compared to 2016. The $12 million decrease in other income (expense), net was primarily impacted by a reduction of the contingent liability consideration related to the MACOM acquisition. Net Loss - In addition to the operating loss effect, the Zenuity joint venture cost increased $31 million in 2017 as compared to 2016 since the joint venture was created in April 2017. The income tax expense decrease of $8 million in 2017 as compared to 2016 was primarily due to a reduction in the earnings of our profitable non-US subsidiaries and an increase in tax credits. The increase in the non-controlling interest loss in the VNBS JV of $120 million was mainly due the goodwill impairment charge in 2017. Loss per Share - The loss per share for 2017 increased to $2.49 as compared to a loss of $0.61 per share in 2016 due to the increased net loss, mainly related to the goodwill impairment charge in the VNBS joint venture, as the share count was virtually unchanged. Reconciliations of U.S. GAAP to non U.S. GAAP Liquidity and Capital Resources Liquidity As of December 31, 2018, the Company had cash and cash equivalents of $864 million and short-term investments of $5 million which will be primarily use for ongoing working capital requirements, capital expenditures and investments in joint ventures particularly Zenuity. We expect the combined effects of a stronger LVP and new program launches in the second half of the year combined with our own efficiency and prioritization initiatives to start to lead to improved cash-flow in the latter part of the year. Assuming successful execution of these initiatives, we expect our net cash to cover our funding requirements until the Company reaches positive cash flow. However, additional funding may be required if order intake increases beyond our expectations, if the underlying near-term business conditions deteriorate further, or if we make acquisitions. During the year ended December 31, 2017, the Company entered an unconditional purchase obligation whereof the outstanding balance as of December 31, 2018 is $10 million which will be paid in 2019. The amount will be reimbursed by Zenuity. In addition, the Company has a holdback of $2 million related to the Fotonic acquisition to be paid in 2019. See Note 4, Business Combinations, to the consolidated financial statements included herein. The Company has no other material obligations other than short-term obligations related to operations, inventory, services, tooling and property, plant and equipment purchased in the ordinary course of business. On June 30, 2017, Veoneer committed to make a $15 million investment in Autotech Fund I, L.P. pursuant to a limited partnership agreement, and as a limited partner, will periodically make capital contributions toward this total commitment amount. As of December 31, 2018, Veoneer contributed a total of approximately $8 million to the fund. The initial term of the fund is set to expire on December 31, 2025. This fund focuses broadly on the automotive industry and complements the Company’s innovation strategy, particularly in the areas of active safety and autonomous driving. Under the limited partnership agreement, the general partner has the sole and exclusive right to manage, control and conduct the affairs of the fund. Cash Flow 1 Non-U.S. GAAP measure see reconciliation for Net Working Capital Net Working Capital1 - The net working capital of $42 million as of December 31, 2018 was a decrease of $17 million and $31 million as compared with 2017 and 2016, respectively. These decreases were mainly due to favorable timing effects in working capital. Net Cash Used in Operating Activities - Net cash used in operating activities of $179 million for the year ended December 31, 2018 increased by $178 million and $172 million as compared with 2017 and 2016, respectively, due to change in net loss and timing effects in working capital. Net Cash Used in Investing Activities - Net cash used in investing activities of $185 million for the year ended December 31, 2018 was $45 million lower and $150 million lower as compared with 2017 and 2016, respectively, mainly due to higher capital expenditures, which was more than offset by lower affiliate investments and acquisitions. Net Cash Provided by Financing Activities - Net cash provided by financing activities for the year ended December 31, 2018 includes the net capital contribution from Autoliv at the Distribution Date. Capital Expenditures - Capital expenditures during the year ended December 31, 2018 of $188 million, around 8% of sales, was $78 million and $85 million higher as compared with 2017 and 2016, respectively. This level as a percentage of sales in 2018 was in line with the full year expectation. Associates - The number of associates increased to 8,600 in 2018 by 1,116 compared to 2017, mainly due to the hiring of approximately 1,100 engineers to support our future sales growth and current development programs. Off-Balance Sheet Arrangements The Company does not have any off-balance sheet arrangements. Contractual Obligations and Commitments The table below reflects our contractual obligations as of December 31, 2018. The Company’s future contractual obligations have not changed materially. 1 Excludes contingent liabilities arising from litigation, arbitration, regulatory actions or income taxes Contractual obligations include related party long-term debt, lease and purchase obligations that are enforceable and legally binding on the Company. Non-controlling interest is not included in this table. Related party long-term debt: The related party debt obligation relates to capital lease obligations. The capital lease obligations mainly relate to property and plants in Japan and is between Veoneer Nissin Brake Systems (a 51% owned subsidiary) and Nissin Kogyo. See Note 19, Relationship with Former Parent and Related Entities, to the consolidated financial statements included herein. Operating lease obligations: The Company leases certain offices, manufacturing and research buildings, machinery, automobiles and data processing and other equipment. Such operating leases, some of which are non-cancelable and include renewals, expire on various dates. See Note 16, Commitments and Contingencies, to the consolidated financial statements included herein. Build-to-suit lease obligations: The Company has entered into build-to-suit lease arrangements for certain buildings during 2017. See Note 16, Commitments and Contingencies, to the consolidated financial statements included herein. Pension contribution requirements: The Company sponsors defined benefit plans that cover eligible employees in Japan, Canada, and France. In 2019, the expected contribution to all plans, including direct payments to retirees, is $3 million, of which the major contribution is $1 million for our Canada pension plans. Due to volatility associated with future changes in interest rates and plan asset returns, the Company cannot predict with reasonable reliability the timing and amounts of future funding requirements, and therefore the above table shows expected contributions (to funded plans, or direct payments to retirees in the case of unfunded plans) for 2019, but only shows benefit payments (from funded plans, or direct to retirees in the case of unfunded plans) for 2020 and subsequent years. We may elect to make contributions in excess of the minimum funding requirements for the Japan, Canada, and France plans in response to investment performance and changes in interest rates, or when we believe that it is financially advantageous to do so and based on other capital requirements. This contribution amount does not include plans considered to be multiemployer with Autoliv. See Note 2, Summary of Significant Accounting Policies, and Note 14, Retirement Plans, to the consolidated financial statements included herein. Other non-current liabilities reflected on the balance sheet: The Company has $2 million of deferred purchase consideration, payable at the 18-month anniversary of the closing date.related to the Fotonic acquisition to be paid in 2019. See Note 4, Business Combinations, to the consolidated financial statements included herein. Unconditional purchase obligations: During the year ended December 31, 2017, the Company entered into an unconditional purchase obligation of $30 million of which $10 million was paid in each of the years ended December 31, 2017 and December 31, 2018. The remaining $10 million will be paid in 2019. This amount will be reimbursed by Zenuity. There are no obligations other than short-term obligations related to inventory, services, tooling, and property, plant and equipment purchased in the ordinary course of business. Autotech Venture Fund: On June 30, 2017, Veoneer committed to make a $15 million investment in Autotech Fund I, L.P. pursuant to a limited partnership agreement, and, as a limited partner, will periodically make capital contributions toward this total commitment amount. As of December 31, 2018, Veoneer has in total contributed $8 million to the fund. The initial term of the fund is set to expire on December 31, 2025. This fund focuses broadly on the automotive industry and complements the Company’s innovation strategy, particularly in the areas of active safety and autonomous driving. Under the limited partnership agreement, the general partner has the sole and exclusive right to manage, control, and conduct the affairs of the fund. Significant Accounting Policies and Critical Accounting Estimates New Accounting Pronouncements The Company has considered all applicable recently issued accounting guidance. The Company has summarized in Note 2, Summary of Significant Accounting Policies to the consolidated financial statements included herein each of the recently issued accounting pronouncements and stated the impact or whether management is continuing to assess the impact. Critical Accounting Estimates The application of accounting policies necessarily requires judgments and the use of estimates by a Company’s management. Actual results could differ from these estimates. By their nature, these judgments are subject to an inherent degree of uncertainty. These judgments are based on our historical experience, terms of existing contracts, and management’s evaluation of trends in the industry, information provided by our customers and information available from other outside sources, as appropriate. Certain policies relate to estimates that involve matters that are highly uncertain at the time the accounting estimate is made and different estimates or changes to an estimate could have a material impact on the reported financial position, changes in financial condition or results of operations. Such critical estimates are discussed below. For these, materially different amounts could be reported under varied conditions and assumption. Other items in the Company's consolidated financial statements require estimation, however, in our judgment, they are not as critical as those discussed below. Revenue Recognition In accordance with ASC 606, Revenue from Contracts with Customers, revenue is measured based on consideration specified in a contract with a customer, adjusted for any variable consideration (i.e. price concessions or annual price adjustments) and estimated at contract inception. The Company recognizes revenue when it satisfies a performance obligation by transferring control over a product to a customer. In addition, from time to time, Veoneer may make payments to customers in connection with ongoing and future business. These payments to customers are generally recognized as a reduction to revenue at the time of the commitment to make these payments, unless certain criteria are met, warranting capitalization. If the payments are capitalized, the amounts are amortized as the related goods are transferred. As of December 31, 2018, and 2017, the Company capitalized $54 million and $23 million, respectively, in Other non-current assets related payments to customers. The Company assesses these amounts for impairment. There was no impairment. Taxes assessed by a governmental authority that are both imposed on and concurrent with a specific revenue-producing transaction, that are collected by the Company from a customer, are excluded from revenue. Shipping and handling costs associated with outbound freight after control of a product has transferred to a customer are accounted for as a fulfillment cost and are included in cost of sales. Nature of goods and services The following is a description of principal activities from which the Company generates its revenue. The Company has two operating segments, Electronics and Brake Systems. Electronics includes all of electronics resources and expertise, restraint control systems and active safety products. Brake Systems provides brake control and actuation systems. The principal activities are essentially the same for each of the segments. Both of the segments generate revenue from the sale of production parts to original equipment manufacturers (“OEMs”). The Company accounts for individual products separately if they are distinct (i.e., if a product is separately identifiable from other items and if a customer can benefit from it on its own or with other resources that are readily available to the customer). The consideration, including any price concession or annual price adjustments, is based on their stand-alone selling prices for each of the products. The stand-alone selling prices are determined based on the cost-plus margin approach. The Company recognizes revenue for production parts primarily at a point in time. For production parts with revenue recognized at a point in time, the Company recognizes revenue upon shipment to the customers and transfer of title and risk of loss under standard commercial terms (typically F.O.B. shipping point). There are certain contracts where the criteria to recognize revenue over time have been met (e.g., there is no alternative use to the Company and the Company has an enforceable right to payment). In such cases, at period end, the Company recognizes revenue and a related asset and associated cost of goods sold and inventory. However, the financial impact of these contracts is immaterial considering the very short production cycles and limited inventory days on hand, which is typical for the automotive industry. The amount of revenue recognized is based on the purchase order price and adjusted for variable consideration (i.e. price concessions or annual price adjustments). Customers typically pay for the production parts based on customary business practices with payment terms averaging 30 days. Contract balances The contract assets related to the Company’s rights to consideration for work completed but not billed (generally in conjunction with contracts for which revenue is recognized over time) at the reporting date on production parts. The contract assets are reclassified into the receivables balance when the rights to receive payments become unconditional. There have been no impairment losses recognized related to contract assets arising from the Company’s contracts with customers. Business Combinations In accordance with accounting guidance for the provisions in FASB ASC 805, Business Combinations, the Company allocates the purchase price of an acquired business to its identifiable assets and liabilities based on estimated fair values. The excess of the purchase price over the amount allocated to the assets and liabilities, if any, is recorded as goodwill. In addition, an acquisition may include a contingent consideration component. The fair value of the contingent consideration is estimated as of the date of the acquisition and is recorded as part of the purchase price. Each quarter this contingent consideration is re-measured using the discounted cash flow method. The Company uses actual revenue levels as well as changes in the estimated probability of different revenue scenarios to estimate fair values. The Company has engaged outside appraisal firms to assist in the fair value determination of identifiable intangible assets and any other significant assets or liabilities. The Company adjusts the preliminary purchase price allocation, as necessary, up to one year after the acquisition closing date as the Company obtains more information regarding asset valuations and liabilities assumed. The Company’s purchase price allocation methodology contains uncertainties because it requires management to make assumptions and to apply judgment to estimate the fair value of acquired assets and liabilities. Management estimates the fair value of assets and liabilities based upon quoted market prices, the carrying value of the acquired assets and widely accepted valuation techniques, including discounted cash flows and market multiple analyses. Unanticipated events or circumstances may occur which could affect the accuracy of our fair value estimates, including assumptions regarding industry economic factors and business strategies. Other estimates used in determining fair value include, but are not limited to, future cash flows or income related to intangibles, market rate assumptions, actuarial assumptions for benefit plans and appropriate discount rates. The Company estimates the fair value based upon assumptions believed to be reasonable, but these are inherently uncertain, and therefore, may not be realized. Accordingly, there can be no assurance that the estimates, assumptions, and values reflected in the valuations will be realized, and actual results could vary materially. Equity Method Investments The Company initially accounts for an equity method investment at its fair value on the date of acquisition. See Note 2, Summary of Significant Accounting Policies and Note 9, Investments related to the Company’s investment in Zenuity, to the consolidated financial statements included. Inventory Reserves Inventories are evaluated based on individual or, in some cases, groups of inventory items. Reserves are established to reduce the value of inventories to the lower of cost and net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation. Excess inventories are quantities of items that exceed anticipated sales or usage for a reasonable period. The Company has guidelines for calculating provisions for excess inventories based on the number of months of inventories on hand compared to anticipated sales or usage. Management uses its judgment to forecast sales or usage and to determine what constitutes a reasonable period. There can be no assurance that the amount ultimately realized for inventories will not be materially different than that assumed in the calculation of the reserves. Goodwill and Intangibles The Company performs an annual impairment review of goodwill in the fourth quarter of each year following the Company’s annual forecasting process. Management uses its judgment to determine the Company’s reporting units for goodwill impairment testing. The estimated fair market value of goodwill is determined by the discounted cash flow method. The Company discounts projected operating cash flows using its weighted average cost of capital. Estimating the fair value requires the Company to make judgments about appropriate discount rates, growth rates, relevant comparable company earnings multiples and the amount and timing of expected future cash flows. If the fair value of the reporting unit is less than its carrying amount, an impairment loss is recognized for the excess of carrying amount over the fair value of the respective reporting unit. In the fourth quarter of 2017, in connection with the annual impairment test, the Company recorded a goodwill impairment charge of $234 million in its Electronics Segment, relating to the VNBS acquisition. For more information, see Note 2, Summary of Significant Accounting Policies, to the consolidated financial statements included herein) due to lower than originally anticipated sales development. There is no remaining goodwill related to VNBS after the impairment. There were no goodwill impairments recognized during 2018 and 2016. The Company reviews indefinite-lived intangible assets for impairment annually or more frequently if events or changes in circumstances indicate the assets might be impaired. Similar to the goodwill impairment test described above, the Company performs a quantitative impairment test by comparing the estimated fair value of the asset, based upon its forecasted cash flows, to its carrying value. Other intangible assets with definite lives are amortized over their useful lives. The Company evaluates the carrying value and useful lives of long-lived assets other than goodwill when indications of impairment are evident, or it is likely that the useful lives have decreased, in which case the Company depreciates the assets over the remaining useful lives. Impairment testing is primarily done by using the cash flow method based on undiscounted future cash flows. Estimated undiscounted cash flows for a long-lived asset being evaluated for recoverability are compared with the respective carrying amount of that asset. If the estimated undiscounted cash flows exceed the carrying amount of the assets, the carrying amounts of the long-lived asset are considered recoverable and an impairment cannot be recorded. However, if the carrying amount of a group of assets exceeds the undiscounted cash flows, an entity must then measure the long-lived assets’ fair value to determine whether an impairment loss should be recognized, generally using a discounted cash flow model. Recall Provisions and Warranty Obligations The Company records liabilities for product recalls when probable claims are identified and when it is possible to reasonably estimate costs. Recall costs are costs incurred when the customer decides to formally recall a product due to a known or suspected safety concern. Product recall costs typically include the cost of the product being replaced as well as the customer’s cost of the recall, including labor to remove and replace the defective part. In some cases, portions of the product recall costs are reimbursed by an insurance company. Actual costs incurred could differ from the amounts estimated, requiring adjustments to these reserves in future periods. It is possible that changes in our assumptions or future product recall issues could materially affect our financial position, results of operations or cash flows. Estimating warranty obligations requires the Company to forecast the resolution of existing claims and expected future claims on products sold. The Company bases the estimate on historical trends of units sold and payment amounts, combined with our current understanding of the status of existing claims and discussions with our customers. These estimates are re-evaluated on an ongoing basis. Actual warranty obligations could differ from the amounts estimated requiring adjustments to existing reserves in future periods. Due to the uncertainty and potential volatility of the factors contributing to developing these estimates, changes in our assumptions could materially affect our results of operations. Defined Benefit Pension Plans Veoneer’s employees participate in defined benefit plans sponsored by Autoliv and certain defined benefit plans sponsored by Veoneer in Japan (the Japan plans), France (the France plans), and Canada (the Canada plans). For the Japan, French, and Canada plans, the amount recognized as a defined benefit liability is the net total of projected benefit obligation (PBO) minus the fair value of plan assets (if any). The plan assets are measured at fair value. Net periodic benefit cost was reported within Costs of sales, Selling, general and administrative expenses and RD&E expenses in the Consolidated Statement of Operations. Veoneer has considered the remaining plans to be part of a multiemployer plan with Autoliv. Pension expense was allocated for these plans and reported within Costs of sales, Selling, general and administrative expenses and RD&E expenses in the Consolidated Statement of Operations. Of the plans sponsored by Veoneer, the most significant plans are the Japan plans. These plans represent approximately 44% of the Company’s total pension benefit obligation. See Note 14, Retirement Plans, to the consolidated financial statements included herein. The Company, in consultation with its actuarial advisors, determines certain key assumptions to be used in calculating the projected benefit obligation and annual pension expense. For the Japan plans, the assumptions used for calculating the 2018 pension expense were a discount rate of 0.5%, expected rate of increase in compensation levels of 5.0%, and an expected long-term rate of return on plan assets of 0.75%. The discount rate for the Japanese plans has been set based on the rates of return of high-quality fixed-income investments currently available at the measurement date and are expected to be available during the period the benefits will be paid. The expected rate of increase in compensation levels and long-term return on plan assets are determined based on a number of factors and must take into account long-term expectations and reflect the financial environment in the respective local markets. As of December 31, 2018 and 2017, 100% and 97% of the Japanese plan assets were invested in insurance contracts. Income Taxes Significant judgment is required in determining the worldwide provision for income taxes. In the ordinary course of a global business, there are many transactions for which the ultimate tax outcome is uncertain. Many of these uncertainties arise as a consequence of intercompany transactions. See Note 1, Basis of Presentation, Note 6, Income Taxes and Note 19, Relationship with Parent and Related Entities, to the Consolidated Financial Statements included herein. Although the Company believes that its tax return positions are supportable, no assurance can be given that the final outcome of these matters will not be materially different than that which is reflected in the historical income tax provisions and accruals. Such differences could have a material effect on the income tax provisions or benefits in the periods in which such determinations are made. See also the discussion of the determinations of valuation allowances on our deferred tax assets in Note 6, Income Taxes, to the consolidated financial statements included herein. Contingent Liabilities Various claims, lawsuits and proceedings are pending or threatened against the Company or its subsidiaries, covering a range of matters that arise in the ordinary course of its business activities with respect to commercial, product liability or other matters. For a discussion of legal matters we are involved in, see Note 16, Contingent Liabilities, to the condensed consolidated financial statements included herein. The Company diligently defends itself in such matters and, in addition, carries insurance coverage to the extent reasonably available against insurable risks. The Company records liabilities for claims, lawsuits and proceedings when they are probable, and it is possible to reasonably estimate the cost of such liabilities. Legal costs expected to be incurred in connection with a loss contingency are expensed as such costs are incurred. A loss contingency is accrued by a charge to income if it is probable that an asset has been impaired, or a liability has been incurred and the amount of the loss can be reasonably estimated. In determining whether a loss should be accrued management evaluates, among other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our consolidated financial statements.
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0.050079
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<s>[INST] The following MD&A is intended to help you understand the business operations and financial condition of the Company. This MD&A is presented in the following sections: Executive Overview Trends, Uncertainties and Opportunities Market Overview NonU.S. GAAP Financial Measures Results of Operations Liquidity and Capital Resources OffBalance Sheet Arrangements Contractual Obligations and Commitments Significant Accounting Policies and Critical Accounting Estimates Veoneer is a Delaware corporation with its principal executive offices in Stockholm, Sweden. The Company functions as a holding corporation and owns two principal operating subsidiaries, Veoneer AB and Veoneer US, Inc. On June 29, 2018 the SpinOff of Veoneer from Autoliv, Inc. ("Autoliv") was completed through the distribution by Autoliv of all the outstanding shares of common stock of Veoneer to Autoliv’s stockholders as of the close of business on June 12, 2018, the common stock record date for the distribution, in a taxfree, pro rata distribution (the "SpinOff"). On July 2, 2018, the shares of Veoneer common stock commenced trading on the New York Stock Exchange under the symbol “VNE” and the Veoneer Swedish Depository Receipts representing shares of Veoneer common stock commenced trading on Nasdaq Stockholm under the symbol “VNE SDB.” Veoneer is a global leader in the design, development, manufacture, and sale of automotive safety electronics with a focus on innovation, quality and manufacturing excellence. Prior to the SpinOff, Veoneer operated for almost four years as an operating segment within Autoliv. Veoneer's Safety Systems are designed to make driving safer and easier, more comfortable and convenient for the end consumer and to intervene before a collision. Veoneer endeavors to prevent vehicle accidents or reduce the severity of impact in the event a crash is unavoidable. Through our customer focus, being an expert partner with our customers, we intend to develop human centric systems that benefit vehicle occupants. Veoneer’s current product offering includes automotive radars, monoand stereovision cameras, night driving assist systems, positioning systems, ADAS (advanced driver assist systems) electronic control units, passive safety electronics (airbag control units and crash sensors), brake control systems and a complete ADAS software offering towards highly automated driving (HAD) and eventually autonomous driving (AD). In addition, we offer driver monitoring systems, LiDAR sensors, RoadScape positioning and other technologies critical for HAD and AD solutions by leveraging our partnership network and internally developed intellectual property. Executive Overview The environment around us is rapidly changing and we currently see a shift across the automotive and autotech industries. New technologies, creating new levels of interaction and driver support are starting to revolutionize driving, but we also see the driver being actively involved for years to come. We call this Collaborative Driving; the industry also calls it “Level 2+” driver support. At the same time there is also a growing realization that the introduction of truly selfdriving cars will likely take longer and be more expensive than previously anticipated. This fundamental insight opens up new opportunities for companies, including Veoneer, but it also requires a reprioritization of resources. In the near term there is also an increased uncertainty regarding the development of global light vehicle production (LVP). During the fourth quarter of 2018 we saw a sharp decline in the LVP in China and Western Europe and we anticipate that these markets will continue to show weakness in the first half of this year. We expect the situation to improve in the second half, but we currently expect a slight decline in the global LVP for the full year 2019. In response to the larger role in the market for Collaborative Driving, the expected delay of selfdriving, and the weaker LVP trend, we are actively reviewing our investment priorities and the focus of our product portfolio. Our purpose is to identify the most effective way to allocate talent and capital to meet these new market realities. In December we refined our organization to create a more agile and focused company, and during 2019 we expect our renewed organization, combined with other initiatives to gradually [/INST] Positive. </s>
2,019
9,495
1,733,186
Veoneer, Inc.
2020-02-21
2019-12-31
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Introduction The following MD&A is intended to help you understand the business operations and financial condition of the Company. This MD&A is presented in the following sections: •Executive Overview •Trends, Uncertainties and Opportunities •Market Overview •Non-U.S. GAAP Financial Measures •Results of Operations •Liquidity and Capital Resources •Off-Balance Sheet Arrangements •Contractual Obligations and Commitments •Significant Accounting Policies and Critical Accounting Estimates Veoneer is a Delaware corporation with its principal executive offices in Stockholm, Sweden. The Company functions as a holding corporation and owns two principal operating subsidiaries, Veoneer AB and Veoneer US, Inc. On June 29, 2018, the Spin-Off of Veoneer from Autoliv, Inc. ("Autoliv") was completed through the distribution by Autoliv of all the outstanding shares of common stock of Veoneer to Autoliv’s stockholders as of the close of business on June 12, 2018, the common stock record date for the distribution, in a tax-free, pro rata distribution (the "Spin-Off"). On July 2, 2018, the shares of Veoneer common stock commenced trading on the New York Stock Exchange under the symbol “VNE” and the Veoneer Swedish Depository Receipts representing shares of Veoneer common stock commenced trading on Nasdaq Stockholm under the symbol “VNE SDB.” Veoneer is a global leader in the design, development, manufacture, and sale of automotive safety electronics with a focus on innovation, quality and manufacturing excellence. Prior to the Spin-Off, Veoneer operated for almost four years as an operating segment within Autoliv. Veoneer's safety systems are designed to make driving safer and easier, more comfortable and convenient for the end consumer and to intervene before a potential collision. Veoneer endeavors to prevent vehicle accidents or reduce the severity of impact in the event a crash is unavoidable. Through our customer focus, being an expert partner with our customers, we intend to develop human centric systems that benefit automotive light vehicle occupants. Veoneer’s current product offering includes automotive radars, mono-and stereo-vision cameras, night driving assist (thermal sensing) systems, positioning systems, ADAS (advanced driver assist systems) electronic control units, passive safety electronics (airbag control units and crash sensors), brake control systems and a complete ADAS software offering towards highly automated driving (HAD) and eventually autonomous driving (AD). In addition, we offer driver monitoring systems, LiDAR sensors, RoadScape positioning and other technologies critical for HAD and AD solutions by leveraging our partnership network and internally developed intellectual property. Executive Overview Organic sales in the quarter were in-line with our expectations at the beginning of the quarter, despite some weakness in the LVP. Our operating loss was lower than expected at the beginning of the quarter, primarily due to continuing cost control activities across the company, particularly with respect to customer reimbursements and control of our RD&E costs. In general, our market adjustment initiatives are continuing to positively impact our cost structure. During 2020 we intend to take further actions under our market adjustment initiative program. These actions include: further partnering, further focusing our product portfolio, reviewing certain customer contracts, and a continued focus on other cost improvement initiatives. We are also continuing to define the scope and priorities of Zenuity, where the Polestar 2 and the Volvo XC 40 Recharge, both launching in the upcoming months, will be the first two vehicles with the full Zenuity software suite for collaborative driving. This is a major milestone and achievement for Zenuity. 2020 is a major customer launch year for Veoneer and we are gearing up for the launch of our fourth-generation vision systems during the first half of the year. The bulk of the launches, and importantly the higher delivery volumes, are concentrated toward the second half of the year which is when we expect Veoneer to return to organic sales growth. We are basing our 2020 outlook on our core Active Safety and Restraint Control Systems businesses and our VBS US operations Brake Systems business, as we completed the divestiture of the Asian operations of our VNBS joint venture on February 3, 2020 as part of an on-going strategic review of our brake business. In the early part of January, we participated to the Consumer Electronics Show where we showcased our latest solutions in Collaborative Driving, which further confirmed our decision to focus our sales, operations and development on Active Safety solutions where the driver remains involved. Customer feedback to our approach is very positive and we expect to win significant, profitable orders with our focused, refined Active Safety portfolio throughout 2020. We are currently monitoring and taking appropriate actions on a daily basis related to the effects from the Coronavirus outbreak in China. As always, the health and safety of our employees is our primary focus. To date we are not aware of any cases of the virus with our employees, however it is too early to assess the effects on our China business as this is an on-going situation. For the next several quarters our focus is on preparing for: successful customer launches in 2020 and heading into 2021, market adjustment initiatives to continue to drive efficiencies and improve cash flow, and continuing to win profitable new business. 2020 Outlook and Targets Our 2020 outlook includes our core Active Safety and Restraint Control Systems business (Electronics segment) and the VBS US operations since we completed the VNBS JV divestiture on February 3, 2020. Our current customer call-offs and deliveries point to a weak first quarter, mostly in China and Europe, both sequentially from the previous quarter and year-over-year. This leads us to expect a LVP decline for the first six months and a decline in the low single digits for 2020, both as compared to 2019. Veoneer expects to return to organic sales growth in the mid-single digits in 2020. This expected sales growth is driven by new program launches, mostly in Active Safety, during the second half of the year. During the first half of 2020 our net sales are expected to remain relatively flat sequentially from the second half of 2019, and then ramp-up sequentially during the second half of 2020. During 2020, our market adjustment initiatives are expected to generate further cost structure and balance sheet improvements. We expect RD&E, net along with the operating loss and cash flow before financing to improve in 2020 from 2019 levels, on a comparable basis, although most of the improvement is expected to come during the second half of the year. This excludes any one-time effects related to our strategic reviews. Based on the market opportunities we currently foresee in 2020, we estimate our order intake to be approximately $1 billion of average annual sales for our core Electronics segment. Lastly, our medium-term targets are based on our approximately $19 billion order book, of which approximately 80% is for the Electronics segment (Active Safety and Restraint Control Systems). We estimate the net sales of this segment will increase to approximately $2.5 billion in 2022, which is a CAGR of approximately 19% from 2019. During this same period Active Safety net sales are expected to approximately double. Financial Results Significant aspects of the Company's financial results for the year ended December 31, 2019, include the following. Net Sales - Veoneer’s net sales for the full year of 2019 declined by 15% to $1,902 million as compared to 2018. Gross Profit - The gross profit of $311 million for the full year of 2019 was $119 million lower as compared to 2018. The negative volume and product mix effects that caused the lower organic sales were the main contributors to the gross profit decline. Net currency effects on the gross profit were approximately $28 million unfavorable for the same period as compared to 2018, primarily due to the stronger US dollar. Operating Loss - The operating loss of $460 million for the full year of 2019 increased by $263 million as compared to 2018. Net currency effects on the operating loss were negative $8 million for the same period as compared to 2018. Net Loss - The net loss for the full year of 2019 increased by $228 million to $522 million as compared to 2018. Veoneer’s net loss from its equity method investment (Zenuity) of $70 million for the full year of 2019 increased by $7 million as compared to 2018. This increase is mainly attributable to the hiring and continued build-up of software engineers through the first half of 2019. The increase in equity method investment loss was partially offset by interest income, net of $8 million, which was an increase of $2 million as compared to 2018. Interest expense related to the convertible debt issuance in 2019 was approximately $10 million for the full year of 2019. The Income tax expense for the full year of 2019 decreased by $41 million as compared to 2018, mainly due to a $10 million tax benefit from the convertible debt and $26 million of discrete tax items in 2018. The non-controlling interest loss of $22 million in the VNBS JV for the full year of 2019 was $3 million higher as compared to 2018. The increase is mainly due to the organic sales impact on earnings. Loss per Share - The loss per share of $4.92 for the full year of 2019 increased by $1.75 per share as compared to 2018 mainly due to the increase in the operating loss. The share count increase from the common stock issuance in 2019 reduced the loss by $0.80 per share. Trends, Uncertainties and Opportunities Trend toward Collaborative Driving The environment around us continues to be rapidly changing and we currently see a shift across the automotive and autotech industries. The industry developments during 2019 have further strengthened the trend toward advanced driver support - Collaborative Driving - and away from fully autonomous cars for the consumer based vehicle mass market. New technologies, creating new levels of interaction and driver support are starting to revolutionize driving, but we also see the driver being actively involved for many years to come. While the industry refers to “Level 2+” or even "Level 2++" Veoneer calls this Collaborative Driving, and includes any SAE level of automation. At the same time there is a growing realization that the introduction of truly self-driving cars will likely take longer and be more expensive than previously anticipated. This fundamental insight opens up new opportunities for companies, including Veoneer, but it also requires a reprioritization of resources. As such, we believe that the market will stay mainly focused on Level 1-Level 2+ autonomous driving solutions for the next decade. Global Regulatory and Test Rating Developments Europe continues to take a proactive role in promoting or requiring Active Safety technologies. The European New Car Assessment Program (“NCAP”) continuously updates its test rating program to include more active safety technologies to help the European Union reach its target of cutting road fatalities by 50% by 2030, as compared to 2020. We anticipate strong global sensor adoption rate increases (forward, side and rear) due to the European NCAP's push for crash avoidance, increased adoption rates due to growing demand around ADAS software features, volume growth due to redundant sensing concepts needed for higher levels of autonomy, potential opportunities in relation to compliance with cyber-security and software updates and step-by-step increased demand for connectivity components as a result. On May 17, 2018, the European Commission proposed a new mandate, as party of the EU General Safety Regulation road-map through 2028, to make certain Active Safety features compulsory in light vehicles by 2022. During March of 2019 the EU mandate was adopted as initially proposed by the European Commission. We believe that adoption of the mandate will significantly expand demand for our Active Safety products. Indeed, with respect to sensors and Advanced Driver Assistance Systems (ADAS) software features, our order intake since the adoption of the mandate seems to reflect the anticipated increase in demand. However, during 2019 we have seen OEM delays in the sourcing of these technologies as customers reconsider how they want to architect and design, in a scalable way to include these new standard technologies. In addition, we believe that the mandate and the EU General Safety Regulations (GSR) generally will influence other market regulators as they evaluate their respective vehicle test rating programs and safety legislation. In China, the Ministry of Industry and Information Technology issued the Key Working Points of Intelligent Connected Vehicle Standardization for 2018 to promote and facilitate the development of the intelligent connected vehicles industry, and advance the development of fundamental standards and those that are in urgent demand. The guideline has pointed out that more than 30 key standards will be defined by 2020 to fund the systems for (ADAS) and low-level autonomous driving, and a system of over 100 standards will be set up by 2025 for higher level autonomous driving. During the third quarter of 2018, the Chinese government commenced testing of new vehicles according to the new China New Car Assessment Program (CNCAP) where active safety features like Autonomous Emergency Braking (AEB) are required to achieve the maximum safety rating. On October 4, 2018, the U.S. Department of Transportation (DoT) issued new voluntary guidelines on automated driving systems (ADS) under its “Preparing for the Future of Transportation: Automated Vehicles 3.0” initiative, building on its “Vision for Safety 2.0” from September 2017, which prioritized aligning federal guidance around twelve safety design elements of interest to the auto industry. This initiative should have a positive impact on the adoption of ADAS and Highly Automated Driving (HAD) on the road towards Autonomous Vehicles (AV). In 2018 the UN Economic Commission for Europe (ECE) created a new Working Party to deal with regulations for Automated/Autonomous and Connected Vehicles (GRVA). In addition to the EU and Japan, which have both started to work closely together to develop ADAS regulations, in the last three years, the U.S. and China have both indicated a willingness to be active in several working groups towards harmonization of future regulations for ADAS and AV. This would create a common umbrella for countries which follow type-approval rules (EU, Japan, Australia) and countries which are outside of type-approval system, e.g., under self-certification regimes (U.S., Korea) or specific national rules (China). Key future potential regulations are expected for (i) safety critical ADAS-features (e.g. AEB); (ii) Highway AV-features (Physical Tests + Real World Test Drive + Audit); (iii) Cyber-security and Software updates; and (iv) Connected Vehicles. On one hand, the agreement on minimal common base requirements for the industry will take a longer time and therefore may postpone introduction of regulations. On the other hand, the harmonization with base requirements would help the industry while a more active position from China may help to pull forward some safety critical ADAS technologies which are not yet considered as relevant for regulation in EU and Japan (e.g. Blind Spot or Night Vision). Market Overview For the full year of 2019, the global light vehicle production (according to IHS) declined by approximately 6% as the expected second half improvement for 2019 did not materialize as expected at the beginning of 2019, mainly due to a continued deterioration in China, RoA and Western Europe throughout 2019. This decline is approximately 7 percentage points lower than expected at the beginning of 2019. This is the largest single year decline since the financial crisis in 2009. Despite the overall light vehicle production decline as compared to 2018, North America remained relatively stable, and near peak levels, where the decline in 2019 was 4% to 15.1 million vehicles, as compared to 2018. This is the second consecutive annual decline in light vehicle production from 2017 when a record 92 million vehicles were produced. The IHS outlook for global light vehicle production in 2020 is for a 1% decline from 2019 levels to 85 million vehicles. China, Japan and Western Europe are expected to be the main drivers of the decline in 2020 as compared to 2019. Non-U.S. GAAP Financial Measures Non-U.S. GAAP financial measures are reconciled throughout this report. In this report we refer to organic sales or changes in organic sales growth, a non-U.S. GAAP financial measure that we, investors and analysts use to analyze the Company's sales trends and performance. We believe that this measure assists investors and management in analyzing trends in the Company's business because the Company generates approximately 68% of its sales in currencies other than in U.S. dollars (its reporting currency) and currency rates have been and can be rather volatile. The Company has historically made several acquisitions and divestitures, although none that impacted the reporting periods in question. Organic sales and organic sales growth represent the increase or decrease in the overall U.S. dollar net sales on a comparable basis, allowing separate discussions of the impact of acquisitions/divestitures and exchange rates on the Company’s performance. The tables in this report present the reconciliation of changes in the total U.S. GAAP net sales to changes in organic sales growth. The Company uses in this report EBITDA, a non-U.S. GAAP financial measure, which represents the Company’s net income excluding interest expense, income taxes, depreciation and amortization and including loss from equity method investment. The Company also uses Segment EBITDA, a non-U.S. GAAP financial measure, which represents the Company’s EBITDA which has been further adjusted on a segment basis to exclude certain corporate and other items. We believe that EBITDA and Segment EBITDA are useful measures for management, analysts and investors to evaluate operating performance on a consolidated and reportable segment basis, because it assists in comparing our performance on a consistent basis. The tables below provide reconciliations of net income (loss) to EBITDA and Segment EBITDA. The Company uses in this report net working capital, a non-U.S. GAAP financial measure, which is defined as current assets (excluding cash and cash equivalents) minus current liabilities excluding short-term debt and net assets and liabilities held for sale. The Company also uses in this report cash flow before financing activities, a non-U.S. GAAP financial measure, which is defined as net cash used in operating activities plus net cash used in investing activities. Management uses these measures to improve its ability to assess operating performance at a point in time as well as the trends over time. The tables below provide a reconciliation of current assets and liabilities to net working capital and cash flow before financing activities. Investors should not consider these non-U.S. GAAP measures as substitutes, but rather as additions, to financial reporting measures prepared in accordance with U.S. GAAP. These measures, as defined, may not be comparable to similarly titled measures used by other companies. Forward-looking non-U.S. GAAP financial measures used in this report are provided on a non-U.S. GAAP basis. Veoneer has not provided a U.S. GAAP reconciliation of these measures because items that impact these measures, such as foreign currency exchange rates and future investing activities, cannot be reasonably predicted or determined. As a result, such reconciliations are not available without unreasonable efforts and Veoneer is unable to determine the probable significance of the unavailable information. Results of Operations Fiscal Year 2019 compared to 2018 The following tables show Veoneer’s performance by segment for the years ended December 31, 2019 and 2018 along with components of change compared to the prior year. 1 Non-U.S. GAAP measure reconciliation for Organic Sales and EBITDA Net Sales - The net sales in the Electronics segment decreased by $270 million to $1,530 million for the full year of 2019 as compared to 2018. This decline was mainly due to the organic sales1 decline in Active Safety and Restraint Control Systems of $81 million and $123 million, respectively, along with the currency translation effects of $66 million. Operating Loss - The operating loss for the Electronics segment of $324 million for the full year of 2019 increased by $208 million as compared to 2018. This increase was mainly due to the negative volume and product mix effects causing lower organic sales in Active Safety and Restraint Control Systems and an increase in RD&E cost to support future organic sales growth and current development programs. EBITDA1 - The EBITDA loss for the Electronics segment decreased by $199 million to negative $242 million for the full year of 2019 as compared to 2018. This was mainly due to the increase in operating loss as depreciation and amortization increased by $9 million. Associates - The number of associates in the Electronics segment increased by 279 to 7,384 as compared to 2018. This increase is primarily due to the hiring of engineers to support the strong order intake for future sales growth. Deliveries - The quantities delivered during the full year of 2019 were 16.0 and 8.3 million units for Restraint Controls Systems and Active Safety, respectively. 1 Non-U.S. GAAP measure reconciliation for Organic Sales and EBITDA Net Sales - The net sales in the Brake Systems segment decreased by $56 million to $372 million for the full year of 2019 as compared to 2018. This sales decline was mainly attributable to temporary lower volumes on certain Honda vehicle models, mainly in China and Japan. Operating Loss - The operating loss for the Brake Systems segment increased by $34 million to $64 million for the full year of 2019 as compared to 2018. This increase was mainly due to the negative volume and product mix effects causing lower organic sales and a slight increase in RD&E, net to support future organic sales growth. Within the Brake Systems segment, the VNBS JV Asia operations (including China and Japan) generated Net Sales of $313 million for the full year of 2019 and $370 million for the full year of 2018. The RD&E, net for the VNBS JV Asia operations (including China and Japan) was approximately $25 million in 2019. EBITDA1 - The EBITDA loss for Brake Systems segment decreased to negative $32 million for the full year of 2019 as compared to $7 million in 2018, mainly due to the increase in the operating loss for the segment. Associates - The number of associates in the Brake Systems segment declined slightly to 1,447 as compared to 2018. An increase in RD&E was mostly offset by reductions in direct and indirect labor associates. Deliveries - The quantities delivered during the full year of 2019 were 1.7 million units for Brake Systems. 1 Non-U.S. GAAP measure reconciliation for EBITDA Operating Loss and EBITDA1 - The operating and EBITDA loss for Corporate and other for the full year of 2019 increased to $72 and $71 million, respectively, as compared to $51 million in 2018, mainly due to additional costs associated with being a standalone listed company. Associates - The number of associates remained unchanged at 43 as compared to 2018 mainly due to the hiring of personnel to support a standalone listed company that was completed in 2018. The Veoneer associates and financial figures for the full year of 2019 are not comparable since the first half of 2018 is based on carve-out reporting. Net Sales by Product The following tables show Veoneer’s consolidated net sales by product for the years ended December 31, 2019 and 2018 along with components of change compared to the prior year. 1 Non-U.S. GAAP measure reconciliation for Organic Sales Veoneer Performance The following table shows Veoneer’s performance for the year ended December 31, 2019 and 2018 along with components of change compared to the prior year. Net Sales - Veoneer’s net sales for the full year of 2019 declined by 15% to $1,902 million as compared to 2018. Organic sales1 declined by 12% while the combined currency translation effects were 3%. More than half of the organic sales decline for the full year of 2019 was in North America, and was related to both the Restraint Control Systems and the Active Safety product areas. The LVP, according to IHS, declined by close to 6% for the full year of 2019 as compared to 2018. This decrease was mainly attributable to China, Western Europe, North America, South Korea and India. The global LVP of close to 86 million vehicles for 2019 is the lowest level since 2015 when the global LVP was approximately 86 million. Restraint Control Systems - Net sales for the full year of 2019 decreased by 16% to $822 million as compared to 2018. The organic sales1 decline of 13% was due to lower volumes in North America, China and South Korea, where we have a temporary phase-out of our products on certain vehicle models, and lower underlying LVP. Active Safety - Net sales for the full year of 2019 decreased by 14% to $708 million as compared to 2018. This decline was driven by currency translation effects of 4% while organic sales1 declined by 10%. The LVP in our major markets for Active Safety (Western Europe, North America, China and Japan), where we have a relatively higher CPV on premium brands produced in those markets, declined by close to 6%. Strong demand for mono, stereo and night vision (thermal sensing) systems and ADAS ECUs on several models drove an increase in organic sales. This growth was more than offset by the negative product mix impact from 24GHz to 77GHz radar technology and the phase-out of mono vision cameras on certain BMW models. Brake Systems - Net sales for the full year of 2019 decreased by 13% to $372 million as compared to 2018. The organic sales¹ decline of 12% was mainly due to lower volumes in China and Japan, where we have a temporary phase-out of our products on certain Honda vehicle models. 1 Including Corporate and other sales. 2 Basic number of shares used to compute net loss per share. Participating share awards with right to receive dividend equivalents are (under the two class method) excluded from EPS calculation. 3 The first half of 2018 are according to Carve-out reporting from Autoliv Spin-Off of Veoneer. Gross Profit - The gross profit of $311 million for the full year of 2019 was $119 million lower as compared to 2018. The negative volume and product mix effects that caused the lower organic sales were the main contributors to the gross profit decline. Net currency effects on the gross profit were approximately $28 million unfavorable for the same period as compared to 2018, primarily due to the stronger US dollar. Operating Loss - The operating loss of $460 million for the full year of 2019 increased by $263 million as compared to 2018. Net currency effects on the operating loss were negative $8 million for the same period as compared to 2018. The RD&E, net increase of $96 million for the full year of 2019 as compared to 2018 was mainly due to the ramp-up of engineering hiring during 2018 to support future organic sales growth. The SG&A increase of $33 million for the full year of 2019 as compared to 2018 was mostly related to the additional costs associated with being a standalone listed company during the first half of 2019. Other income was $18 million lower for the full year of 2019 as compared to 2018 primarily due to the reversal of the $14 million MACOM earn-out provision. Net Loss - The net loss for the full year of 2019 increased by $228 million to $522 million as compared to 2018. Veoneer’s net loss from its equity method investment (Zenuity) of $70 million for the full year of 2019 increased by $7 million as compared to 2018. This increase is mainly attributable to the hiring and continued build-up of software engineers through the first half of 2019. The increase in equity method investment loss was partially offset by interest income, net of $8 million, which was an increase of $2 million as compared to 2018. Interest expense related to the convertible debt issuance in 2019 was approximately $10 million for the full year of 2019. The Income tax expense for the full year of 2019 decreased by $41 million as compared to 2018, mainly due to a $10 million tax benefit from the convertible debt and $26 million of discrete tax items in 2018.The non-controlling interest loss of $22 million in the VNBS JV for the full year of 2019 was $3 million higher as compared to 2018. The increase is mainly due to the organic sales impact on earnings. Loss per Share - The loss per share of $4.92 for the full year of 2019 increased by $1.75 per share as compared to 2018 mainly due to the increase in the operating loss. The share count increase from the common stock issuance in 2019 reduced the loss by $0.80 per share. Results of Operations Fiscal Year 2018 compared to 2017 Veoneer’s results of operations for the year ended December 31, 2018 compared to the year ended December 31, 2017 along with components of change compared to the prior year that have been omitted under this item can be found in Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations in the Company's Form 10-K for the year ended December 31, 2018 filed with the SEC on February 22, 2019. Reconciliations of U.S. GAAP to non U.S. GAAP Liquidity and Capital Resources Liquidity As of December 31, 2019, the Company had cash and cash equivalents of $894 million (includes $35 million in assets held for sale), which will be primarily used for ongoing working capital requirements, capital expenditures and investments in joint ventures particularly Zenuity. As of February 3, 2020, Veoneer received approximately $170 million cash from the sale of VNBS Asia operations. The Company has no material obligations other than short-term obligations related to operations, inventory, services, tooling and property, plant and equipment purchased in the ordinary course of business. On June 30, 2017, Veoneer committed to make a $15 million investment in Autotech Fund I, L.P. pursuant to a limited partnership agreement, and as a limited partner, will periodically make capital contributions toward this total commitment amount. As of December 31, 2019, Veoneer contributed a total of approximately $10 million to the fund. As of December 31, 2019, the Company has received approximately $2 million of distributions from the fund. The initial term of the fund is set to expire on December 31, 2025. This fund focuses broadly on the automotive industry and complements the Company’s innovation strategy, particularly in the areas of active safety and autonomous driving. Under the limited partnership agreement, the general partner has the sole and exclusive right to manage, control and conduct the affairs of the fund. Cash Flow 1 Non-U.S. GAAP measure see reconciliation for Net Working Capital Net Working Capital1 - Net working capital of $3 million improved by $39 million during the full year of 2019 as compared to 2018 primarily due to a reduction in customer trade receivables and inventories, net. Net cash used in operating activities - Net cash used in operating activities of $325 million during the full year of 2019 was $146 million higher as compared to 2018. The higher net loss was partially offset by the positive change in net working capital1 and other, net. Net cash used in investing activities - Net cash used in investing activities of $265 million during the full year of 2019 increased $80 million as compared to 2018 due to higher capital expenditures and lower related party notes receivable partially offset by Zenuity funding. Net Cash Provided by Financing Activities - Net cash provided by financing activities for the year ended December 31, 2019 includes the net capital raise of $603 million derived from the issuance of common stock and convertible debt notes in May of 2019. Capital Expenditures - Capital expenditures of $213 million, or 11% of sales, for the full year of 2019 increased by $25 million as compared to 2018. We expect the level of capital expenditures to be ~11% of sales for 2020, including VBS, to support sales growth in 2020 and in the future. The increase in associates of 274 as compared to the same period in 2018 to 8,874 from 8,600 is primarily due to the net hiring of 231 associates to support our investment in engineering for future growth opportunities. Temporary associates increased by 67 as compared to 2018 due to the uncertain macro situation and new program launches. Off-Balance Sheet Arrangements The Company does not have any off-balance sheet arrangements. Contractual Obligations and Commitments The table below reflects our contractual obligations as of December 31, 2019. The Company’s future contractual obligations have not changed materially. 1 Excludes contingent liabilities arising from litigation, arbitration, regulatory actions or income taxes Contractual obligations include related party long-term debt, leases and purchase obligations that are enforceable and legally binding on the Company. Non-controlling interest is not included in this table. Operating lease obligations: The Company leases certain offices, manufacturing and research buildings, machinery, automobiles and data processing and other equipment. Such operating leases, some of which are non-cancelable and include renewals, expire on various dates. See Note 16, Commitments and Contingencies, to the consolidated financial statements included herein. Pension contribution requirements: The Company sponsors defined benefit plans that cover eligible employees in Japan, Canada, and France. In 2020, the expected contribution to all plans, including direct payments to retirees, is $2 million, of which the major contribution is $1 million for our Canada pension plans. Due to volatility associated with future changes in interest rates and plan asset returns, the Company cannot predict with reasonable reliability the timing and amounts of future funding requirements, and therefore the above table shows expected contributions (to funded plans, or direct payments to retirees in the case of unfunded plans) for 2020, but only shows benefit payments (from funded plans, or direct to retirees in the case of unfunded plans) for 2021 and subsequent years. We may elect to make contributions in excess of the minimum funding requirements for the Japan, Canada, and France plans in response to investment performance and changes in interest rates, or when we believe that it is financially advantageous to do so and based on other capital requirements. This contribution amount does not include plans considered to be multiemployer with Autoliv. See Note 2, Summary of Significant Accounting Policies, and Note 17, Retirement Plans, to the consolidated financial statements included herein. 4% Convertible Senior Notes and Financial loans: On May 28, 2019, the Company issued, in a registered public offering in the U.S., the Notes with an aggregate principal amount of $207 million. The Notes bear interest at a rate of 4.00% per year payable semi-annually in arrears on June 1 and December 1 of each year, beginning on December 1, 2019. The Notes will mature on June 1, 2024, unless repurchased, redeemed or converted in accordance with their terms prior to such date. Unconditional purchase obligations: There are no material obligations other than short-term obligations related to inventory, services, tooling, and property, plant and equipment purchased in the ordinary course of business. Autotech Venture Fund: On June 30, 2017, Veoneer committed to make a $15 million investment in Autotech Fund I, L.P. pursuant to a limited partnership agreement, and, as a limited partner, will periodically make capital contributions toward this total commitment amount. As of December 31, 2019, Veoneer has in total contributed $10 million to the fund. As of December 31, 2019, the Company has received approximately $2 million of distributions from the fund. The initial term of the fund is set to expire on December 31, 2025. This fund focuses broadly on the automotive industry and complements the Company’s innovation strategy, particularly in the areas of active safety and autonomous driving. Under the limited partnership agreement, the general partner has the sole and exclusive right to manage, control, and conduct the affairs of the fund. Significant Accounting Policies and Critical Accounting Estimates New Accounting Pronouncements The Company has considered all applicable recently issued accounting guidance. The Company has summarized in Note 2, Summary of Significant Accounting Policies to the consolidated financial statements included herein each of the recently issued accounting pronouncements and stated the impact or whether management is continuing to assess the impact. Critical Accounting Estimates The application of accounting policies necessarily requires judgments and the use of estimates by a Company’s management. Actual results could differ from these estimates. By their nature, these judgments are subject to an inherent degree of uncertainty. These judgments are based on our historical experience, terms of existing contracts, and management’s evaluation of trends in the industry, information provided by our customers and information available from other outside sources, as appropriate. Certain policies relate to estimates that involve matters that are highly uncertain at the time the accounting estimate is made and different estimates or changes to an estimate could have a material impact on the reported financial position, changes in financial condition or results of operations. Such critical estimates are discussed below. For these, materially different amounts could be reported under varied conditions and assumption. Other items in the Company's consolidated financial statements require estimation, however, in our judgment, they are not as critical as those discussed below. Revenue Recognition In accordance with ASC 606, Revenue from Contracts with Customers, revenue is measured based on consideration specified in a contract with a customer, adjusted for any variable consideration (i.e. price concessions or annual price adjustments) and estimated at contract inception. The variable consideration calculation involves management assumptions including the volume of light vehicle production, future sales volumes for specific parts, or future price concessions to be granted. The Company recognizes revenue when it satisfies a performance obligation by transferring control over a product to a customer. In addition, from time to time, Veoneer may make payments to customers in connection with ongoing and future business. These payments to customers are generally recognized as a reduction to revenue at the time of the commitment to make these payments, unless certain criteria are met, warranting capitalization. If the payments are capitalized, the amounts are amortized as the related goods are transferred. As of December 31, 2019, and 2018, the Company capitalized $81 million and $62 million, respectively, in Other non-current assets related payments to customers. The Company assesses these amounts for impairment. There was no impairment. Taxes assessed by a governmental authority that are both imposed on and concurrent with a specific revenue-producing transaction, that are collected by the Company from a customer, are excluded from revenue. Shipping and handling costs associated with outbound freight after control of a product has transferred to a customer are accounted for as a fulfillment cost and are included in cost of sales. Nature of goods and services The following is a description of principal activities from which the Company generates its revenue. The Company has two operating segments, Electronics and Brake Systems. Electronics includes all of electronics resources and expertise, restraint control systems and active safety products. Brake Systems provides brake control and actuation systems. The principal activities are essentially the same for each of the segments. Both of the segments generate revenue from the sale of production parts to original equipment manufacturers (“OEMs”). The Company accounts for individual products separately if they are distinct (i.e., if a product is separately identifiable from other items and if a customer can benefit from it on its own or with other resources that are readily available to the customer). The consideration, including any price concession or annual price adjustments, is based on their stand-alone selling prices for each of the products. The stand-alone selling prices are determined based on the cost-plus margin approach. The Company recognizes revenue for production parts primarily at a point in time. For production parts with revenue recognized at a point in time, the Company recognizes revenue upon shipment to the customers and transfer of title and risk of loss under standard commercial terms (typically F.O.B. shipping point). There are certain contracts where the criteria to recognize revenue over time have been met (e.g., there is no alternative use to the Company and the Company has an enforceable right to payment). In such cases, at period end, the Company recognizes revenue and a related asset and associated cost of goods sold and inventory. However, the financial impact of these contracts is immaterial considering the very short production cycles and limited inventory days on hand, which is typical for the automotive industry. The amount of revenue recognized is based on the purchase order price and adjusted for variable consideration (i.e. price concessions or annual price adjustments). Customers typically pay for the production parts based on customary business practices with payment terms averaging 30 days. Contract balances The contract assets related to the Company’s rights to consideration for work completed but not billed (generally in conjunction with contracts for which revenue is recognized over time) at the reporting date on production parts. The contract assets are reclassified into the receivables balance when the rights to receive payments become unconditional. There have been no impairment losses recognized related to contract assets arising from the Company’s contracts with customers. As of December 31, 2019, the Company has capitalized $12 million of direct and incremental contract costs incurred in connection with obtaining a contract with a customer. These costs will be amortized as the related goods are transferred. Business Combinations In accordance with accounting guidance for the provisions in FASB ASC 805, Business Combinations, the Company allocates the purchase price of an acquired business to its identifiable assets and liabilities based on estimated fair values. The excess of the purchase price over the amount allocated to the assets and liabilities, if any, is recorded as goodwill. In addition, an acquisition may include a contingent consideration component. The fair value of the contingent consideration is estimated as of the date of the acquisition and is recorded as part of the purchase price. Each quarter this contingent consideration is re-measured using the discounted cash flow method. The Company uses actual revenue levels as well as changes in the estimated probability of different revenue scenarios to estimate fair values. The Company has engaged outside appraisal firms to assist in the fair value determination of identifiable intangible assets and any other significant assets or liabilities. The Company adjusts the preliminary purchase price allocation, as necessary, up to one year after the acquisition closing date as the Company obtains more information regarding asset valuations and liabilities assumed. The Company’s purchase price allocation methodology contains uncertainties because it requires management to make assumptions and to apply judgment to estimate the fair value of acquired assets and liabilities. Management estimates the fair value of assets and liabilities based upon quoted market prices, the carrying value of the acquired assets and widely accepted valuation techniques, including discounted cash flows and market multiple analyses. Unanticipated events or circumstances may occur which could affect the accuracy of our fair value estimates, including assumptions regarding industry economic factors and business strategies. Other estimates used in determining fair value include, but are not limited to, future cash flows or income related to intangibles, market rate assumptions, actuarial assumptions for benefit plans and appropriate discount rates. The Company estimates the fair value based upon assumptions believed to be reasonable, but these are inherently uncertain, and therefore, may not be realized. Accordingly, there can be no assurance that the estimates, assumptions, and values reflected in the valuations will be realized, and actual results could vary materially. Equity Method Investments The Company initially accounts for an equity method investment at its fair value on the date of acquisition. See Note 2, Summary of Significant Accounting Policies and Note 12, Investments related to the Company’s investment in Zenuity, to the consolidated financial statements included. Inventory Reserves Inventories are evaluated based on individual or, in some cases, groups of inventory items. Reserves are established to reduce the value of inventories to the lower of cost and net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation. Excess inventories are quantities of items that exceed anticipated sales or usage for a reasonable period. The Company has guidelines for calculating provisions for excess inventories based on the number of months of inventories on hand compared to anticipated sales or usage. Management uses its judgment to forecast sales or usage and to determine what constitutes a reasonable period. There can be no assurance that the amount ultimately realized for inventories will not be materially different than that assumed in the calculation of the reserves. Goodwill and Intangibles The Company evaluates the carrying value and useful lives of long-lived assets when indications of impairment are evident or it is likely that the useful lives have decreased, in which case the Company depreciates the assets over the remaining useful lives. Impairment testing is primarily performed by using the cash flow method based on undiscounted future cash flows. Estimated undiscounted cash flows for a long-lived asset being evaluated for recoverability are compared with the respective carrying amount of that asset. If the estimated undiscounted cash flows exceed the carrying amount of the assets, the carrying amounts of the long-lived asset are considered recoverable and an impairment is not recorded. However, if the carrying amount of a group of assets exceeds the undiscounted cash flows, an entity must then estimate, generally using a discounted cash flow model the long-lived assets’ fair value to determine whether an impairment loss should be recognized. The Company reviews goodwill for impairment annually in the fourth quarter or more frequently if events or changes in circumstances indicate the assets might be impaired. The impairment test was performed on December 31 in 2018 but the Company elected changed its annual impairment test date to October 31 in 2019. In conducting its impairment testing, the Company compares the estimated fair value of each of its reporting units to the related carrying value of the reporting unit. If the estimated fair value of a reporting unit exceeds its carrying value, goodwill is considered not to be impaired. If the carrying value of a reporting unit exceeds its estimated fair value, an impairment loss is recognized for the excess of carrying amount over the fair value of the respective reporting unit. The estimated fair value of the reporting unit is determined by the discounted cash flow method taking into account expected long-term operating cash-flow performance. The Company discounts projected operating cash flows using the reporting unit’s weighted average cost of capital, including a risk premium to adjust for market risk. The Company's assumptions in conducting its impairment testing include revenue growth rates, Earnings Before Income Tax ("EBIT") margin rate in the discrete and terminal period and the discount rate applied to the future cash flows. The estimated fair value is based on automotive industry volume projections which are based on third-party and internally developed forecasts and discount rate assumptions. To supplement this analysis, the Company compares the market value of its equity, calculated by reference to the quoted market prices of its shares, to the estimated fair values of its reporting units. In the fourth quarter of 2017, in connection with the annual impairment test, the Company recorded a goodwill impairment charge of $234 million in its Electronics Segment, relating to the VNBS acquisition. For more information, see Note 2, Summary of Significant Accounting Policies, to the consolidated financial statements included herein) due to lower than originally anticipated sales development. There is no remaining goodwill related to VNBS after the impairment. There were no goodwill impairments recognized during 2019 and 2018. Recall Provisions and Warranty Obligations The Company records liabilities for product recalls when probable claims are identified and when it is possible to reasonably estimate costs. Recall costs are costs incurred when the customer decides to formally recall a product due to a known or suspected safety concern. Product recall costs typically include the cost of the product being replaced as well as the customer’s cost of the recall, including labor to remove and replace the defective part. In some cases, portions of the product recall costs are reimbursed by an insurance company. Actual costs incurred could differ from the amounts estimated, requiring adjustments to these reserves in future periods. It is possible that changes in our assumptions or future product recall issues could materially affect our financial position, results of operations or cash flows. Estimating warranty obligations requires the Company to forecast the resolution of existing claims and expected future claims on products sold. The Company bases the estimate on historical trends of units sold and payment amounts, combined with our current understanding of the status of existing claims and discussions with our customers. These estimates are re-evaluated on an ongoing basis. Actual warranty obligations could differ from the amounts estimated requiring adjustments to existing reserves in future periods. Due to the uncertainty and potential volatility of the factors contributing to developing these estimates, changes in our assumptions could materially affect our results of operations. Defined Benefit Pension Plans Veoneer’s employees participate in defined benefit plans sponsored by Autoliv and certain defined benefit plans sponsored by Veoneer in Japan (the Japan plans), France (the France plans), and Canada (the Canada plans). For the Japan, French, and Canada plans, the amount recognized as a defined benefit liability is the net total of projected benefit obligation (PBO) minus the fair value of plan assets (if any). The plan assets are measured at fair value. Net periodic benefit cost was reported within Costs of sales, Selling, general and administrative expenses and RD&E expenses in the Consolidated Statement of Operations. Veoneer has considered the remaining plans to be part of a multiemployer plan with Autoliv. Pension expense was allocated for these plans and reported within Costs of sales, Selling, general and administrative expenses and RD&E expenses in the Consolidated Statement of Operations. Of the plans sponsored by Veoneer, the most significant plans are the France plans. These plans represent approximately 33% of the Company’s total pension benefit obligation. See Note 17, Retirement Plans, to the consolidated financial statements included herein. The Company, in consultation with its actuarial advisors, determines certain key assumptions to be used in calculating the projected benefit obligation and annual pension expense. For the France plans, the assumptions used for calculating the 2019 pension expense were a discount rate of 0.9%, expected rate of increase in compensation levels of 2.5%. The discount rate for the Japanese plans has been set based on the rates of return of high-quality fixed-income investments currently available at the measurement date and are expected to be available during the period the benefits will be paid. The expected rate of increase in compensation levels and long-term return on plan assets are determined based on a number of factors and must take into account long-term expectations and reflect the financial environment in the respective local markets. This plan does not have assets as of December 31, 2019 and 2018. Income Taxes Significant judgment is required in determining the worldwide provision for income taxes. In the ordinary course of a global business, there are many transactions for which the ultimate tax outcome is uncertain. Many of these uncertainties arise as a consequence of intercompany transactions. See Note 1, Basis of Presentation, Note 19, Income Taxes and Note 22, Relationship with Parent and Related Entities, to the Consolidated Financial Statements included herein. Although the Company believes that its tax return positions are supportable, no assurance can be given that the final outcome of these matters will not be materially different than that which is reflected in the historical income tax provisions and accruals. Such differences could have a material effect on the income tax provisions or benefits in the periods in which such determinations are made. See also the discussion of the determinations of valuation allowances on our deferred tax assets in Note 19, Income Taxes, to the consolidated financial statements included herein. Contingent Liabilities Various claims, lawsuits and proceedings are pending or threatened against the Company or its subsidiaries, covering a range of matters that arise in the ordinary course of its business activities with respect to commercial, product liability or other matters. For a discussion of legal matters we are involved in, see Note 16, Contingent Liabilities, to the consolidated financial statements included herein. The Company diligently defends itself in such matters and, in addition, carries insurance coverage to the extent reasonably available against insurable risks. The Company records liabilities for claims, lawsuits and proceedings when they are probable, and it is possible to reasonably estimate the cost of such liabilities. Legal costs expected to be incurred in connection with a loss contingency are expensed as such costs are incurred. A loss contingency is accrued by a charge to income if it is probable that an asset has been impaired, or a liability has been incurred and the amount of the loss can be reasonably estimated. In determining whether a loss should be accrued management evaluates, among other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our consolidated financial statements. Leases Lease Classification The Company, as a lessee, determine the lease classification for each separate lease component at the lease commencement date. Commencement date is defined as the date on which a lessor makes an underlying asset available for use by the Company. This date can be different from the stated commencement date in the contract. This date is when Veoneer takes possession of or be given control over the use of an underlying asset. For lessees, a lease can be classified either as an operating lease or a finance lease. Initial Measurement The Company will recognize a right-of-use asset and a lease liability at lease commencement. The lease liability for both finance and operating leases equals the present value of the unpaid lease payments, discounted at Veoneer’s incremental borrowing rate. Lease payment includes undiscounted fixed (including in-substance fixed) payments plus optional payments (e.g. for purchase options, optional renewal periods, periods subsequent to a termination option) that are reasonably certain to be owed. Lease payments do not include variable lease payments that depend on an index or a rate, any guarantee by the lessee of the lessor’s debt; or amounts allocated to non-lease components. The incremental borrowing rate is the rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment. In general, the discount rate will not be reassessed unless there is a change in the lease term or in the assessment of a lessee purchase option represent a significant change in the economics of the arrangement. Short-term Lease & Low Value Lease Recognition Exemption A short-term lease is a lease that, at the commencement date, has a lease term of 12 months or less and does not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise. For leases that meet the definition of “short-term”, the Company elected the practical expedient under ASC 842 which allows for simplified accounting. The practical expedient will apply for all classes of underlying assets and under the practical expedient, the Company will recognize the lease payments as lease cost on a straight-line basis over the lease term and will disclose the costs. In addition, the Company determined that the expenses derived from leases with lease term of one month or less will be exempt from being assessed under lease recognition. Impairment test The Company will use the long-lived assets impairment guidance (ASC 360) to determine whether a right-of-use asset is impaired, and if so, the amount of the impairment loss to recognize. The impairment loss related to a right-of-use asset is presented in the same manner in the income statement as an impairment loss recognized for any other long-lived asset. Assets and liabilities held for sale The Company classifies assets and liabilities (disposal groups) to be sold as held for sale in the period in which all of the following criteria are met: management, having the authority to approve the action, commits to a plan to sell the disposal group; the disposal group is available for immediate sale in its present condition subject only to terms that are usual and customary for sales of such disposal groups; an active program to locate a buyer and other actions required to complete the plan to sell the disposal group have been initiated; the sale of the disposal group is probable, and transfer of the disposal group is expected to qualify for recognition as a completed sale within one year, except if events or circumstances beyond the Company's control extend the period of time required to sell the disposal group beyond one year; the disposal group is being actively marketed for sale at a price that is reasonable in relation to its current fair value; and actions required to complete the plan indicate that it is unlikely that significant changes to the plan will be made or that the plan will be withdrawn. The Company initially measures a disposal group that is classified as held for sale at the lower of its carrying value or fair value less any costs to sell. Any loss resulting from this measurement is recognized in the period in which the held for sale criteria are met. Conversely, gains are not recognized on the sale of a disposal group until the date of sale. The Company assesses the fair value of a disposal group, less any costs to sell, each reporting period it remains classified as held for sale and reports any subsequent changes as an adjustment to the carrying value of the disposal group, as long as the new carrying value does not exceed the carrying value of the disposal group at the time it was initially classified as held for sale.
-0.04738
-0.047228
0
<s>[INST] The following MD&A is intended to help you understand the business operations and financial condition of the Company. This MD&A is presented in the following sections: Executive Overview Trends, Uncertainties and Opportunities Market Overview NonU.S. GAAP Financial Measures Results of Operations Liquidity and Capital Resources OffBalance Sheet Arrangements Contractual Obligations and Commitments Significant Accounting Policies and Critical Accounting Estimates Veoneer is a Delaware corporation with its principal executive offices in Stockholm, Sweden. The Company functions as a holding corporation and owns two principal operating subsidiaries, Veoneer AB and Veoneer US, Inc. On June 29, 2018, the SpinOff of Veoneer from Autoliv, Inc. ("Autoliv") was completed through the distribution by Autoliv of all the outstanding shares of common stock of Veoneer to Autoliv’s stockholders as of the close of business on June 12, 2018, the common stock record date for the distribution, in a taxfree, pro rata distribution (the "SpinOff"). On July 2, 2018, the shares of Veoneer common stock commenced trading on the New York Stock Exchange under the symbol “VNE” and the Veoneer Swedish Depository Receipts representing shares of Veoneer common stock commenced trading on Nasdaq Stockholm under the symbol “VNE SDB.” Veoneer is a global leader in the design, development, manufacture, and sale of automotive safety electronics with a focus on innovation, quality and manufacturing excellence. Prior to the SpinOff, Veoneer operated for almost four years as an operating segment within Autoliv. Veoneer's safety systems are designed to make driving safer and easier, more comfortable and convenient for the end consumer and to intervene before a potential collision. Veoneer endeavors to prevent vehicle accidents or reduce the severity of impact in the event a crash is unavoidable. Through our customer focus, being an expert partner with our customers, we intend to develop human centric systems that benefit automotive light vehicle occupants. Veoneer’s current product offering includes automotive radars, monoand stereovision cameras, night driving assist (thermal sensing) systems, positioning systems, ADAS (advanced driver assist systems) electronic control units, passive safety electronics (airbag control units and crash sensors), brake control systems and a complete ADAS software offering towards highly automated driving (HAD) and eventually autonomous driving (AD). In addition, we offer driver monitoring systems, LiDAR sensors, RoadScape positioning and other technologies critical for HAD and AD solutions by leveraging our partnership network and internally developed intellectual property. Executive Overview Organic sales in the quarter were inline with our expectations at the beginning of the quarter, despite some weakness in the LVP. Our operating loss was lower than expected at the beginning of the quarter, primarily due to continuing cost control activities across the company, particularly with respect to customer reimbursements and control of our RD&E costs. In general, our market adjustment initiatives are continuing to positively impact our cost structure. During 2020 we intend to take further actions under our market adjustment initiative program. These actions include: further partnering, further focusing our product portfolio, reviewing certain customer contracts, and a continued focus on other cost improvement initiatives. We are also continuing to define the scope and priorities of Zenuity, where the Polestar 2 and the Volvo XC 40 Recharge, both launching in the upcoming months, will be the first two vehicles with the full Zenuity software suite for collaborative driving. This is a major milestone and achievement for Zenuity. 2020 is a major customer launch year for Veoneer and we are gearing up for the launch of our fourthgeneration vision systems during the first half of the year. The bulk of the launches, and importantly the higher delivery volumes, are concentrated toward the second half of the year which is when we expect Veoneer to return to organic sales growth. We are basing our 2020 outlook on our core Active Safety and Restraint Control Systems businesses and our VBS US operations Brake Systems business, as we completed the divestiture [/INST] Negative. </s>
2,020
9,633
1,708,493
Harpoon Therapeutics, Inc.
2019-03-14
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 financial statements and related notes and other financial information included elsewhere in this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties. See “Special Note Regarding Forward-Looking Statements” and “Risk Factors” for a discussion of forward-looking statements and important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements. Overview We are a clinical-stage immunotherapy company developing a novel class of T cell engagers that harness the power of the body’s immune system to treat patients suffering from cancer and other diseases. T cell engagers are engineered proteins that direct a patient’s own T cells to kill target cells that express specific proteins, or antigens, carried by the target cells. Using our proprietary TriTAC platform, we are developing a pipeline of novel T cell engagers, or TriTACs, initially focused on the treatment of solid tumors and hematologic malignancies. Since commencing operations in 2015, we have devoted substantially all of our resources to performing research and development and manufacturing 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 of convertible notes, the sale of convertible preferred stock and payments received under our discovery collaboration agreement with AbbVie. 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 $27.4 million, $16.8 million and $11.4 million for the years ended December 31, 2018, 2017 and 2016, respectively. As of December 31, 2018, we had an accumulated deficit of $62.6 million. Our primary use of cash is to fund operating expenses, which consist primarily of research and development expenditures, and to a lesser extent, general and administrative expenditures. We expect to continue to incur net losses for the foreseeable future, and we expect our research and development expenses, general and administrative expenses, and capital expenditures will continue to increase. 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 research and development of HPN424 and HPN536, as well as our other product candidates; • initiate preclinical studies and clinical trials for any additional product candidates that we may pursue in the future; • seek marketing approvals for 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 invest in our technology platforms, including TriTAC and ProTriTAC; • 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. Furthermore, we expect to incur additional costs associated with operating as a public company, including significant legal, accounting, investor relations and other expenses that we did not incur as a private company. In February 2019, we closed our initial public offering of our common stock, in which we issued and sold an aggregate of 5,400,000 shares of common stock at a price of $14.00 per share for gross proceeds of approximately $75.6 million. Shortly following the close of the offering, the underwriters exercised in part their option to purchase an additional 369,201 shares at the initial public offering price for gross proceeds of approximately $5.2 million. In the aggregate, we received net proceeds from the offering of approximately $70.7 million, after deducting underwriting discounts, commissions and offering expenses. Collaboration Agreement with AbbVie On October 10, 2017, we entered into a Discovery Collaboration and License Agreement, or the Collaboration Agreement, with AbbVie. Pursuant to the Collaboration Agreement, we granted to AbbVie worldwide exclusive rights to develop and commercialize products that incorporate our proprietary TriTAC technology together with soluble TCRs provided by AbbVie that bind to targets accepted by the parties. Under the terms of the Collaboration Agreement, AbbVie is allowed to designate up to two targets, subject to confirmation of target availability. During a period of up to four years following the date of AbbVie’s designation of each target for the products, and confirmation of target availability, we and AbbVie will conduct certain research and discovery activities under a mutually agreed discovery and research plan in connection with the creation and evaluation of constructs comprising our proprietary TriTAC technology in conjunction with the soluble TCR sequences directed at the agreed upon targets of interest. We may not, by ourselves or through any third party, develop or commercialize any competing product that binds to any of the included targets. Following the discovery phase, AbbVie will be solely responsible, at its cost, for the development, manufacture and commercialization of the products that arise from the activities under the discovery plan. AbbVie is required to use commercially reasonable efforts to develop and commercialize one such product directed to each target for which the discovery activities were completed, in the United States and specified European markets. In addition to an upfront payment to us of $17.0 million, AbbVie will be required to make further payments to us of up to $600.0 million in the aggregate, for the achievement of specified development, regulatory and commercial sale milestones for licensed products indicated for human therapeutic or prophylactic use, if such licensed products are successfully progressed against all included targets and indications. We will also receive tiered royalties from AbbVie on net sales by AbbVie, its affiliates and sublicensees of licensed products at percentages in the mid-single digits, subject to specified offsets and reductions. If licensed products are developed and commercialized for diagnostic or veterinary use, or certain screening or monitoring uses, the parties have agreed to negotiate an appropriate reduction in the economic terms applicable to such non-therapeutic and prophylactic applications. We will recognize revenue under the Collaboration Agreement over the four-year research period as research and development activities occur. Accordingly, of the $17.0 million upfront payment received in 2017, $4.3 million and $0.7 million of revenue was recognized during the years ended 2018 and 2017, respectively, and, as of December 31, 2018, we had $12.0 million of deferred revenue under the Collaboration Agreement. License Agreement with Werewolf Therapeutics, Inc. In March 2018, we entered into an assignment and license agreement, or the Werewolf Agreement, with Werewolf Therapeutics, Inc., or Werewolf, a portfolio company of MPM Capital, Inc., a holder of more than 5% of our capital stock. Dr. Evnin, a member of our board of directors, is the interim Chief Executive Offer and Chairman of the board of directors of Werewolf. Dr. Baeuerle, a member of our board of directors, serves on the board of directors of Werewolf. Under the Werewolf Agreement, we assigned certain patents that relate to certain inducible polypeptides (and binding moiety for conditional activation of certain polypeptides) to Werewolf and granted to Werewolf a non-exclusive, royalty-bearing, sublicenseable license under certain other patents owned by us and relating to certain proteins, to make, use and commercialize products that are covered by such patents in the field of molecules comprising a certain polypeptide. Werewolf assigned certain patents to us relating to adoptive cell therapies and binding moieties for conditional activation of immunoglobulin and non-immunoglobulin molecules. Under the Werewolf Agreement, Werewolf paid us an upfront fee of $0.5 million. If Werewolf commercializes products covered by the licensed patents, then beginning on the first sale of such products, Werewolf will be obligated to pay to us a royalty on net sales of such products by Werewolf, its affiliates and licensees at a percentage in the low single digits, subject to an obligation to make a minimum annual royalty payment at an amount in the low hundreds of thousands of dollars. For the year ended December 31, 2018, $0.5 million of revenue under the Werewolf Agreement related to the upfront payment has been recognized in the accompanying statement of operations and comprehensive loss. Royalties on net sales will be recognized when the underlying sales occur. No royalty revenue was recognized under the Werewolf Agreement as of December 31, 2018. Financial Operations Overview Revenue We have no products approved for commercial sale and have not generated any revenue from product sales. Our collaboration revenue to date is deferred revenue related to the upfront payment received by us in October 2017 under the Collaboration Agreement, and is recognized when designated research and development services are performed. To date, we have not received any milestone or royalty payments under the Collaboration Agreement. We expect that any collaboration revenue we generate from the Collaboration Agreement and any future collaboration partners will fluctuate from period to period as a result of the timing and amount of milestones and other payments. Operating Expenses Research and Development Research and development expenses represent costs incurred in performing research, development and manufacturing activities in support of our own product development efforts and those of our collaborators, and include salaries, employee benefits, stock-based compensation, laboratory supplies, outsourced research and development expenses, professional services and allocated facilities-related costs. We expense both internal and external research and development expenses as they are incurred. We do not allocate our costs by product candidates, as our research and development expenses include internal costs, such as payroll and other personnel expenses, and external costs, neither of which are tracked by product candidate. In particular, with respect to internal costs, several of our departments support multiple product candidate research and development programs. Non-refundable advance payments for services that will be used or rendered for future research and development activities are recorded as prepaid expenses and recognized as expenses as the related services are performed. We expect our research and development expenses to increase substantially in absolute dollars for the foreseeable future as we advance our product candidates into and through preclinical studies and clinical trials, pursue regulatory approval of our product candidates and expand our pipeline of product candidates. The process of conducting the necessary preclinical and clinical research to obtain regulatory approval is costly and time consuming. The actual probability of success for our product candidates may be affected by a variety of factors, including the safety and efficacy of our product candidates, early clinical data, investment in our clinical programs, the ability of collaborators to successfully develop our licensed product candidates, competition, manufacturing capability and commercial viability. We may never succeed in achieving regulatory approval for any of our product candidates. As a result of the uncertainties discussed above, 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 our product candidates. General and Administrative Our general and administrative expenses consist primarily of personnel costs, allocated facilities costs and other expenses for outside professional services, including legal, human resource, audit and accounting 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, NASDAQ 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. Other Expense Other expense is primarily comprised of foreign currency transaction losses related to certain transactions with European third-party vendors. Results of Operations Comparison of Years Ended December 31, 2018 and 2017 * Not meaningful Revenue Collaboration and license revenue of $4.8 million for the year ended December 31, 2018 consisted of the amortized portion of the deferred $17.0 million upfront payment received by us in October 2017 under the Collaboration Agreement, and the $0.5 million upfront payment received by us in May 2018 under the Werewolf Agreement. Collaboration revenue of $0.7 million for the year ended December 31, 2017 consisted entirely of the amortized portion of the deferred $17.0 million upfront payment received by us in October 2017 under the Collaboration Agreement. Research and Development The following table summarizes our research and development expenses incurred during the respective periods: Research and development expenses increased by $12.7 million, or 94%, in 2018 compared to 2017. The increase was primarily due to a $4.2 million increase in pharmacology services and product and clinical development expense due to development of four identified product candidates, including conducting preclinical studies and manufacturing runs to support preparation for potential NDA filings for our lead product candidates, a $2.6 million increase in research and technology services due to an increase in experimental studies, a $2.8 million increase in personnel-related expenses due to an increase in headcount, a $1.5 million increase in consulting expenses due to increased activity related to project management, quality assurance and regulatory matters, a $1.2 million increase in facility and other allocated expenses related to the new lease entered into in March 2017, and a $0.4 million increase in laboratory supplies and equipment to support increased activity related to all of our product candidates. General and Administrative General and administrative expenses increased by $2.5 million, or 69%, in 2018 compared to 2017. The increase was primarily due to a $1.4 million increase in consulting and accounting services related to quarterly reviews and year-end audits associated with preparations for our initial public offering, $0.2 million increase in patent legal costs, and $0.9 million increase in personnel-related expenses due to an increase in headcount. Interest Income Interest income was $0.4 million during the year ended December 31, 2018 and consisted of interest earned on our cash deposit accounts during the period. Interest Expense Interest expense in 2017 pertained to interest on convertible notes. There were no convertibles notes outstanding during the year ended December 31, 2018. Other Expense Other expense did not significantly fluctuate period over period. Comparison of the Years Ended December 31, 2017 and 2016 * Not meaningful Revenue Collaboration revenue of $0.7 million for the year ended December 31, 2017 consisted entirely of the amortized portion of the deferred $17.0 million upfront payment received by us in October 2017 under the Collaboration Agreement. We had no collaboration and license revenue for the year ended December 31, 2016. Research and Development The following table summarizes our research and development expenses incurred during the respective periods: Research and development expenses increased by $5.8 million, or 75%, in 2017 compared to 2016. The increase was primarily due to a $4.6 million increase in costs supporting the continuing product and clinical development of our four identified product candidates and pharmacology services, including conducting preclinical studies and manufacturing runs to support preparation for potential IND filings for our lead product candidates. The remaining increase was primarily due to increases in facilities expenses of $0.6 million, consulting expenses of $0.4 million and personnel-related expenses of $0.2 million, all of which were the result of increased activities associated with the continued advancement of our product candidate pipeline. General and Administrative General and administrative expenses were primarily related to personnel-related expenses and did not significantly fluctuate period over period. There was no significant change in headcount between the periods. Interest Income Interest income was $0.1 million during the year ended December 31, 2017 and consisted of interest earned on our cash deposit accounts during the period. Interest Expense Interest expense in 2017 and 2016 pertained to interest on convertible notes and did not significantly fluctuate period over period. Other Expense Other expense did not significantly fluctuate period over period. Liquidity and Capital Resources Liquidity Since our inception and through December 31, 2018, we have financed our operations primarily through the issuance of convertible notes, the sale of convertible preferred stock, and upfront payments received by us under the Collaboration Agreement and Werewolf Agreement. As of December 31, 2018, we had $89.5 million in cash and cash equivalents, an accumulated deficit of $62.6 million and working capital of $78.3 million. In February 2019, we closed on the initial public offering of our common stock on the NASDAQ Global Select Market, including the partial exercise of the underwriters’ option to purchase additional shares, in which we received an aggregate of approximately $70.7 million in net proceeds, which amount is net of $10.1 million in underwriters’ discount and offering costs. We expect to continue to incur substantial costs in order to conduct research and development activities necessary to develop and commercialize our product candidates. Additional capital will be needed to undertake these activities and commercialization efforts, and, therefore, we intend to raise such capital through the issuance of additional equity, borrowings, and potentially strategic alliances with other companies. However, if such financing is not available at adequate levels or on acceptable terms, we could be required to significantly reduce operating expenses and delay, reduce the scope of or eliminate some of the development programs or commercialization efforts, out-license intellectual property rights to our product candidates and sell unsecured assets, or a combination of the above, any of which may have a material adverse effect on the our business, results of operations, financial condition and/or out ability to fund our scheduled obligations on a timely basis or at all. Capital Resources Our primary uses of cash are to fund operating expenses, which consist primarily of funding our clinical and preclinical trials, research and development expenditures and related personnel costs. 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 and accrued expenses. The timing and amount of our future funding requirements depends on many factors, including the following: • the scope, rate of progress, results and cost of our preclinical studies, clinical trials and other related activities; • the cost of manufacturing clinical supplies, and establishing commercial supplies, of our product candidates and any products that we may develop; • the number and characteristics of product candidates that we pursue; • the cost, timing and outcomes of regulatory approvals; • the cost and timing of establishing sales, marketing and distribution capabilities; • the terms and timing of any other collaborative, licensing and other arrangements that we may establish; • the timing, receipt and amount of sales, profit sharing or royalties, if any, from our potential products; • the cost of preparing, filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights • the extent to which we acquire or invest in businesses, products or technologies, although we currently have no commitments or agreements relating to any of these types of transactions; • the compliance and administrative costs associated with being a public company; and • the cost of attracting, hiring and retaining additional administrative, clinical, regulatory and scientific personnel. Based on our current business plans, we believe that our existing cash and cash equivalents, will be sufficient to fund our planned operations for at least the next 12 months from the issuance date of these financials. However, we will require additional funding in order to complete development of our product candidates and commercialize our products, if approved. We may seek to raise any necessary additional capital through a combination of public or private equity offerings, debt financings, collaborations, strategic alliances, licensing arrangements and other marketing and distribution arrangements. 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. 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 and clinical trials, research and development programs or commercialization efforts. Because of the numerous risks and uncertainties associated with the development and commercialization of our product candidates and the extent to which we may enter into additional collaborations with third parties to participate in their development and commercialization, we are unable to estimate the amounts of increased capital outlays and operating expenditures associated with our current and anticipated preclinical studies and clinical trials. To the extent that we raise additional capital through additional collaborations, strategic alliances or licensing arrangements with third parties, we may have to relinquish valuable rights to our product candidates, future revenue streams, research programs or product candidates or to grant licenses on terms that may not be favorable to us. If we do raise additional capital through public or private equity or convertible debt offerings, the ownership interest of our existing stockholders will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect our stockholders’ rights. 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. Please see the section entitled “Risk Factors” for additional risks associated with our substantial capital requirements and the challenges we may face in raising capital. Cash Flows Cash Flows from Operating Activities In 2018, cash used in operating activities was $27.1 million, which consisted of a net loss of $27.4 million and a net change of $1.1 million in our net operating assets and liabilities, partially offset by $1.3 million in non-cash charges. The non-cash charges consisted of stock-based compensation of $0.7 million and depreciation and amortization of $0.6 million. The change in operating assets and liabilities was primarily due to a decrease in deferred revenue of $4.3 million resulting from the recognition of collaboration revenue, an increase in accounts payable and accrued liabilities of $3.6 million, and an increase in prepaid expenses and other current assets of $0.5 million resulting from the timing of payments made for research and development activities. In 2017, cash provided by operating activities was $1.7 million, which consisted of a net loss of $16.8 million, partially offset by $1.0 million in non-cash charges and a net change of $17.5 million in our net operating assets and liabilities. The non-cash charges primarily consisted of stock-based compensation of $0.4 million, depreciation and amortization of $0.4 million and accrued interest on convertible notes payable of $0.2 million. The change in operating assets and liabilities was primarily due to an increase in deferred revenue of $16.3 million resulting from the upfront payment received by us under the Collaboration Agreement, an increase in accounts payable of $0.8 million due to an increase in the level of research and development expenses and a decrease in prepaid expenses and other current assets of $0.3 million resulting from the timing of payments made for research and development activities. In 2016, cash used in operating activities was $10.8 million, which consisted of a net loss of $11.4 million, partially offset by $0.5 million in non-cash charges and a net change of $0.1 million in our net operating assets and liabilities. The non-cash charges primarily consisted of depreciation and amortization of $0.2 million, accrued interest on convertible notes payable of $0.2 million and stock-based compensation of $0.1 million. The change in our operating assets and liabilities was primarily due to an increase in accounts payable of $0.6 million resulting from a higher level of research and development activities, partially offset by a decrease in accrued liabilities of $0.3 million due to the final payment under a research license agreement and an increase in prepaid expenses and other current assets of $0.3 million resulting from the timing of payments made for research and development activities. Cash Flows from Investing Activities In 2018, cash used in investing activities of $0.7 million related to purchases of property and equipment consisting primarily of laboratory equipment. In 2017, cash provided by investing activities of $4.5 million was related to $6.8 million in gross proceeds received from the payment by Maverick of its outstanding promissory note, partially offset by $2.3 million in purchases of property and equipment consisting primarily of laboratory equipment. In 2016, cash used in investing activities of $0.6 million related to the purchase of property and equipment. Cash Flows from Financing Activities In 2018, cash provided by financing activities of $88.3 million was related primarily to $69.8 million in net cash proceeds received from the November 2018 issuance of our Series C convertible preferred stock, $20.0 million in net cash proceeds received from the July 2018 issuance of our Series B convertible preferred stock as a result of our IND filing for HPN424, and $0.2 million in proceeds from the issuance of common stock upon the exercise of stock options, partially offset by $1.7 million in deferred offering costs related to our initial public offering. In 2017, cash provided by financing activities of $22.2 million was related primarily to $19.7 million in net proceeds received from the issuance of our Series B convertible preferred stock and $2.5 million in net cash proceeds received from the issuance of convertible notes. These convertible notes were settled in 2017 in shares of our Series B convertible preferred stock. In 2016, cash provided by financing activities of $10.0 million was related to $7.4 million in net proceeds from the issuance of our Series A convertible preferred stock, $2.5 million in net cash proceeds received from the issuance of convertible notes and $0.1 million in proceeds from the issuance of common stock upon the exercise of stock options. The outstanding convertible notes were settled in 2016 and 2017 in shares of our Series A and Series B convertible preferred stock. Contractual Obligations and Other Commitments The following table summarizes our contractual obligations as of December 31, 2018: The obligations noted above represent operating lease obligations related to our currently occupied premises at 4000 Shoreline Court in South San Francisco, California that commenced in March 2017 and expires in April 2020. In addition, in August 2018, we entered into an operating lease for our new office and laboratory space in South San Francisco, California that consists of approximately 35,000 square feet of new office and laboratory space. We anticipate moving into the new facility on June 1, 2019 and the lease expires eight years from that date. We estimate it will cost approximately $10.3 million to build-out the facility to meet our operational requirements. The lease provides for a tenant improvement allowance of approximately $5.2 million and the option for an additional tenant improvement allowance of approximately $1.4 million. The additional tenant improvement allowance of $1.4 million would be treated as a loan from the landlord and is expected to be paid back (including interest) by the Company through additional rental payments. In December 2018, the company exercised this option for the use of the additional tenant improvement allowance of $1.4 million. The initial annual base rent is approximately $2.2 million, and such amount will increase by 3.5% annually on each anniversary of the commencement date, equaling approximately $20.0 million over the eight-year lease term. In connection with the lease, we will maintain a letter of credit for the benefit of the landlord in the amount of $0.5 million. In December 2016, we entered into a royalty transfer agreement with MPM Oncology Charitable Foundation, Inc. and UBS Optimus Foundation pursuant to which we will pay 0.5% of our annual global net sales to each of the counterparties for products that incorporate or utilize intellectual property that was discovered or developed by us prior to our initial public offering. See “Item 13 - Certain Relationships and Related Transactions, and Director Independence-Royalty Transfer Agreement with MPM Oncology Charitable Foundation and UBS Optimus Foundation.” In October 2015, we entered into a collaboration and license agreement with AGC Biologics, Inc. (formerly known as CMC ICOS Biologics, Inc.), or AGC, for certain manufacturing-related technology, and in July 2016, we entered into a development and manufacturing agreement with AGC. Pursuant to these agreements, so long as AGC is our exclusive manufacturer, we will not owe AGC any milestone or royalty payments for the use of their manufacturing technology. However, if AGC is no longer our exclusive manufacturer, and we still use such technology, we will owe AGC specified milestones of up to $350,000 per specified product and a royalty on net sales of these products of less than 1%. We have an option to buy out these royalty obligations by making a one-time payment to AGC in a dollar amount in the mid-single digit millions. See “Business-License and Collaboration Agreements-Agreements with AGC Biologics, Inc.” In addition, we enter into agreements in the normal course of business with contract research organizations for clinical trials and with vendors for preclinical studies and other services and products for operating purposes, which are generally cancelable upon written notice. These payments are not included in this table of contractual obligations. Off-Balance Sheet Arrangements Since our inception, we have not engaged in any off-balance sheet arrangements, as defined in the rules and regulations of the SEC. Quantitative and Qualitative Disclosures about Market Risk The primary objectives of our investment activities are to ensure liquidity and to preserve capital. We are exposed to market risks in the ordinary course of our business. These risks primarily include interest rate sensitivities. We held cash and cash equivalents of $89.5 million and $29.4 million as of December 31, 2018 and 2017, respectively. We generally hold our cash in interest-bearing money market accounts. Historical fluctuations in interest rates have not been significant for us. Due to the short-term maturities of our cash equivalents and the low risk profile of our investments, an immediate 10% change in interest rates would not have a material effect on the fair market value of our cash equivalents. Critical Accounting Polices 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 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 date of the financial statements, as well as the reported revenue generated, and 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 the notes to our financial statements included elsewhere in this Annual Report on Form 10-K, we believe that the following critical accounting policies are most important to understanding and evaluating our reported financial results. Revenue Recognition Effective January 1, 2017, we early adopted on a full retrospective basis Accounting Standards Codification Topic 606, Revenue from Contracts with Customers, or Topic 606. This standard 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. In accordance with ASC 606, we recognize revenue when our customer obtains control of promised goods or services, in an amount that reflects the consideration which we expect to receive in exchange for those goods or services. To determine revenue recognition for arrangements that we determine are within the scope of Topic 606, we perform 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 we satisfy a performance obligation. We only apply the five-step model to contracts when it is probable that we will collect the consideration we are entitled to in exchange for the goods and services we transfer to the customer. At contract inception, we assess the goods or services promised within each contract that falls under the scope of Topic 606, determine those that are performance obligations and assesses whether each promised good or service is distinct. We then recognize as revenue the amount of the transaction price that is allocated to the respective performance obligation when or as the performance obligation is satisfied. We enter into corporate collaborations under which we may obtain upfront license fees, research and development funding, and development, regulatory and commercial milestone payments and royalty payments. Our performance obligations under these arrangements may include licenses of intellectual property, distribution rights, research and development services, delivery of manufactured product and/or participation on joint steering committees. • Licenses of Intellectual Property. If the license to our intellectual property is determined to be distinct from the other performance obligations identified in the arrangement, we recognize revenue from upfront license fees allocated to the license when the license is transferred to the customer and the customer is able to use and benefit from the license. For licenses that are bundled with other promises, we utilize judgement to assess the nature of the combined performance obligation to determine whether the combined performance obligation is satisfied over time or at a point in time and, if over time, the appropriate method of measuring proportional performance for purposes of recognizing revenue from non-refundable, upfront fees. We evaluate the measure of proportional performance each reporting period and, if necessary, adjust the measure of performance and related revenue recognition. • Milestone Payments. At the inception of each arrangement that includes development, regulatory or commercial milestone payments, we evaluate whether the milestones are considered probable of being reached and estimates the amount to be included in the transaction price. Topic 606 suggests two alternatives to use when estimating the amount of variable consideration: the expected value method and the most likely amount method. Under the expected value method, an entity considers the sum of probability-weighted amounts in a range of possible consideration amounts. Under the most likely amount method, an entity considers the single most likely amount in a range of possible consideration amounts. Whichever method is used, it should be consistently applied throughout the life of the contract; however, it is not necessary for us to use the same approach for all contracts. We expect to use the most likely amount method for development and regulatory milestone payments. If it is probable that a significant revenue reversal would not occur, the associated milestone value is included in the transaction price. Milestone payments that are not within our or the licensee’s control, such as regulatory approvals, are not considered probable of being achieved until those approvals are received. The transaction price is then allocated to each performance obligation on a relative stand-alone selling price basis. We recognize revenue as or when the performance obligations under the contract are satisfied. At the end of each subsequent reporting period, we re-evaluate the probability or achievement of each such milestone and any related constraint, and if necessary, adjust our estimates of the overall transaction price. Any such adjustments are recorded on a cumulative catch-up basis, which would affect revenues and earnings in the period of adjustment. • Commercial Milestones and Royalties. For arrangements that include sales-based royalties, including milestone payments based on the level of sales, and in which the license is deemed to be the predominant item to which the royalties relate, we recognize revenue when the related sales occur. To date, we have not recognized any royalty revenue resulting from our collaboration arrangements. Upfront payments and fees are recorded as deferred revenue upon receipt or when due, and may require deferral of revenue recognition to a future period until we perform our obligations under these arrangements. Amounts payable to us are recorded as accounts receivable when our right to consideration is unconditional. Research and Development Expenses and Accrued Research and Development Costs We expense research and development costs as incurred. Research and development expenses consist of personnel costs for our research and product development employees. Also included are non-personnel costs such as professional fees payable to third parties for preclinical and preclinical studies, clinical trials and research services, laboratory supplies and equipment maintenance and depreciation, intellectual property licenses and other consulting costs. We estimate preclinical and clinical study and research expenses based on the services performed, pursuant to contracts with research institutions that conduct and manage preclinical studies, clinical trials and research services on our behalf. We estimate these expenses based on discussions with management and external service providers as to the progress or stage of completion of services and the contracted fees to be paid for such services. We record the estimated costs of research and development activities based upon the estimated amount services provided but not yet invoiced, and include these costs in development expenses. We accrue for these costs based on factors such as estimates of the work completed and in accordance with agreements established with our third-party service provides under the service agreements. We make significant judgments and estimates in determining the accrued liabilities balance in each reporting period. As actual costs become known, we adjust our accrued liabilities. We have not experienced any material differences between accrued costs and actual costs incurred. However, the status and timing of actual services performed may vary from our estimates, resulting in adjustments to expense in future periods. Changes in these estimates that result in material changes to our accruals could materially affect our results of operations. Payments associated with licensing agreements to acquire exclusive license to develop, use, manufacture and commercialize products that have not reached technological feasibility and do not have alternate future use are expensed as incurred. Payments made to third parties under these arrangements in advance of the performance of the related services by the third parties are recorded as prepaid expenses until the services are rendered. Such payments are evaluated for current or long-term classification based on when such services are expected to be received. Stock-Based-Compensation We maintain a stock-based compensation plan as a long-term incentive for employees, consultants and members of our board of directors. The plan allows for the issuance of non-statutory options, or NSOs, and incentive stock options to employees and NSOs to nonemployees. Share-based payments are measured using fair-value-based measurements and recognized as compensation expense over the service period in which the awards are expected to vest. Our fair-value-based measurements of awards to employees and directors as of the grant date utilize the single-option award-valuation approach, and we use the straight-line method for expense attribution. The fair-value-based measurements of options granted to nonemployees are remeasured at each period end until the options vest and are amortized to expense as earned. The valuation model used for calculating the estimated fair value of stock awards is the Black-Scholes option-pricing model. The Black-Scholes model requires us to make assumptions and judgments about the variables used in the calculations, including the expected term (weighted-average period of time that the options granted are expected to be outstanding), the expected volatility of our common stock, the related risk-free interest rate and the expected dividend. We have elected to recognize forfeitures of share-based payment awards as they occur. Effective January 1, 2018, we early adopted ASU No. 2018-07, Compensation - Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting (“ASU 2018-07”). The new guidance requires equity-classified share-based payment awards issued to nonemployees to be measured on the grant date, instead of being measured through the performance completion date under the current guidance. For stock-based awards issued to non-employees, we record expense related to stock options based on the fair value of the options calculated using the Black-Scholes option-pricing model based on the measured grant date. For stock-based awards issued to non-employees prior to January 1, 2018, we recorded expense related to stock options based on the fair value of the options calculated using the Black-Scholes option-pricing model over the service performance period. 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. The expected term represents the period that stock-based awards are expected to be outstanding. The expected term for option grants is determined using the simplified method. The simplified method deems the term to be the average of the time-to-vesting and the contractual life of the stock-based awards. • Expected volatility. Since we have been privately held and do not have any trading history for its common stock, the expected volatility was estimated based on the average volatility for comparable publicly traded biotechnology companies over a period equal to the expected term of the stock option grants. The comparable companies were 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 option. • 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. Fair Value of Common Stock Prior to our initial public offering in February 2019, the fair values of the shares of common stock underlying our share-based awards were estimated on each grant date by our board of directors. Given the absence of a public trading market for our common stock prior to our February 2019 initial public offering, our board of directors exercised reasonable judgment and considered a number of objective and subjective factors to determine the best estimate of the fair value of our common stock, including our stage of development; our actual operating results and financial performance; progress of our research and development efforts; conditions in the industry and economy in general; the rights, preferences and privileges of our convertible preferred stock relative to those of our common stock; the likelihood of achieving a liquidity event for the holders of our common stock, such as an initial public offering or a sale of our company, given prevailing market conditions; equity market conditions affecting comparable public companies; the lack of marketability of our common stock and the results of independent third-party valuations. Valuations of our common stock were prepared by an unrelated third-party valuation firm in accordance with the guidance provided by the American Institute of Certified Public Accountants 2013 Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. For our valuations performed prior to December 31, 2018, we used the OPM Backsolve method to estimate the fair value of our common stock. In an option pricing method, or OPM, framework, the backsolve method for inferring the equity value implied by a recent financing transaction involves making assumptions for the expected time to liquidity, volatility and risk-free rate and then solving for the value of equity such that value for the most recent financing equals the amount paid. Furthermore, as of each of the valuation dates prior to December 31, 2018, we were at an early stage of development and future liquidity events were difficult to forecast. We applied a discount for lack of marketability to account for a lack of access to an active public market. Subsequent to the completion of our initial public offering in February 2019, our board of directors determines the fair value of our common stock based on the closing price of our common stock as reported on the date of grant on the primary stock exchange on which our common stock is traded. Income Taxes We provide for income taxes under the asset and liability method. Current income tax expense or benefit represents the amount of income taxes expected to be payable or refundable for the current year. Deferred income tax assets and liabilities are determined based on differences between the financial statement reporting and tax bases of assets and liabilities and net operating loss and credit carryforwards, and are measured using the enacted tax rates and laws that will be in effect when such items are expected to reverse. We record a valuation allowance to reduce our deferred tax assets to reflect the net amount that we believe is more likely than not to be realized. Realization of our deferred tax assets is dependent on the generation of future taxable income, the amount and timing of which are uncertain. The valuation allowance requires an assessment of both positive and negative evidence when determining whether it is more likely than not that deferred tax assets are recoverable. Based upon the weight of available evidence at December 31, 2018, we continue to maintain a full valuation allowance against all of our deferred tax assets after management considered all available evidence both positive and negative, including but not limited to our historical operating results, income or loss in recent periods, cumulative income in recent years, forecasted earnings, future taxable income, and significant risk and uncertainty related to forecasts. We account for uncertain tax positions in accordance with ASC 740-10, Accounting for Uncertainty in Income Taxes. We recognize the tax effects of an uncertain tax position only if it is more likely than not to be sustained based solely on its technical merits as of the reporting date and only in an amount more likely than not to be sustained upon review by the tax authorities. evaluate uncertain tax positions on a quarterly basis and adjust the liability for changes in facts and circumstances, such as new regulations or interpretations by the taxing authorities, new information obtained during a tax examination, significant amendment to an existing tax law, or resolution of an examination. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact the income tax provision in the period in which such determination is made. The resolution of our uncertain income tax positions is dependent on uncontrollable factors such as law changes, new case law, and the willingness of the income tax authorities to settle, including the timing thereof and other factors. Although we do not anticipate significant changes to our uncertain income tax positions in the next twelve months, items outside of our control could cause our uncertain income tax positions to change in the future, which would be recorded in our statements of operations. Interest and/or penalties related to income tax matters are recognized as a component of income tax expense. On December 22, 2017, the U.S. enacted the Tax Cuts and Jobs Act, or the Tax Act that instituted fundamental changes to the taxation of multinational corporations. The Tax Act includes changes to the taxation of foreign earnings by implementing a dividend exemption system, expansion of the current anti-deferral rules, a minimum tax on low-taxed foreign earnings and new measures to deter base erosion. The Tax Act also includes a permanent reduction in the corporate tax rate to 21%, repeal of the corporate alternative minimum tax, expensing of capital investment, and limitation of the deduction for interest expense. Furthermore, as part of the transition to the new tax system, a one-time transition tax is imposed on a U.S. shareholder’s historical undistributed earnings of foreign affiliates. Although the Tax Act is generally effective January 1, 2018, GAAP requires recognition of the tax effects of new legislation during the reporting period that includes the enactment date, which was December 22, 2017. As a result of the impacts of the Tax Act, the SEC provided guidance that allows the Company to record provisional amounts for those impacts, with the requirement that the accounting be completed in a period not to exceed one year from the date of enactment. Based on provisions of the Tax Act, the Company remeasured its deferred tax assets and liabilities to reflect the lower statutory tax rate. However, since the Company established a valuation allowance to offset its deferred tax assets, there was no impact to the effective tax rate, as any changes to deferred taxes would be offset by the valuation allowance. The deferred tax remeasurement was provisional and was subject to revision as the Company completes its analysis of the Tax Act, collects and prepares necessary data and interprets any additional guidance issued by standard-setting bodies. The Company has completed its analysis and determined no adjustment is required related to the tax effects of the Tax Act in 2018. As of December 31, 2018 our total deferred tax assets were $14.3 million. Due to our lack of earnings history and uncertainties surrounding our ability to generate future taxable income, the net deferred tax assets have been fully offset by a valuation allowance. The deferred tax assets were primarily comprised of federal and state tax net operating losses, or NOLs. Utilization of NOLs may be limited by the “ownership change” rules, as defined in Section 382 of the Code. Similar rules may apply under state tax laws. Our ability to use our remaining NOLs may be further limited if we experience an ownership change in connection with future offerings or as a result of future changes in our stock ownership. Recent Accounting Pronouncements See Note 2 to our financial statements included elsewhere in this report for more information. Emerging Growth Company Status We are an emerging growth company, as defined in 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 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 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. As a result, these financial statements may not be comparable to companies that comply with the new or revised accounting pronouncements as of public company effective dates. We early adopted ASU 2014-09, Revenue from Contracts with Customers (Accounting Standards Codification Topic 606), ASU 2016-09, Stock Compensation-Improvements to Employee Share-Based Payment Accounting, and ASU 2018-07, Compensation - Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting, as the JOBS Act does not preclude an emerging growth company from early adopting a new or revised accounting standard earlier than the time that such standard applies to private companies. In February 2016, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2016-02, (Topic 842), Leases. For public entities, ASU 2016-02 is effective for fiscal years beginning after December 15, 2018. We are considering early adoption of this standard in the first half of 2019 and are currently evaluating the effect the new guidance will have on our financial statements. We expect to use the extended transition period for any other new or revised accounting standards during the period in which we remain an emerging growth company. We will remain an emerging growth company until the earliest of (i) the last day of our first fiscal year (a) following the fifth anniversary of the completion of our initial public offering, (b) in which we have total annual gross revenues of at least $1.07 billion or (c) in which we are deemed to be a large accelerated filer, which means the market value of our common stock that is held by non-affiliates exceeds $700.0 million as of the prior June 30th and (ii) the date on which we have issued more than $1.0 billion in non-convertible debt securities during the prior three-year period.
0.042986
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<s>[INST] Overview We are a clinicalstage immunotherapy company developing a novel class of T cell engagers that harness the power of the body’s immune system to treat patients suffering from cancer and other diseases. T cell engagers are engineered proteins that direct a patient’s own T cells to kill target cells that express specific proteins, or antigens, carried by the target cells. Using our proprietary TriTAC platform, we are developing a pipeline of novel T cell engagers, or TriTACs, initially focused on the treatment of solid tumors and hematologic malignancies. Since commencing operations in 2015, we have devoted substantially all of our resources to performing research and development and manufacturing 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 of convertible notes, the sale of convertible preferred stock and payments received under our discovery collaboration agreement with AbbVie. 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 $27.4 million, $16.8 million and $11.4 million for the years ended December 31, 2018, 2017 and 2016, respectively. As of December 31, 2018, we had an accumulated deficit of $62.6 million. Our primary use of cash is to fund operating expenses, which consist primarily of research and development expenditures, and to a lesser extent, general and administrative expenditures. We expect to continue to incur net losses for the foreseeable future, and we expect our research and development expenses, general and administrative expenses, and capital expenditures will continue to increase. 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 research and development of HPN424 and HPN536, as well as our other product candidates; initiate preclinical studies and clinical trials for any additional product candidates that we may pursue in the future; seek marketing approvals for 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 invest in our technology platforms, including TriTAC and ProTriTAC; maintain, protect and expand our portfolio of intellectual property rights, including patents, trade secrets and knowhow; implement operational, financial and management systems; and attract, hire and retain additional administrative, clinical, regulatory and scientific personnel. Furthermore, we expect to incur additional costs associated with operating as a public company, including significant legal, accounting, investor relations and other expenses that we did not incur as a private company. In February 2019, we closed our initial public offering of our common stock, in which we issued and sold an aggregate of 5,400,000 shares of common stock at a price of $14.00 per share for gross proceeds of approximately $75.6 million. Shortly following the close of the offering, the underwriters exercised in part their option to purchase an additional 369,201 shares at the initial public offering price for gross proceeds of approximately $5.2 million. In the aggregate, we received net proceeds from the offering of approximately $70.7 million, after deducting underwriting discounts, commissions and offering expenses. Collaboration Agreement with AbbVie On October 10, 2017, we entered into a Discovery Collaboration and License Agreement, or the Collaboration Agreement, with AbbVie. Pursuant to the Collaboration Agreement, we granted to AbbVie worldwide exclusive rights to develop and commercialize products that incorporate [/INST] Positive. </s>
2,019
8,725
1,708,493
Harpoon Therapeutics, 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 and analysis of our financial condition and results of operations together with our financial statements and related notes and other financial information included elsewhere in this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties. See “Special Note Regarding Forward-Looking Statements” and “Risk Factors” for a discussion of forward-looking statements and important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements. In addition, the section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations 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 that are not included in this Annual Report on Form 10-K can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II Item 7 of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2018, filed with the SEC on March 14, 2019. Overview We are a clinical-stage immunotherapy company developing a novel class of T cell engagers that harness the power of the body’s immune system to treat patients suffering from cancer and other diseases. T cell engagers are engineered proteins that direct a patient’s own T cells to kill target cells that express specific proteins, or antigens, carried by the target cells. Using our proprietary TriTAC platform, we are developing a pipeline of novel T cell engagers, or TriTACs, initially focused on the treatment of solid tumors and hematologic malignancies. We currently have two TriTAC product candidates in clinical development. HPN424, is currently in a Phase 1 clinical trial for the treatment of metastatic castration-resistant prostate cancer, or mCRPC. HPN536, is currently in a Phase 1/2a clinical trial for the treatment of ovarian cancer and other mesothelin-, or MSLN-, expressing solid tumors. We also have two TriTAC product candidates in preclinical development, HPN217, targeting B-cell maturation antigen, or BCMA, for the treatment of multiple myeloma and HPN328, targeting Delta-like ligand 3, or DLL3, for the treatment of small cell lung cancer, or SCLC. Pipeline Update HPN424: Our lead product candidate is currently in the dose escalation portion of a Phase 1 clinical trial for the treatment of mCRPC. The dose escalation phase is designed to determine the maximum tolerated dose and a recommended Phase 2 dose. Once a recommended Phase 2 dose is determined, we will initiate the dose expansion phase. Consistent with the TriTAC mechanism of action, we observed adverse events associated with T cell activation and cytokine induction, which prompted us to explore the use of dexamethasone as a premedication to limit potential adverse events. We have found that the addition of weekly dexamethasone premedication, tapered over several weeks, has successfully limited adverse events. Several patients have completed the scheduled taper and have successfully continued treatment with HPN424 in the absence of dexamethasone, with no complications observed thus far. Enrollment is ongoing in the dose-escalation phase of the trial. Pharmacokinetics observed to date continue to support once-weekly dosing of HPN424. We expect to present interim dose-escalation data at ASCO at the end of May 2020 and to initiate an expansion cohort in 2020. HPN536: In April 2019, we advanced our second TriTAC, HPN536, a MSLN-targeting T cell engager, into the clinic and dosed the first patient in a Phase 1/2a clinical trial for ovarian and other MSLN-expressing solid tumors. Patient enrollment continues as planned in the dose-escalation phase of the trial. The study consists of two phases, an initial dose escalation phase of approximately 20 ovarian and pancreatic cancer patients, followed by an expansion phase of up to three additional parallel cohorts of 20 patients each with ovarian, pancreatic and mesothelioma cancer. The study is collecting data to evaluate the safety, tolerability, pharmacokinetics and activity of HPN536. We expect to present interim data from the trial in the second half of 2020. HPN217: In November 2019 we submitted an IND to the FDA, for the treatment of multiple myeloma, as well as entered into a Development and Option Agreement with AbbVie. Under our agreement with AbbVie, we have already received an upfront payment of $30 million and anticipate receiving a cash milestone payment of up to $50 million upon dosing the first patient in the Phase 1/2 clinical trial for HPN217 within a specified time period, which we expect to occur in the first half of 2020. Additionally, we are eligible to receive future payments totaling up to $430 million upon AbbVie’s exercise of an exclusive license option and achievement of certain development, regulatory, and commercial milestones, in addition to receipt of royalties on commercial sales. We are responsible for conducting the Phase 1/2 clinical trial of HPN217 under our agreement with AbbVie. HPN328: We are developing HPN328, which targets DLL3, to initially treat SCLC. We plan to file an IND for HPN328 by mid-year 2020 and to initiate a Phase 1/2a clinical trial in the second half of 2020. In October 2019, we presented data on HPN328 for the treatment of small cell lung cancer at the AACR-NCI-EORTC International Conference on Molecular Targets and Cancer Therapeutics. HPN328 was well-tolerated in cynomolgus monkeys at 1 and 10 mg/kg and pharmacokinetic data support the potential for once weekly dosing. Since commencing operations in 2015, we have devoted substantially all of our resources to performing research and development and manufacturing 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 of convertible notes, the sale of convertible preferred stock, the sale of common stock, payments received under our discovery collaboration agreement with AbbVie, and most recently the initial public offering, or IPO, of our common stock on the NASDAQ Global Select Market, or Nasdaq. 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 $55.6 million, 27.4 million, and $16.8 million for the years ended December 31, 2019, 2018, and 2017, respectively. As of December 31, 2019, we had an accumulated deficit of $118.2 million. Our primary use of cash is to fund operating expenses, which consist primarily of research and development expenditures, and to a lesser extent, general and administrative expenditures. We expect to continue to incur net losses for the foreseeable future, and we expect our research and development expenses, general and administrative expenses, and capital expenditures will continue to increase. 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 research and development of HPN424, HPN536, and HPN217, as well as our other product candidates; • initiate preclinical studies and clinical trials for any additional product candidates that we may pursue in the future; • seek marketing approvals for 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 invest in our technology platforms, including TriTAC and ProTriTAC; • 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. Furthermore, we expect to incur additional costs associated with operating as a public company, including significant legal, accounting, investor relations and other expenses that we did not incur as a private company. In early 2019, we closed the IPO of our common stock, in which we issued and sold an aggregate of 5,769,201 shares of common stock at a price of $14.00 per share for net proceeds of approximately $70.7 million (inclusive of a partial exercise of the underwriters’ option), after deducting underwriting discounts, commissions and offering expenses. Collaborations with AbbVie Development and Option Agreement On November 20, 2019, we entered into a Development and Option Agreement Development and Option Agreementwith AbbVie in connection with our HPN217 program, which targets B cell maturation antigen, or BCMA. Pursuant to such agreement, we granted to AbbVie an option to a worldwide, exclusive license to our patents and know-how applicable to the HPN217 program to develop, manufacture, and commercialize products arising from the HPN217 program and targeting BCMA, or HPN217 Products. Under the Development and Option Agreement, we filed an IND for HPN217, and will conduct clinical development activities pursuant to a mutually agreed upon development plan, including conducting a Phase 1/2 clinical trial of HPN217, in order for AbbVie to determine whether it wishes to exercise its option to a worldwide, exclusive license to such HPN217 program. We plan to initiate a Phase 1/2 clinical trial in the first half of 2020. Under the Development and Option Agreement, AbbVie may exercise its license option at any time during a period commencing on the effective date of the agreement and expiring after a specified period following delivery by us of a specified data package arising from the first Phase 1/2 trial for the HPN217 Product. Following AbbVie’s exercise of its option, and except for completion of certain development activities by us under the development plan, AbbVie will be solely responsible, at its cost, for the development, manufacture and commercialization of HPN217 Products. AbbVie is required to use commercially reasonable efforts to develop and obtain regulatory approval for one HPN217 Product, for at least one indication, for use in each Major Market (as defined in the Development and Option Agreement). AbbVie paid an upfront payment of $30.0 million and we expect to receive a development milestone payment of up to $50.0 million upon dosing the first patient in the Phase 1/2 clinical trial within a specified time period, which we expect to occur in the first half of 2020. If AbbVie exercises its option, AbbVie will pay us an option exercise fee of $200 million. Following option exercise, AbbVie will be required to make further payments to us of up to $230 million in the aggregate for the achievement of specified development, regulatory and commercial sales milestones for HPN217 Products. We will also receive tiered royalties on net sales by AbbVie, its affiliates and sublicensees of HPN217 Products at percentages ranging from the high single digits to the very low double digits, subject to specified offsets and reductions. Royalties will be payable under the Development and Option Agreement on a product-by-product and country-by-country basis commencing on the date of first commercial sale of each HPN217 Product, and ending on the later of expiration of all valid claims of specified licensed patents in such country, expiration of regulatory exclusivity in such country, or ten years following first commercial sale of such HPN217 Product in such country. We will recognize revenue under the Development and Option Agreement as the initial development activities are performed using an input method, according to the costs incurred as related to the estimated costs for the development and regulatory activities to be performed through the completion of a Phase 1/2 clinical trial of HPN217. Accordingly, of the $30.0 million upfront payment received in 2019, $1.7 million of revenue was recognized for the year ended 2019 and as of December 31, 2019, we had $29.3 million of deferred revenue under the Development and Option Agreement. Amended and Restated Discovery Collaboration Agreement On November 20, 2019, we entered into an Amended and Restated Discovery Collaboration and License Agreement, or the Restated Collaboration Agreement, with AbbVie, which agreement amends and restates the Discovery Collaboration and License Agreement entered into between us and AbbVie, dated October 10, 2017 and amended April 3, 2019, or the Original Collaboration Agreement. Pursuant to the Original Collaboration Agreement, we granted to AbbVie worldwide exclusive rights to develop and commercialize products that incorporate our proprietary TriTAC technology together with soluble TCRs provided by AbbVie that bind to targets accepted by the parties. Under the terms of the Original Collaboration Agreement, AbbVie was allowed to designate up to two targets, which it selected in 2017 and 2019, respectively. Pursuant to the Restated Collaboration Agreement, the worldwide, exclusive license granted to AbbVie under the Collaboration Agreement to develop and commercialize products that incorporate our proprietary Tri-specific T-cell Activating Construct, or TriTAC, platform technology together with soluble T cell receptors, or TCRs, provided by AbbVie has been expanded to cover products that incorporate antibodies provided by AbbVie or by us. The expansion of the collaboration also allows AbbVie to designate up to six additional targets, selected during a specified period following the effective date, to be the subject of activities under the collaboration. During a period of up to four years following the date of AbbVie’s designation of each target for the products, and confirmation of target availability, we and AbbVie will conduct certain research and discovery activities under a mutually agreed discovery and research plan in connection with the creation and evaluation of constructs comprising our proprietary TriTAC technology, in conjunction with the soluble TCR or antibody sequences directed at the agreed upon targets of interest. We may not, including through any third party, develop or commercialize any competing product that binds to any of the included targets. As was the case under the Original Collaboration Agreement, following the discovery phase, AbbVie will be solely responsible, at its cost, for the development, manufacture and commercialization of the products that arise from the activities under the discovery plan. AbbVie is required to use commercially reasonable efforts to develop and commercialize one such product directed to each target for which the discovery activities were completed in each Major Market (as defined in the Restated Collaboration Agreement). In addition to the upfront payment of $17 million already paid under the Original Collaboration Agreement, under the Restated Collaboration Agreement, we received an upfront payment of $20 million for AbbVie’s right to select two additional targets and an option to select up to four further targets. AbbVie will be required to make payments to us, upon target selection, of $10 million for each target, up to four further targets selected by AbbVie. For each of the up to eight targets selected, we will receive up to $300 million in the aggregate for the achievement of specified development, regulatory and commercial sales milestones for licensed products indicated for human therapeutic or prophylactic use, totaling up to $2.4 billion in the aggregate, if such licensed products are successfully progressed against all-included targets and indications. We will also be eligible to receive tiered royalties on net sales by AbbVie, its affiliates and sublicensees of licensed products at percentages in the mid-single digits, subject to specified offsets and reductions. Royalties will be payable under the Restated Collaboration Agreement on a product-by-product and country-by-country basis commencing on the date of first commercial sale of each product, and ending on the later of expiration of all valid claims of specified licensed patents in such country, expiration of regulatory exclusivity in such country or ten years following first commercial sale of such product in such country. If licensed products are developed and commercialized for diagnostic or veterinary use, or certain screening or monitoring uses, the parties have agreed to negotiate an appropriate reduction in the economic terms applicable to such non-therapeutic and prophylactic applications. We recognized revenue under the Original Collaboration Agreement over a period in which related research and development activities occur. Accordingly, of the $17.0 million upfront payment received in 2017, $4.0 million and $4.3 million of revenue was recognized during the years ended 2019 and 2018, respectively, and, as of December 31, 2019, we had $8.0 million of deferred revenue under the Original Collaboration Agreement. We will recognize revenue under the Restated Collaboration Agreement over a period in which related research and development activities occur. Accordingly, of the $20.0 million upfront payment received in 2019, no revenue was recognized for the year ended 2019 and as of December 31, 2019, we had $20.0 million of deferred revenue under the Restated Collaboration Agreement. The Restated Collaboration Agreement will terminate upon the date of the expiration of all AbbVie’s royalty payment obligations in all countries. The Restated Collaboration Agreement may be terminated by either party immediately for the insolvency of the other party or on 90 days’ written notice for an uncured material breach of such agreement by the other party. AbbVie may also terminate the Restated Collaboration Agreement in its entirety or on a target-by-target or country-by-country basis for any reason on 30 days’ written notice to the Company. In addition, AbbVie may terminate the Restated Collaboration Agreement immediately in its entirety or on a target-by-target basis if AbbVie considers in good faith that there has been a failure of the discovery or development efforts with respect to such target, or that further development or commercialization of products directed to such target is not advisable as a result of a serious safety issue. License Agreement with Werewolf Therapeutics, Inc. In March 2018, we entered into an assignment and license agreement, or the Werewolf Agreement, with Werewolf Therapeutics, Inc., or Werewolf, a portfolio company of MPM Capital, Inc., a holder of more than 5% of our capital stock. Dr. Luke Evnin, a member of our Board, is the Chairman of the board of directors of Werewolf. Under the Werewolf Agreement, we assigned certain patents that relate to certain inducible polypeptides (and binding moiety for conditional activation of certain polypeptides) to Werewolf and granted to Werewolf a non-exclusive, royalty-bearing, sublicenseable license under certain other patents owned by us and relating to certain proteins, to make, use and commercialize products that are covered by such patents in the field of molecules comprising a certain polypeptide. Werewolf assigned certain patents to us relating to adoptive cell therapies and binding moieties for conditional activation of immunoglobulin and non-immunoglobulin molecules. Under the Werewolf Agreement, Werewolf paid us an upfront fee of $0.5 million. If Werewolf commercializes products covered by the licensed patents, then beginning on the first sale of such products, Werewolf will be obligated to pay to us a royalty on net sales of such products by Werewolf, its affiliates and licensees at a percentage in the low single digits, subject to an obligation to make a minimum annual royalty payment at an amount in the low hundreds of thousands of dollars. In December 2019, we and Werewolf amended the Werewolf Agreement by entering into a Second Amended and Restated Assignment and License Agreement, or the Amended Werewolf Agreement, to include the grant to Werewolf of an exclusive, royalty-bearing, sublicensable license under certain patents owned by us and relating to certain proteins, to make, use, and commercialize products that are covered by such patents in the field of molecules comprising a certain protein. If Werewolf commercializes products covered by these licensed patents, then beginning on the first sale of such products, Werewolf will be obligated to pay to us a royalty on net sales of such products by Werewolf, its affiliates and licensees at a percentage in the low single digits, and this royalty cannot be added to any other royalty owed to us under the Amended Werewolf Agreement. In addition, each party granted to the other a non-exclusive, royalty-free, sublicensable, perpetual license under certain other patents relating to a certain binding domain of a certain protein, to make, use and commercialize products that are covered by such patents in a field defined by a certain type of molecule for each party. Royalties on net sales will be recognized when the underlying sales occur. No royalty revenue was recognized under the Werewolf Agreement as of December 31, 2019. Financial Operations Overview Revenue We have no products approved for commercial sale and have not generated any revenue from product sales. Our collaboration and license revenue to date is related to work performed by us under the Restated Collaboration Agreement and Development and Option Agreement, and is recognized when designated research and development services are performed. To date, we have not received any milestone or royalty payments under the Original Collaboration Agreement or the Restated Collaboration Agreement. We expect that any collaboration and license revenue we generate from the Restated Collaboration Agreement and the Development and Option Agreement and any future collaboration partners will fluctuate from period to period as a result of the timing and amount of milestones and other payments. Additionally, for R&D services that we recognize over time, we measure our progress using an input method. The input methods we use are based on the effort we expend or costs we incur toward the satisfaction of our performance obligation. We estimate the amount of effort we expend, including the time we estimate it will take us to complete the activities, or costs we incur in a given period, relative to the estimated total effort or costs to satisfy the performance obligation. This results in a percentage that we multiply by the transaction price to determine the amount of revenue we recognize each period. This approach requires us to make numerous estimates and use significant judgement. If our estimates or judgements change over the course of the collaboration, they may affect the timing and amount of revenue that we recognize in the current and future periods. On January 1, 2017, we adopted on a full retrospective basis Accounting Standards Codification Topic 606, Revenue from Contracts with Customers, or Topic 606. See further discussion under “Critical Accounting Policies and Estimates - Revenue Recognition.” Operating Expenses Research and Development Research and development expenses represent costs incurred in performing research, development and manufacturing activities in support of our own product development efforts and those of our collaborators, and include salaries, employee benefits, stock-based compensation, laboratory supplies, outsourced research and development expenses, professional services and allocated facilities-related costs. We expense both internal and external research and development expenses as they are incurred. We do not allocate our costs by product candidates, as our research and development expenses include internal costs, such as payroll and other personnel expenses, and external costs, neither of which are tracked by product candidate. In particular, with respect to internal costs, several of our departments support multiple product candidate research and development programs. Non-refundable advance payments for services that will be used or rendered for future research and development activities are recorded as prepaid expenses and recognized as expenses as the related services are performed. We expect our research and development expenses to continue to increase substantially in absolute dollars for the foreseeable future as we advance our product candidates into and through preclinical studies and clinical trials, pursue regulatory approval of our product candidates and expand our pipeline of product candidates. The process of conducting the necessary preclinical and clinical research to obtain regulatory approval is costly and time consuming. The actual probability of success for our product candidates may be affected by a variety of factors, including the safety and efficacy of our product candidates, early clinical data, investment in our clinical programs, the ability of collaborators to successfully develop our licensed product candidates, competition, manufacturing capability and commercial viability. We may never succeed in achieving regulatory approval for any of our product candidates. As a result of the uncertainties discussed above, 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 our product candidates. General and Administrative Our general and administrative expenses consist primarily of personnel costs, allocated facilities costs and other expenses for outside professional services, including legal, human resource, audit and accounting 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 Securities and Exchange Commission, or the SEC, Nasdaq 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. Other Expense Other expense is primarily comprised of foreign currency transaction losses related to certain transactions with European third-party vendors. Results of Operations Comparison of Years Ended December 31, 2019 and 2018 * Not meaningful Revenue Collaboration and license revenue of $5.8 million for the year ended December 31, 2019 consisted of revenue recognized related to research and development services performed under the Restated Collaboration Agreement of $4.0 million and the Development and Option Agreement of $1.7 million. Collaboration and license revenue of $4.8 million for the year ended December 31, 2018 primarily consisted of revenue recognized related to research and development services performed under the Restated Collaboration Agreement of $4.3 million and $0.5 million of the upfront payment received by us in May 2018 under the Werewolf Agreement. Research and Development The following table summarizes our research and development expenses incurred during the respective periods: Research and development expenses increased by $15.2 million, or 58%, in 2019 compared to 2018. The increase was primarily due to a $8.9 million increase in product and clinical development expense and pharmacology services due to development of four identified product candidates, which includes conducting preclinical and clinical studies and manufacturing runs to support ongoing clinical development, a $3.0 million increase in facility and other allocated expenses primarily related to a lease agreement for the office and laboratory space in South San Francisco, California, or the Cove Lease, entered into in August 2018, a $2.9 million increase in personnel-related expenses due to an increase in headcount, a $0.6 million increase in consulting expenses primarily due to preparation of our HPN424, HPN536 and HPN217 clinical trials, a $0.4 million increase in laboratory supplies and equipment to support increased activity related to all of our product candidates, which was offset by a $0.6 million decrease in research and technology services due to the completion of certain research activities as our lead product candidates transitioned into clinical development. General and Administrative General and administrative expenses increased by $16.3 million, or 267%, in 2019 compared to 2018. The increase was primarily due to a $11.0 million increase in legal fees primarily associated with ongoing litigation with Maverick Therapeutics, Inc., a $2.7 million increase in personnel-related expenses due to an increase in headcount, a $1.6 million increase in other professional services to support our ongoing operations as a public company, a $0.8 million increase in facility and other allocated expenses primarily related to the Cove Lease, and a net $0.2 million increase consulting and accounting services related to quarterly reviews and year-end audits associated with preparations for our initial public offering. Interest Income Interest income increased by $2.3 million, or 579%, in 2019 compared to 2018. The increase was primarily due to an increase in interest earned on our cash deposit accounts and marketable securities during the year ended December 31, 2019. Other Expense Other expense did not significantly fluctuate period over period. Liquidity and Capital Resources Liquidity Since our inception and through December 31, 2019, we have financed our operations primarily through the issuance of convertible notes, the sale of convertible preferred stock, the sale of common stock, upfront payments received by us from our collaboration and license agreements and the initial public offering of our common stock on the Nasdaq, including the partial exercise of the underwriters’ option to purchase additional shares, in which we received an aggregate of approximately $70.7 million in net proceeds, which amount is net of $10.1 million in underwriters’ discount and offering costs. As of December 31, 2019, we had $155.1 million in cash and cash equivalents and marketable securities, an accumulated deficit of $118.2 million and working capital of $128.1 million. We expect to continue to incur substantial costs in order to conduct research and development activities necessary to develop and commercialize our product candidates. Additional capital will be needed to undertake these activities and commercialization efforts, and, therefore, we intend to raise such capital through the issuance of additional equity, borrowings, and potentially strategic alliances with other companies. However, if such financing is not available at adequate levels or on acceptable terms, we could be required to significantly reduce operating expenses and delay, reduce the scope of or eliminate some of the development programs or commercialization efforts, out-license intellectual property rights to our product candidates and sell unsecured assets, or a combination of the above, any of which may have a material adverse effect on the our business, results of operations, financial condition and/or out ability to fund our scheduled obligations on a timely basis or at all. Capital Resources Our primary uses of cash are to fund operating expenses, which consist primarily of funding our clinical and preclinical trials, research and development expenditures and related personnel costs. 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 and accrued expenses. The timing and amount of our future funding requirements depends on many factors, including the following: • the scope, rate of progress, results and cost of our preclinical studies, clinical trials and other related activities; • the cost of manufacturing clinical supplies, and establishing commercial supplies, of our product candidates and any products that we may develop; • the number and characteristics of product candidates that we pursue; • the cost, timing and outcomes of regulatory approvals; • the cost and timing of establishing sales, marketing and distribution capabilities; • the terms and timing of any other collaborative, licensing and other arrangements that we may establish; • the timing, receipt and amount of sales, profit sharing or royalties, if any, from our potential products; • the cost of preparing, filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights • the extent to which we acquire or invest in businesses, products or technologies, although we currently have no commitments or agreements relating to any of these types of transactions; • the compliance and administrative costs associated with being a public company; and • the cost of attracting, hiring and retaining additional administrative, clinical, regulatory and scientific personnel. Based on our current business plans, we believe that our existing cash, cash equivalents and marketable securities, which include the net proceeds generated from our IPO in February 2019, will be sufficient to fund our planned operations for at least the next 12 months from the issuance date of this Annual Report Form 10-K. However, we will require additional funding in order to complete development of our product candidates and commercialize our products, if approved. We may seek to raise any necessary additional capital through a combination of public or private equity offerings, debt financings, collaborations, strategic alliances, licensing arrangements and other marketing and distribution arrangements. 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. 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 and clinical trials, research and development programs or commercialization efforts. Because of the numerous risks and uncertainties associated with the development and commercialization of our product candidates and the extent to which we may enter into additional collaborations with third parties to participate in their development and commercialization, we are unable to estimate the amounts of increased capital outlays and operating expenditures associated with our current and anticipated preclinical studies and clinical trials. To the extent that we raise additional capital through additional collaborations, strategic alliances or licensing arrangements with third parties, we may have to relinquish valuable rights to our product candidates, future revenue streams, research programs or product candidates or to grant licenses on terms that may not be favorable to us. If we do raise additional capital through public or private equity or convertible debt offerings, the ownership interest of our existing stockholders will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect our stockholders’ rights. 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. Please see the section entitled “Risk Factors” for additional risks associated with our substantial capital requirements and the challenges we may face in raising capital. Cash Flows Cash Flows from Operating Activities In 2019, cash used in operating activities was $2.9 million, which consisted of a net loss of $55.6 million and a net change of $49.0 million in our net operating assets and liabilities, partially offset by $3.6 million in non-cash charges. The non-cash charges consisted of stock-based compensation of $2.1 million, depreciation and amortization of $0.9 million, amortization operating right-of-use lease asset of $1.2 million and net amortization of premiums and discounts on marketable securities of $0.5 million. The change in operating assets and liabilities was primarily due to an increase in deferred revenue of $45.3 million resulting from the upfront payments of $30 million from the Development and Option Agreement and $20 million from the Restated Collaboration Agreement, a net increase in accounts payable and accrued liabilities of $2.5 million related to legal fees associated with Maverick litigation and timing of research and development activities, an increase in prepaid expenses and other current assets of $1.8 million resulting from the timing of payments made for operating costs to support our operations as a public company and timing for ongoing research and development activities and a decrease in other assets of $3.0 million resulting from the recognition of deferred IPO costs. In 2018, cash used in operating activities was $27.1 million, which consisted of a net loss of $27.4 million and a net change of $1.1 million in our net operating assets and liabilities, partially offset by $1.3 million in non-cash charges. The non-cash charges consisted of stock-based compensation of $0.7 million and depreciation and amortization of $0.6 million. The change in operating assets and liabilities was primarily due to a decrease in deferred revenue of $4.3 million resulting from the recognition of collaboration revenue, an increase in accounts payable and accrued liabilities of $3.6 million, and an increase in prepaid expenses and other current assets of $0.5 million resulting from the timing of payments made for research and development activities. Cash Flows from Investing Activities In 2019, cash used in investing activities of $69.3 million primarily related to purchases of marketable securities and property and equipment consisting primarily of laboratory equipment offset by the maturity and sale of marketable securities. In 2018, cash used in investing activities of $0.7 million related to purchases of property and equipment consisting primarily of laboratory equipment. Cash Flows from Financing Activities In 2019, cash provided by financing activities of $71.4 million was primarily related to the proceeds received from our IPO in February 2019. In 2018, cash provided by financing activities of $88.3 million was related primarily to $69.8 million in net cash proceeds received from the November 2018 issuance of our Series C convertible preferred stock, $20.0 million in net cash proceeds received from the July 2018 issuance of our Series B convertible preferred stock as a result of our IND filing for HPN424, and $0.2 million in proceeds from the issuance of common stock upon the exercise of stock options, partially offset by $1.7 million in deferred offering costs related to our initial public offering. Contractual Obligations and Other Commitments The following table summarizes our contractual obligations as of December 31, 2019: The obligations noted above represent operating lease obligations related to our currently occupied premises at 131 Oyster Point Blvd in South San Francisco, California that commenced in July 2019 and expires in June 2027. The initial annual base rent is approximately $2.2 million, and such amount will increase by 3.5% annually on each anniversary of the commencement date, equaling approximately $20.0 million over the eight-year lease term. In connection with the lease, we will maintain a letter of credit for the benefit of the landlord in the amount of $0.5 million. Under the lease agreement, we have an option to extend the lease for an additional period of eight years. As of December 31, 2019, we have not determined whether we will exercise our option to extend the lease term. In December 2016, we entered into a royalty transfer agreement with MPM Oncology Charitable Foundation, Inc. and UBS Optimus Foundation pursuant to which we will pay 0.5% of our annual global net sales to each of the counterparties for products that incorporate or utilize intellectual property that was discovered or developed by us prior to our initial public offering. In October 2015, we entered into a collaboration and license agreement with AGC Biologics, Inc. (formerly known as CMC ICOS Biologics, Inc.), or AGC, for certain manufacturing-related technology, and in July 2016, we entered into a development and manufacturing agreement with AGC. Pursuant to these agreements, so long as AGC is our exclusive manufacturer, we will not owe AGC any milestone or royalty payments for the use of their manufacturing technology. However, if AGC is no longer our exclusive manufacturer, and we still use such technology, we will owe AGC specified milestones of up to $350,000 per specified product and a royalty on net sales of these products of less than 1%. We have an option to buy out these royalty obligations by making a one-time payment to AGC in a dollar amount in the mid-single digit millions. See “Business-Collaboration and License Agreements-Agreements with AGC Biologics, Inc.” In addition, we enter into agreements in the normal course of business with contract research organizations for clinical trials and with vendors for preclinical studies and other services and products for operating purposes, which are generally cancelable upon written notice. These payments are not included in this table of contractual obligations. Off-Balance Sheet Arrangements Since our inception, we have not engaged in any off-balance sheet arrangements, as defined in the rules and regulations of the SEC. Critical Accounting Polices 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 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 date of the financial statements, as well as the reported revenue generated, and 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 the notes to our financial statements included elsewhere in this Annual Report on Form 10-K, we believe that the following critical accounting policies are most important to understanding and evaluating our reported financial results. Revenue Recognition Effective January 1, 2017, we early adopted on a full retrospective basis Accounting Standards Codification Topic 606, Revenue from Contracts with Customers, or Topic 606. This standard 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. In accordance with ASC 606, we recognize revenue when our customer obtains control of promised goods or services, in an amount that reflects the consideration which we expect to receive in exchange for those goods or services. To determine revenue recognition for arrangements that we determine are within the scope of Topic 606, we perform 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 we satisfy a performance obligation. We only apply the five-step model to contracts when it is probable that we will collect the consideration we are entitled to in exchange for the goods and services we transfer to the customer. At contract inception, we assess the goods or services promised within each contract that falls under the scope of Topic 606, determine those that are performance obligations and assesses whether each promised good or service is distinct. We then recognize as revenue the amount of the transaction price that is allocated to the respective performance obligation when or as the performance obligation is satisfied. We allocate the transaction price to each performance obligation on a relative stand-alone selling price basis. The stand-alone selling price may be, but is not presumed to be, the contract price. In determining the allocation, we maximize the use of observable inputs. When the stand-alone selling price of a good or service is not directly observable, we estimate the stand-alone selling price for each performance obligation using assumptions that require judgment. Acceptable estimation methods include, but are not limited to: (i) the adjusted market assessment approach, (ii) the expected cost plus margin approach, and (iii) the residual approach (when the stand-alone selling price is not directly observable and is either highly variable or uncertain). In order for the residual approach to be used, we must demonstrate that (a) there are observable stand-alone selling prices for one or more of the performance obligations and (b) one of the two criteria in ASC 606-10- 32-34(c)(1) and (2) is met. The residual approach cannot be used if it would result in a stand-alone selling price of zero for a performance obligation, as a performance obligation, by definition, has value on a stand-alone basis. An option in a contract to acquire additional goods or services gives rise to a performance obligation only if the option provides a material right to the customer that it would not receive without entering into that contract. Factors that we consider in evaluating whether an option represents a material right include, but are not limited to: (i) the overall objective of the arrangement, (ii) the benefit the collaborator might obtain from the arrangement without exercising the option, (iii) the cost to exercise the option (e.g. priced at a significant and incremental discount) and (iv) the likelihood that the option will be exercised. With respect to options determined to be performance obligations, we recognize revenue when those future goods or services are transferred or when the options expire. We enter into corporate collaborations under which we may obtain upfront license fees, research and development funding, and development, regulatory and commercial milestone payments and royalty payments. Our performance obligations under these arrangements may include licenses of intellectual property, distribution rights, research and development services, delivery of manufactured product and/or participation on joint steering committees. • Licenses of Intellectual Property. If the license to our intellectual property is determined to be distinct from the other performance obligations identified in the arrangement, we recognize revenue from upfront fees allocated to the license when the license is transferred to the customer and the customer is able to use and benefit from the license. For licenses that are bundled with other promises, we utilize judgement to assess the nature of the combined performance obligation to determine whether the combined performance obligation is satisfied over time or at a point in time and, if over time, the appropriate method of measuring proportional performance for purposes of recognizing revenue from non-refundable, upfront fees. We evaluate the measure of proportional performance each reporting period and, if necessary, adjust the measure of performance and related revenue recognition. We recognize collaboration revenue by measuring the progress toward complete satisfaction of the performance obligation using an input measure. In order to recognize revenue over the research and development period, we measure actual costs incurred to date compared to the overall total expected costs to satisfy the performance obligation. Revenues are recognized as the program costs are incurred. We will re-evaluate the estimate of expected costs to satisfy the performance obligation each reporting period and make adjustments for any significant changes. • Milestone Payments. At the inception of each arrangement that includes development, regulatory or commercial milestone payments, we evaluate whether the milestones are considered probable of being reached and estimates the amount to be included in the transaction price. Topic 606 suggests two alternatives to use when estimating the amount of variable consideration: the expected value method and the most likely amount method. Under the expected value method, an entity considers the sum of probability-weighted amounts in a range of possible consideration amounts. Under the most likely amount method, an entity considers the single most likely amount in a range of possible consideration amounts. Whichever method is used, it should be consistently applied throughout the life of the contract; however, it is not necessary for us to use the same approach for all contracts. We expect to use the most likely amount method for development and regulatory milestone payments. If it is probable that a significant revenue reversal would not occur, the associated milestone value is included in the transaction price. Milestone payments that are not within our or the licensee’s control, such as regulatory approvals, are not considered probable of being achieved until those approvals are received. The transaction price is then allocated to each performance obligation on a relative stand-alone selling price basis. We recognize revenue as or when the performance obligations under the contract are satisfied. At the end of each subsequent reporting period, we re-evaluate the probability or achievement of each such milestone and any related constraint, and if necessary, adjust our estimates of the overall transaction price. Any such adjustments are recorded on a cumulative catch-up basis, which would affect revenues and earnings in the period of adjustment. • Commercial Milestones and Royalties. For arrangements that include sales-based royalties, including milestone payments based on the level of sales, and in which the license is deemed to be the predominant item to which the royalties relate, we recognize revenue when the related sales occur. To date, we have not recognized any royalty revenue resulting from our collaboration arrangements. Upfront payments and fees are recorded as deferred revenue upon receipt or when due, and may require deferral of revenue recognition to a future period until we perform our obligations under these arrangements. Amounts payable to us are recorded as accounts receivable when our right to consideration is unconditional. See Note 8, “Collaboration and License Agreements” for additional details regarding our collaboration arrangements with AbbVie. Research and Development Expenses and Accrued Research and Development Costs We expense research and development costs as incurred. Research and development expenses consist of personnel costs for our research and product development employees. Also included are non-personnel costs such as professional fees payable to third parties for preclinical and preclinical studies, clinical trials and research services, production of materials for clinical trials, laboratory supplies and equipment maintenance and depreciation, intellectual property licenses and other consulting costs. We estimate preclinical and clinical study and research expenses based on the services performed, pursuant to contracts with research institutions that conduct and manage preclinical studies, clinical trials and research services on our behalf. We estimate these expenses based on discussions with management and external service providers as to the progress or stage of completion of services and the contracted fees to be paid for such services. We record the estimated costs of research and development activities based upon the estimated amount services provided but not yet invoiced, and include these costs in development expenses. We accrue for these costs based on factors such as estimates of the work completed and in accordance with agreements established with our third-party service provides under the service agreements. We make significant judgments and estimates in determining the accrued liabilities balance in each reporting period. As actual costs become known, we adjust our accrued liabilities. We have not experienced any material differences between accrued costs and actual costs incurred. However, the status and timing of actual services performed may vary from our estimates, resulting in adjustments to expense in future periods. Changes in these estimates that result in material changes to our accruals could materially affect our results of operations. Payments associated with licensing agreements to acquire exclusive license to develop, use, manufacture and commercialize products that have not reached technological feasibility and do not have alternate future use are expensed as incurred. Payments made to third parties under these arrangements in advance of the performance of the related services by the third parties are recorded as prepaid expenses until the services are rendered. Such payments are evaluated for current or long-term classification based on when such services are expected to be received. Stock-Based-Compensation We maintain a stock-based compensation plan as a long-term incentive for employees, consultants and members of our board of directors. The plan allows for the issuance of non-statutory options, or NSOs, and incentive stock options to employees and NSOs to nonemployees. Share-based payments are measured using fair-value-based measurements and recognized as compensation expense over the service period in which the awards are expected to vest. Our fair-value-based measurements of awards to employees and directors as of the grant date utilize the single-option award-valuation approach, and we use the straight-line method for expense attribution. The valuation model used for calculating the estimated fair value of stock awards is the Black-Scholes option-pricing model. The Black-Scholes model requires us to make assumptions and judgments about the variables used in the calculations, including the expected term (weighted-average period of time that the options granted are expected to be outstanding), the expected volatility of our common stock, the related risk-free interest rate and the expected dividend. We have elected to recognize forfeitures of share-based payment awards as they occur. Effective January 1, 2018, we early adopted ASU No. 2018-07, Compensation - Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting (“ASU 2018-07”). The new guidance requires equity-classified share-based payment awards issued to nonemployees to be measured on the grant date, instead of being measured through the performance completion date under the pre-existing guidance. For stock-based awards issued to non-employees, we record expense related to stock options based on the fair value of the options calculated using the Black-Scholes option-pricing model based on the measured grant date. For stock-based awards issued to non-employees prior to January 1, 2018, we recorded expense related to stock options based on the fair value of the options calculated using the Black-Scholes option-pricing model, remeasured at each reporting period until the options vest over the service performance period. We estimate the fair value of stock options granted to our employees on the grant date, and rights to acquire stock granted under our Employee Stock Purchase Plan ("ESPP"), 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. The expected term represents the period that stock-based awards are expected to be outstanding. The expected term for option grants is determined using the simplified method. The simplified method deems the term to be the average of the time-to-vesting and the contractual life of the stock-based awards. • Expected volatility. Since we have a limited trading history for our common stock, the expected volatility was estimated based on the average volatility for comparable publicly traded biotechnology companies over a period equal to the expected term of the stock option grants. The comparable companies were 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 option. • 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. Fair Value of Common Stock Prior to our IPO in February 2019, the fair values of the shares of common stock underlying our share-based awards were estimated on each grant date by our board of directors. Given the absence of a public trading market for our common stock prior to our February 2019 IPO, our board of directors exercised reasonable judgment and considered a number of objective and subjective factors to determine the best estimate of the fair value of our common stock, including our stage of development; our actual operating results and financial performance; progress of our research and development efforts; conditions in the industry and economy in general; the rights, preferences and privileges of our convertible preferred stock relative to those of our common stock; the likelihood of achieving a liquidity event for the holders of our common stock, such as an initial public offering or a sale of our company, given prevailing market conditions; equity market conditions affecting comparable public companies; the lack of marketability of our common stock and the results of independent third-party valuations. Valuations of our common stock were prepared by an unrelated third-party valuation firm in accordance with the guidance provided by the American Institute of Certified Public Accountants 2013 Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. For our valuations performed prior to December 31, 2018, we used the Option Pricing Model (OPM) Backsolve method to estimate the fair value of our common stock. In an option pricing method, or OPM, framework, the backsolve method for inferring the equity value implied by a recent financing transaction involves making assumptions for the expected time to liquidity, volatility and risk-free rate and then solving for the value of equity such that value for the most recent financing equals the amount paid. Furthermore, as of each of the valuation dates prior to December 31, 2018, we were at an early stage of development and future liquidity events were difficult to forecast. We applied a discount for lack of marketability to account for a lack of access to an active public market. Subsequent to the completion of our IPO in February 2019, our board of directors determines the fair value of our common stock based on the closing price of our common stock as reported on the date of grant on the primary stock exchange on which our common stock is traded. Recent Accounting Pronouncements See Note 2 to our financial statements included elsewhere in this report for more information. Emerging Growth Company Status We are an emerging growth company, as defined in 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 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 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. As a result, these financial statements may not be comparable to companies that comply with the new or revised accounting pronouncements as of public company effective dates. We early adopted ASU 2014-09, Revenue from Contracts with Customers (Accounting Standards Codification Topic 606), ASU 2016-09, Stock Compensation-Improvements to Employee Share-Based Payment Accounting, and ASU 2018-07, Compensation - Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting, ASU No. 2016-02, (Topic 842), Leases, as the JOBS Act does not preclude an emerging growth company from early adopting a new or revised accounting standard earlier than the time that such standard applies to private companies. We expect to use the extended transition period for any other new or revised accounting standards during the period in which we remain an emerging growth company. We will remain an emerging growth company until the earliest of (i) the last day of our first fiscal year (a) following the fifth anniversary of the completion of our initial public offering, (b) in which we have total annual gross revenues of at least $1.07 billion or (c) in which we are deemed to be a large accelerated filer, which means the market value of our common stock that is held by non-affiliates exceeds $700.0 million as of the prior June 30th and (ii) the date on which we have issued more than $1.0 billion in non-convertible debt securities during the prior three-year period.
-0.03982
-0.039342
0
<s>[INST] Overview We are a clinicalstage immunotherapy company developing a novel class of T cell engagers that harness the power of the body’s immune system to treat patients suffering from cancer and other diseases. T cell engagers are engineered proteins that direct a patient’s own T cells to kill target cells that express specific proteins, or antigens, carried by the target cells. Using our proprietary TriTAC platform, we are developing a pipeline of novel T cell engagers, or TriTACs, initially focused on the treatment of solid tumors and hematologic malignancies. We currently have two TriTAC product candidates in clinical development. HPN424, is currently in a Phase 1 clinical trial for the treatment of metastatic castrationresistant prostate cancer, or mCRPC. HPN536, is currently in a Phase 1/2a clinical trial for the treatment of ovarian cancer and other mesothelin, or MSLN, expressing solid tumors. We also have two TriTAC product candidates in preclinical development, HPN217, targeting Bcell maturation antigen, or BCMA, for the treatment of multiple myeloma and HPN328, targeting Deltalike ligand 3, or DLL3, for the treatment of small cell lung cancer, or SCLC. Pipeline Update HPN424: Our lead product candidate is currently in the dose escalation portion of a Phase 1 clinical trial for the treatment of mCRPC. The dose escalation phase is designed to determine the maximum tolerated dose and a recommended Phase 2 dose. Once a recommended Phase 2 dose is determined, we will initiate the dose expansion phase. Consistent with the TriTAC mechanism of action, we observed adverse events associated with T cell activation and cytokine induction, which prompted us to explore the use of dexamethasone as a premedication to limit potential adverse events. We have found that the addition of weekly dexamethasone premedication, tapered over several weeks, has successfully limited adverse events. Several patients have completed the scheduled taper and have successfully continued treatment with HPN424 in the absence of dexamethasone, with no complications observed thus far. Enrollment is ongoing in the doseescalation phase of the trial. Pharmacokinetics observed to date continue to support onceweekly dosing of HPN424. We expect to present interim doseescalation data at ASCO at the end of May 2020 and to initiate an expansion cohort in 2020. HPN536: In April 2019, we advanced our second TriTAC, HPN536, a MSLNtargeting T cell engager, into the clinic and dosed the first patient in a Phase 1/2a clinical trial for ovarian and other MSLNexpressing solid tumors. Patient enrollment continues as planned in the doseescalation phase of the trial. The study consists of two phases, an initial dose escalation phase of approximately 20 ovarian and pancreatic cancer patients, followed by an expansion phase of up to three additional parallel cohorts of 20 patients each with ovarian, pancreatic and mesothelioma cancer. The study is collecting data to evaluate the safety, tolerability, pharmacokinetics and activity of HPN536. We expect to present interim data from the trial in the second half of 2020. HPN217: In November 2019 we submitted an IND to the FDA, for the treatment of multiple myeloma, as well as entered into a Development and Option Agreement with AbbVie. Under our agreement with AbbVie, we have already received an upfront payment of $30 million and anticipate receiving a cash milestone payment of up to $50 million upon dosing the first patient in the Phase 1/2 clinical trial for HPN217 within a specified time period, which we expect to occur in the first half of 2020. Additionally, we are eligible to receive future payments totaling up to $430 million upon AbbVie’s exercise of an exclusive license option and achievement of certain development, regulatory, and commercial milestones, in addition to receipt of royalties on commercial sales [/INST] Negative. </s>
2,020
9,604
1,654,595
Medalist Diversified REIT, Inc.
2019-03-11
2018-12-31
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis is based on, and should be read in conjunction with, the consolidated financial statements and the related notes thereto of Medalist Diversified REIT, Inc. as of and for the years ended December 31, 2018 and December 31, 2017. This management’s discussion and analysis of financial condition and results of operations contains forward-looking statements that involve risks, uncertainties and assumptions. See “Cautionary Statement Regarding Forward-Looking Statements” for a discussion of the risks, uncertainties and assumptions associated with those statements. Our actual results may differ materially from those expressed or implied in the forward-looking statements as a result of various factors. Company Overview Medalist Diversified REIT, Inc. is a Maryland corporation formed on September 28, 2015. Beginning with our taxable year ended December 31, 2017, we believe that we have operated in a manner qualifying us as a REIT, and we have elected to be taxed as a REIT for federal income tax purposes. Our company serves as the general partner of Medalist Diversified Holdings, LP which was formed as a Delaware limited partnership on September 29, 2015. Our company was formed to acquire, reposition, renovate, lease and manage income-producing properties, with a primary focus on (i) commercial properties, including flex-industrial, limited service hotels, and retail properties, and (ii) multi-family residential properties in secondary and tertiary markets in the southeastern part of the United States, with an expected concentration in Virginia, North Carolina, South Carolina, Georgia, Florida and Alabama. We may also pursue, in an opportunistic manner, other real estate-related investments, including, among other things, equity or other ownership interests in entities that are the direct or indirect owners of real property, indirect investments in real property, such as those that may be obtained in a joint venture. While these types of investments are not intended to be a primary focus, we may make such investments in our Manager’s discretion. Our company is externally managed by Medalist Fund Manager, Inc. The Manager makes all investment decisions for our company. The Manager and its affiliated companies specialize in acquiring, developing, owning and managing value-added commercial real estate in the Mid-Atlantic and Southeast regions. The Manager oversees our company’s overall business and affairs and has broad discretion to make operating decisions on behalf of our company and to make investment decisions. The Company’s stockholders are not involved in its day-to-day affairs. As of December 31, 2018, our company owned and operated three investment properties, the Shops at Franklin Square (the “Franklin Square Property”), a 134,239 square foot retail property located in Gastonia, North Carolina (the Greensboro Hampton Inn) a hotel with 125 rooms on 2.162 acres in Greensboro, North Carolina and the Hanover North Shopping Center (“Hanover Square North”), a 73,440 square foot retail property located in Mechanicsville, Virginia. As of December 31, 2018, we owned 64% of the Greensboro Hampton Inn as a tenant in common with a noncontrolling owner which owned the remaining 36% interest. The tenants in common lease the Greensboro Hampton Inn to a taxable REIT subsidiary that is also owned 64% by us and 36% by the noncontrolling owner. As of December 31, 2018, we owned 84% of Hanover Square North as a tenant in common with a noncontrolling owner which owned the remaining 16% interest. Recent Trends and Activities There have been several significant events in 2017 and 2018 that have impacted our company. These events are summarized below. Equity Issuances During 2017 our company issued 1,148,000 shares of common stock at $10.00 per share subject to issuance costs and discounts. The net funds after issuance costs were used for the acquisition of our company’s first two investment properties. In addition, our company issued 125,000 operating partnership units, or OP Units, in exchange for $1,175,000 in contributions of equity in the Greensboro Hampton Inn. In January 2018, our company issued and sold 775,460 shares of common stock, and in February 2018, our Company issued and sold 63,620 shares of common stock at an offering price of $10.00 per share. Net proceeds from the issuances totaled $7,684,167, which includes the impact of discounts and offering costs, including the underwriters' selling commissions and legal, accounting and other professional fees. The net funds after issuance costs were used to (i) retire the short-term notes payable used to finance the purchase of the Greensboro Hampton Inn and (ii) fund our company’s acquisition of Hanover Square North, which closed on May 8, 2018. On June 6, 2018, our company issued and sold 8,500 shares of common stock at an offering price of $10.00 per share. Net proceeds from the issuances totaled $65,825, which includes the impact of discounts and offering costs, including the underwriters' selling commissions and legal, accounting and other professional fees. On November 30, 2018, our company issued and sold 240,000 shares of common stock at an offering price of $10.00 per share. Net proceeds from the issuances totaled $1,838,727, which includes the impact of discounts and offering costs, including the underwriters' selling commissions and legal, accounting and other professional fees. On August 31, 2018, the Company’s Board of Directors approved a grant of 80,000 shares of Common Shares to two employees of the Manager who also serve as directors of the Company and a grant of 6,000 Common Shares to the Company’s three independent directors. The effective date of the grants was December 4, 2018, the date on which the registration of the Plan shares was effective. The Common Shares granted vest immediately, but will be restricted for six months by a lock-up agreement associated with the Company’s sale of its Common Shares on November 27, 2018. In addition, the Plan includes other restrictions on the sale of shares issued under the Plan. Because the Common Shares vest immediately, the fair value of the grants, or $790,340, was recorded to expense on the effective date of the grant. The fair value of the grants was determined by the market price of the Company’s Common Shares on the effective date of the grant. Our Company also incurred $299,624 in other issuance costs during the year ended December 31, 2018. 2017 Acquisitions The Shops at Franklin Square On April 28, 2017, we completed our acquisition of the Franklin Square Property through a wholly owned subsidiary. The purchase price for the Franklin Square Property was $20,500,000 paid through a combination of cash and assumed, secured debt. Our total investment, including acquisition and closing costs, escrows and lease reserves was approximately $22,054,071. The Franklin Square Property, built in 2006 and 2007, was 68 percent leased as of the acquisition date, was anchored by Ashley Furniture and Monkey Joe’s as of the acquisition date, and is located in Gastonia, North Carolina. On May 10, 2018, we entered into a lease with Altitude Trampoline Park, or Altitude, a national tenant, for 30,000 square feet of rentable space. Altitude’s occupancy commenced in November 2018 and rent will commence on August 1, 2019. On October 18, 2018, we entered into a lease with Allen Tate, Inc. for 4,156 square feet. Allan Tate’s occupancy commenced on December 1, 2018, and rent will commence on March 1, 2019. Allen Tate’s and Altitude’s occupancy brought the Franklin Square Property’s occupancy rate to 92.5 percent as of December 31, 2018. Greensboro Airport Hampton Inn On November 3, 2017 we completed our acquisition of an undivided 64 percent tenant-in-common interest in the Greensboro Hampton Inn through a wholly owned subsidiary. The total purchase price for the Greensboro Hampton Inn was $15,100,000, paid through a combination of cash provided by our company, the issuance of 125,000 OP Units, the incurrence of new mortgage debt in the original principal amount of $10,600,000 and approximately $2,300,000 in cash provided by PMI Greensboro. The total investment, including acquisition, closing costs, escrow deposits and a reserve for property improvements required under the Greensboro Hampton Inn’s franchise agreement, was $18,004,621. The hotel has 125 rooms and was built in 1996. 2018 Acquisition Hanover North Shopping Center On May 8, 2018 we completed our acquisition of an undivided 84 percent tenant-in-common interest in Hanover Square North through a wholly owned subsidiary. The contract purchase price for Hanover Square North was $12,173,000. We acquired Hanover Square North with $3,291,404 in cash, $648,120 in cash from an unaffiliated tenant-in-common, and the assumption of a secured loan of approximately $8,527,315 from Langley Federal Credit Union, which amount was increased by an additional $372,685 (the “Hanover Square North Loan”). Hanover Square North is located in Mechanicsville, Virginia and consists of approximately 73,440 square feet of improvements located on an 8.766 acre parcel of land (the “Developed Parcel”) and a contiguous, undeveloped parcel of land totaling 0.864 acres. As of December 31, 2018, Hanover Square North was approximately 96.7% occupied. Financing Activities Our company financed its acquisitions of the three properties through mortgages, as follows: (a) The mortgage loan for the Greensboro Hampton Inn bears interest at a variable rate based on LIBOR with a minimum rate of 6.1%. The interest rate payable is the USD LIBOR one-month rate plus 5%. For the years ended December 31, 2018 and 2017, respectively, the rates in effect for the Greensboro Hampton Inn mortgage loan were 7.5 percent and 6.5 percent. (b) As part of its acquisition of Hanover Square North, our company assumed a secured loan of $8,527,315 from Langley Federal Credit Union and incurred additional mortgage debt of $372,685, also from Langley Federal Credit Union (the “Hanover Square North Loan”). The Hanover Square North Loan matures on December 1, 2027 and requires monthly payments of principal, on a 25-year amortization schedule, and interest during the term. The Hanover Square North Loan will bear interest at 4.90% through January 1, 2023, at which time the interest rate will be adjusted to the daily average yield on US Treasury securities adjusted to a constant maturity of five years, plus 3.10% with an interest rate floor of 4.90%. The fixed monthly payment includes principal and interest. The Hanover Square North Loan is secured by the Developed Parcel of Hanover Square North. On November 3, 2017, our company entered into an Interest Rate Protection Transaction to limit our company’s exposure to increases in interest rates on the variable rate mortgage loan on the Greensboro Hampton Inn. Under this agreement, our company’s interest rate exposure is capped at 7 percent if USD 1-Month LIBOR BBA exceeds 2 percent. As of December 31, 2018, USD 1-Month LIBOR was 2.51988 percent. In accordance with the guidance on derivatives and hedging, our company records all derivatives on the balance sheet at fair value. Our company reports the changes in the fair value of the derivative in other income. Beginning in July 2018, the USD 1-Month LIBOR BBA rate exceeded two percent and remained in excess of two percent on each subsequent monthly valuation date from July 2018 through December 31, 2018. Accordingly, the Company received the following payments under the Interest Rate Protection Transaction, all of which were recorded as a reduction to interest expense: In addition, our company issued the following short-term loans on November 3, 2017 to finance the purchase of the Greensboro Hampton Inn. These loans remained outstanding as of December 31, 2017: On January 29, 2018, the Company repaid the following short-term note payable, with interest: Loan payable to Virginia Commonwealth Bank (a) $1,500,000 Interest paid on this loan totaled $37,456, including a loan fee due of $22,500 which was paid at the time of the principal repayment and which was recorded as interest during the year ended December 31, 2018, and $4,985 and $9,971 of interest accrued during the years ended December 31, 2018 and 2017, respectively. On January 29, 2018, the Company repaid the following related party short-term notes payable, with interest: (a) Interest rate of 4.223 percent per annum (b) Interest rate of 5 percent for the term of the loan (c) Short term loan from seller of the Greensboro Hampton Inn which did not bear interest. On a weighted average basis, the effective interest rate on the short-term loans payable was 8.0 percent per annum. Each loan was issued on November 2, 2017 and the proceeds were used to fund the purchase of the Greensboro Hampton Inn. As of December 31, 2018, the Company had no notes payable, short term or related party notes payable, short term outstanding. Off-Balance Sheet Arrangements As of December 31, 2018, we have no off-balance sheet arrangements. Summary of Critical Accounting Policies The preparation of consolidated financial statements in conformity with GAAP requires management to use judgment in the application of accounting policies, including making estimates and assumptions. If our judgment or interpretation of the facts and circumstances relating to various transactions had been different, or different assumptions were made, it is possible that different accounting policies would have been applied, resulting in different financial results or a different presentation of our financial statements. Below is a discussion of the accounting policies that we consider critical to an understanding of our financial condition and operating results that may require complex or significant judgment in their application or require estimates about matters which are inherently uncertain. A discussion of our significant accounting policies, including further discussion of the accounting policies described below, can be found in Note 2, “Summary of Significant Accounting Policies,” of our Consolidated Financial Statements. We believe that the application of these policies on a consistent basis enables us to provide useful and reliable financial information about our operating results and financial condition. Revenue Recognition Principal components of our total revenues for our retail properties include base rents and tenant reimbursements. We accrue minimum (base) rent on a straight-line basis over the terms of the respective leases which results in an unbilled rent asset or deferred rent liability being recorded on the balance sheet. Certain lease agreements contain provisions that grant additional rents based on tenants’ sales volumes (contingent or percentage rent) which we recognize when the tenants achieve the specified targets as defined in their lease agreements. We periodically review the valuation of the asset/liability resulting from the straight-line accounting treatment of our leases in light of any changes in lease terms, financial condition or other factors concerning our tenants. Rents and Other Tenant Receivables We record a tenant receivable for amounts due from tenants such as base rents, tenant reimbursements and other charges allowed under the lease terms. We periodically review tenant receivables for collectability and determine the need for an allowance for the uncollectible portion of accrued rents and other accounts receivable based upon customer creditworthiness (including expected recovery of a claim with respect to any tenants in bankruptcy), historical bad debt levels and current economic trends. We consider a receivable past due once it becomes delinquent per the terms of the lease. A past due receivable triggers certain events such as notices, fees and other actions per the lease. Acquisition of Investments in Real Estate The adoption of ASU 2017-01, as discussed in Note 2, “Summary of Significant Accounting Policies” of the Consolidated Financial Statements included in this report, has impacted our accounting framework for the acquisition of investment properties. Upon acquisition of investment properties, the Company estimates the fair value of acquired tangible assets (consisting of land, buildings and improvements, and furniture, fixtures and equipment) and identified intangible assets and liabilities, including in-place leases, above- and below-market leases, tenant relationships and assumed debt based on evaluation of information and estimates available at that date. Fair values for these assets are not directly observable and estimates are based on comparable market data and other information which is subjective in nature, including estimated cash flow projections that utilize appropriate discount and capitalization rates and available market information. Impairment of Long-Lived Assets We periodically review investment properties for impairment on a property-by-property basis to identify any events or changes in circumstances that indicate that the carrying value of investment properties may not be recoverable. These circumstances include, but are not limited to, declines in the property’s cash flows, occupancy and fair market value. If any such events or changes in circumstances are identified, we perform a formal impairment analysis. We measure any impairment of investment property when the estimated undiscounted operating income before depreciation and amortization, is less than the carrying value of the property. To the extent impairment has occurred, we charge to income the excess of carrying value of the property over its estimated fair value. We estimate fair value using data such as operating income, estimated capitalization rates or multiples, leasing prospects and local market information. The Company also reviews its intangible assets for impairment whenever events or changes in circumstances indicate that the carrying value of its intangible assets may not be recoverable, but at least annually. REIT Status We are a Maryland corporation that has elected to be treated, for U.S. federal income tax purposes, as a REIT. We elected to be taxed as a REIT under the Code for the year ended December 31, 2017 and have not revoked such election. A REIT is a corporate entity which holds real estate interests and must meet a number of organizational and operational requirements, including a requirement that it currently distribute at least 90% of its adjusted taxable income to stockholders. As a REIT, we generally will not be subject to corporate level federal income tax on our taxable income if we annually distribute 100% of our taxable income to our stockholders. If we fail to qualify as a REIT in any taxable year, we will be subject to regular federal and state corporate income taxes and may not be able to elect to qualify as a REIT for four subsequent taxable years. Our qualification as a REIT requires management to exercise significant judgment and consideration with respect to operational matters and accounting treatment. Therefore, we believe our REIT status is a critical accounting estimate. Liquidity and Capital Resources Our business model is intended to drive growth through acquisitions. Access to the capital markets is an important factor for our continued success. We expect to continue to issue equity in our company through our offering with proceeds being used to acquire additional target properties. Our liquidity needs are primarily to fund (i) operating expenses and cash dividends; (ii) property acquisitions; (iii) deposits and fees associated with long-term debt financing for our properties; (iv) recurring capital expenditures; (v) debt repayments; (vi) payment of principal of, and interest on, outstanding indebtedness; and (vii) corporate and administrative costs. Internal liquidity will be provided solely by the rental receipts from our real properties. The only external liquidity source we have currently identified is our ongoing efforts to raise capital by the issuance of shares of common stock. During 2017 our company issued 1,148,000 shares of common stock at $10 per share, subject to issuance costs and discounts. The net funds after offering costs were used for the acquisition of our company’s first two investment properties. During January and February 2018 our company issued 839,080 shares of common stock at $10 per share subject to issuance costs and discounts. The net funds after issuance costs were used to (i) retire the short term notes payable used to finance the purchase of the Greensboro Hampton Inn and (ii) fund our company’s acquisition of Hanover Square North, which closed on May 8, 2018. On June 6, 2018, our company issued 8,500 shares of common stock at an offering price of $10 per share. We completed our initial registered public offering on Form S-11 on November 30, 2018, or our IPO, pursuant to which we issued an aggregate of 240,000 shares of our common stock and received approximately $1,838,727 in net proceeds. We have contributed the net proceeds of our IPO for OP Units. We utilized $250,176 of such proceeds to pay a cash dividend and $732,730 for working capital purposes, including short-term advances to the Greensboro Hampton Inn to fund property improvements. with the remaining $855,821 kept as cash on hand. Cash Flows Comparison of Year Ended December 31, 2018 to Year Ended December 31, 2017 At December 31, 2018, our consolidated cash on hand totaled $1,327,424 compared to consolidated cash on hand of $263,002 at December 31, 2017. Cash flows from operating activities, investing activities and financing activities for the years ended December 31, 2018 and 2017 are as follows: Operating Activities During 2017 the Company acquired and commenced operations of its first two operating properties, the Franklin Square Property in May 2017 and the Greensboro Hampton Inn in November 2017. During 2018 the Company acquired and commenced operations of its third property, Hanover Square North in May 2018. During the year ended December 31, 2018 our cash flows used in operating activities increased to $450,766 from $43,847 during the year ended December 31, 2017. Our net loss increased from $968,548 for the year ended December 31, 2017 to $2,991,153 for the year ended December 31, 2018, but this was driven by increases in non-cash items, including an increase in depreciation and amortization of $1,300,177, share based compensation costs of $790,340 and a loss on impairment of $191,578. Excluding these non-cash items, our net cash provided by operating activities was $305,057 for the year ended December 31, 2018, an increase of $481,228 over the net cash, as adjusted for non-cash items, used in operating activities of $176,171 for the year ended December 31, 2017. Changes in assets and liabilities, net of acquisitions (working capital) used $755,823 in cash for the year ended December 31, 2018, compared to providing $132,324 in cash for the year ended December 31, 2017, a decrease of $888,147. This was driven primarily by the Company’s payment of accounts payable and accrued liabilities. Investing Activities During the year ended December 31, 2018, our cash flows used in investing activities were $5,153,863 compared to cash flows used in investing activities of $23,923,247 during the year ended December 31, 2017. During the year ended December 31, 2018, cash used in investing activities included $4,312,209 for the acquisition of Hanover Square North, $349,699 in capital expenditures for leasing commissions and tenant improvements for the Franklin Square Property, $6,115 in leasing commissions for the Hanover Square Property, and $630,656 for interior and exterior renovations at the Greensboro Hampton Inn. Additionally, $423,747 in advance deposits for furniture and fixtures was incurred and paid related to the Greensboro Hampton Inn renovation. Funds released from property capital reserves offset some of these capital expenditures. During the year ended December 31, 2017, investing activities were related to the acquisition of the Greensboro Hampton Inn and capital expenditures were related to tenant improvements for the Franklin Square Property. Financing Activities During the year ended December 31, 2018, our cash flows provided by financing activities were $6,669,051 compared to $24,230,014 during the year ended December 31, 2017. During the year ended December 31, 2018, our company generated net proceeds, after offering costs, from its common stock issuances, of $9,289,095. Additionally, we repaid short term notes payable of $2,177,538, paid dividends and distributions of $1,213,840, and incurred new mortgage debt associated with Hanover Square North of $372,685 which payable proceeds were $250,652 after deducting loan issuance costs that were incurred and capitalized of $122,033. The Company made $127,438 in principal payments on the Hanover Square North mortgage payable. During the year ended December 31, 2017, our company generated net proceeds, after offering costs, from our common stock issuances of $9,993,822 and paid dividends and distributions of $422,686. Additionally, our company issued notes payables and related party payables which generated proceeds of $2,177,538, incurred new mortgage debt associated with the purchase of the Greensboro Hampton Inn of $10,181,309, and accepted $2,300,031 in investment of noncontrolling interests associated with the purchase of the Greensboro Hampton Inn. Non-cash financing activities that did not affect our cash flows provided by financing activities include the assumption of mortgage debt of $8,527,315 associated with Hanover Square North and $14,275,000 associated with the purchase of the Franklin Square Property, Future Liquidity Needs Liquidity for general operating needs and our company’s investment properties is provided solely by the rental receipts from those properties. Liquidity for growth (acquisition of new investment properties) will be provided by additional equity issuances, net of issuance costs. In addition to the funding of our ongoing operations, our primary liquidity needs at December 31, 2018 were to provide funding for the ongoing costs associated with our company’s continuing efforts to raise capital through the issuance of additional shares of common stock. We anticipate that these costs will be funded by proceeds from the future issuances of common stock. Results of Operations Comparison of Year Ended December 31, 2018 to Year Ended December 31, 2017 Total Revenue Total revenue was $6,589,951 for the year ended December 31, 2018, consisting of $2,049,580 in revenues from the Franklin Square Property, $864,202 in revenues from Hanover Square North (which was owned by our company for eight months during 2018) and $3,676,169 in revenues from the Greensboro Hampton Inn. Total revenue was $1,724,657 for the year ended December 31, 2017, consisting of $1,325,155 in revenues from the Franklin Square Property (which was owned by our company for eight months during 2017) and $399,502 in revenues from the Greensboro Hampton Inn (which was owned by our company for two months during 2017). Total revenues for the year ended December 31, 2018 increased by $4,865,294 over the year ended December 31, 2017. This increase was a result of owning the two properties acquired in 2017 for a full year in 2018 and new revenues from the acquisition of Hanover Square North. Total Operating Expenses Total operating expenses for the year ended December 31, 2018 were $7,654,864, consisting of $758,232 in expenses for the Franklin Square Property, $218,236 for Hanover Square North, $2,608,825 for the Greensboro Hampton Inn, $790,340 of share based compensation expenses, $938,049 of legal, accounting and other professional fees, $106,281 in corporate general and administrative expenses, a $191,478 loss on impairment and $2,043,323 in depreciation and amortization expenses. Total operating expenses for the year ended December 31, 2017 were $2,009,784, consisting of $602,970 in expenses for the Franklin Square Property, $356,427 for the Greensboro Hampton Inn, $253,056 of legal, accounting and other professional fees, $54,185 of corporate general and administrative expenses, and $743,146 in depreciation and amortization expenses. Total operating expenses for the year ended December 31, 2018 increased by $5,645,080 over the year ended December 31, 2017. This increase was a result of owning the two properties acquired in 2017 for a full year in 2018, owning Hanover Square North for eight months during 2018, the share based compensation costs incurred during 2018 and the loss on impairment recognized during 2018. Interest Expense Interest expense for the year ended December 31, 2018 was $1,917,183. This consisted of (i) $680,242 in mortgage interest and $18,552 in amortization of loan issuance costs for the Franklin Square Property, (ii) $761,544 in mortgage interest, $139,560 in amortization of loan issuance costs and $12,330 in payments (recorded as a reduction in interest expense) from the interest rate cap transaction for the Greensboro Hampton Inn, (iii) $280,377 in mortgage interest and $8,488 in amortization of loan issuance costs for Hanover Square North and (iv) other interest of $40,750. Interest expense for the year ended December 31, 2017 was $766,857. This consisted of (i) $512,482 in mortgage interest, $12,369 in amortization of loan issuance costs and $43,681 in interest on an acquisition bridge loan for the Franklin Square Property, (ii) $137,726 in mortgage interest and $23,261 in amortization of loan issuance costs for the Greensboro Hampton Inn, (iii) $18,400 in interest on related party short-term notes payable, (iv) $9,971 in interest on a short term note payable and (v) $8,967 in miscellaneous interest. Total interest expense for the year ended December 31, 2018 increased by $1,150,326 over the year ended December 31, 2017. This increase was a result of owning two of our properties for a full year in 2018 and new interest expense from the acquisition of Hanover Square North in 2018. Other Income On November 3, 2017, our company entered into an Interest Rate Protection Transaction to limit our company’s exposure to increases in interest rates on the variable rate mortgage loan on the Greensboro Hampton Inn. Under this agreement, our company’s interest rate exposure is capped at 7% if USD 1-Month LIBOR BBA exceeds 2%. As of December 31, 2018, USD 1-Month LIBOR was 2.51988%. In accordance with the guidance on derivatives and hedging, our company records all derivatives on the balance sheet at fair value. Our company reports the changes in the fair value of the derivative in other income. As of December 31, 2018, the fair value of the Interest Rate Protection Transaction was $126,797, an increase of $43,361 over the December 31, 2017 fair value. This increase in fair value was recognized as other income during the year ended December 31, 2018. Beginning in July 2018, the USD 1-Month LIBOR BBA rate exceeded 2 percent and remained in excess of 2 percent on each monthly valuation date during the period ended December 31, 2018. Accordingly, the Company received the following payments under the Interest Rate Protection Transaction, all of which were recorded as a reduction to interest expense: The Company also recognized $733 and $0 in interest income on cash balances held in a money market account for the years ended December 31, 2018 and 2017, respectively. Net Loss Total net loss was $2,991,153 for the year ended December 31, 2018, before adjustments for net loss attributable to noncontrolling interests. After adjusting for noncontrolling interests, the net loss attributable to our common shareholders was $2,743,323. Total net loss was $968,548 for the year ended December 31, 2017, before adjustments for net loss attributable to noncontrolling interests. After adjusting for noncontrolling interests, the net loss attributable to our common shareholders was $847,919. Total net loss for the year ended December 31, 2018 increased by $2,022,605 over the year ended December 31, 2017, before adjustments for net loss attributable to noncontrolling interests. After adjusting for noncontrolling interests, total net loss for the year ended December 31, 2018 increased by $1,895,404 over the year ended December 31, 2017. This increase was primarily a result of owning two of our properties for a full year in 2018 and owning Hanover Square North for eight months during 2018. Funds from Operations We use Funds from operations (“FFO”), a non-GAAP measure, as an alternative measure of our operating performance, specifically as it relates to results of operations and liquidity. We compute FFO in accordance with standards established by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”) in its March 1995 White Paper (as amended in November 1999, April 2002 and December 2018). As defined by NAREIT, FFO represents net income (computed in accordance with GAAP), excluding gains (or losses) from sales of property, plus real estate related depreciation and amortization (excluding amortization of loan origination costs and above and below market leases) and after adjustments for unconsolidated partnerships and joint ventures. Most industry analysts and equity REITs, including us, consider FFO to be an appropriate supplemental measure of operating performance because, by excluding gains or losses on dispositions and excluding depreciation, FFO is a helpful tool that can assist in the comparison of the operating performance of a company’s real estate between periods, or as compared to different companies. Management uses FFO as a supplemental measure to conduct and evaluate our business because there are certain limitations associated with using GAAP net income alone as the primary measure of our operating performance. Historical cost accounting for real estate assets in accordance with GAAP implicitly assumes that the value of real estate assets diminishes predictably over time, while historically real estate values have risen or fallen with market conditions. Accordingly, we believe FFO provides a valuable alternative measurement tool to GAAP when presenting our operating results. NAREIT’s December 2018 White Paper states, “FFO of a REIT includes the FFO of all consolidated properties, including consolidated, partially owned affiliates”. Additionally, since the adjustments to GAAP net income, such as depreciation and amortization, used in the reconciliation of net income (loss) to determine FFO are not allocated between shareholders and noncontrolling interests (i.e. 100% of depreciation and amortization are “added back” without reduction to reflect the noncontrolling owners’ interest in such items), the Company believes that the appropriate starting point for the calculation is the net income (loss) before allocation to noncontrolling interests. This allows the Company to use FFO as a tool to measure the overall performance of its investment properties, as a whole, not just the portion of the investment properties controlled by Company shareholders. Below is our company’s FFO, which is a non-GAAP measurement, for the year ended December 31, 2018: (1) Depreciation expense for buildings, site improvements and furniture and fixtures. (2) Depreciation of tenant improvements, including those acquired as part of the purchase of the Franklin Square Property and Hanover Square North and those constructed during the years ended December 31, 2018 and 2017. (3) Amortization of leasing commissions paid for the Franklin Square Property and Hanover Square North during the year ended December 31, 2018. (4) Amortization of tenant inducements paid for the Franklin Square Property during the year ended December 31, 2018. (5) Amortization of intangible assets acquired as part of the purchase of the Franklin Square Property and Hanover Square North, including leasing commissions, leases in place and legal and marketing costs. (6) NAREIT’s December 2018 White Paper provides guidance for the treatment of impairment write-downs. Specifically, “To the extent there is an impairment write-down of depreciable real estate … related to a REIT’s main business, the write-down is excluded from FFO (i.e., adjusted from net income in calculating FFO).” NAREIT’s December 2018 White Paper encourages companies reporting FFO to “make supplemental disclosure of all material non-cash revenues and expenses affecting their results for each period.” We believe that the computation of FFO in accordance with NAREIT’s definition includes certain items that are not indicative of the results provided by our operating portfolio and affect the comparability of our period-over-period performance. These items include non-cash items such as amortization of loans and above and below market leases, unbilled rent arising from applying straight line rent revenue recognition and share-based compensation expenses. Additionally, the impact of capital expenditures, including tenant improvement and leasing commissions, net of reimbursements of such expenditures by property escrow funds, is included in our calculation of AFFO. Therefore, in addition to FFO, management uses Adjusted FFO (“AFFO”), which we define to exclude such items. Management believes that these adjustments are appropriate in determining AFFO as their exclusion is not indicative of the operating performance of our assets. In addition, we believe that AFFO is a useful supplemental measure for the investing community to use in comparing us to other REITs as many REITs provide some form of adjusted or modified FFO. However, there can be no assurance that AFFO presented by us is comparable to the adjusted or modified FFO of other REITs. Total AFFO for the year ended December 31, 2018 was as follows: (1) Adjustment to FFO resulting from non-cash amortization of intangible assets recorded as part of the purchase of the Franklin Square Property and Hanover Square North. (2) Adjustment to FFO resulting from non-cash amortization of intangible liabilities recorded as part of the purchase of the Franklin Square Property and Hanover Square North. (3) Adjustment to FFO resulting from non-cash revenues recognized as a result of applying straight line revenue recognition for the Franklin Square Property and Hanover Square North. (4) Adjustment to FFO for capital expenditures made during the year ended December 31, 2018 for the Franklin Square Property, Hanover Square North and Greensboro Hampton Inn that will not be reimbursed by property escrow accounts. During the year ended December 31, 2018, the Company paid $1,547,391 in costs for leasing commissions, tenant inducements and tenant improvements at the Franklin Square Property and Hanover Square North and interior and exterior renovations and advance deposits for furniture and fixtures at the Greensboro Hampton Inn. During 2018, the Company received $604,290 in funds from property capital reserves held by the Greensboro Hampton Inn mortgage holder and $64,944 from the Franklin Square Property mortgage holder. (5) Adjustment to FFO resulting from non-cash revenues recognized as a result of increase in fair value of interest rate cap. (6) Adjustment to FFO for amortization of non-cash expenses recognized as a result of amortizing loan issuance costs over the terms of the respective mortgages. (7) Adjustment to FFO resulting from non-cash expenses recorded for share based compensation.
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0.125579
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<s>[INST] This management’s discussion and analysis of financial condition and results of operations contains forwardlooking statements that involve risks, uncertainties and assumptions. See “Cautionary Statement Regarding ForwardLooking Statements” for a discussion of the risks, uncertainties and assumptions associated with those statements. Our actual results may differ materially from those expressed or implied in the forwardlooking statements as a result of various factors. Company Overview Medalist Diversified REIT, Inc. is a Maryland corporation formed on September 28, 2015. Beginning with our taxable year ended December 31, 2017, we believe that we have operated in a manner qualifying us as a REIT, and we have elected to be taxed as a REIT for federal income tax purposes. Our company serves as the general partner of Medalist Diversified Holdings, LP which was formed as a Delaware limited partnership on September 29, 2015. Our company was formed to acquire, reposition, renovate, lease and manage incomeproducing properties, with a primary focus on (i) commercial properties, including flexindustrial, limited service hotels, and retail properties, and (ii) multifamily residential properties in secondary and tertiary markets in the southeastern part of the United States, with an expected concentration in Virginia, North Carolina, South Carolina, Georgia, Florida and Alabama. We may also pursue, in an opportunistic manner, other real estaterelated investments, including, among other things, equity or other ownership interests in entities that are the direct or indirect owners of real property, indirect investments in real property, such as those that may be obtained in a joint venture. While these types of investments are not intended to be a primary focus, we may make such investments in our Manager’s discretion. Our company is externally managed by Medalist Fund Manager, Inc. The Manager makes all investment decisions for our company. The Manager and its affiliated companies specialize in acquiring, developing, owning and managing valueadded commercial real estate in the MidAtlantic and Southeast regions. The Manager oversees our company’s overall business and affairs and has broad discretion to make operating decisions on behalf of our company and to make investment decisions. The Company’s stockholders are not involved in its daytoday affairs. As of December 31, 2018, our company owned and operated three investment properties, the Shops at Franklin Square (the “Franklin Square Property”), a 134,239 square foot retail property located in Gastonia, North Carolina (the Greensboro Hampton Inn) a hotel with 125 rooms on 2.162 acres in Greensboro, North Carolina and the Hanover North Shopping Center (“Hanover Square North”), a 73,440 square foot retail property located in Mechanicsville, Virginia. As of December 31, 2018, we owned 64% of the Greensboro Hampton Inn as a tenant in common with a noncontrolling owner which owned the remaining 36% interest. The tenants in common lease the Greensboro Hampton Inn to a taxable REIT subsidiary that is also owned 64% by us and 36% by the noncontrolling owner. As of December 31, 2018, we owned 84% of Hanover Square North as a tenant in common with a noncontrolling owner which owned the remaining 16% interest. Recent Trends and Activities There have been several significant events in 2017 and 2018 that have impacted our company. These events are summarized below. Equity Issuances During 2017 our company issued 1,148,000 shares of common stock at $10.00 per share subject to issuance costs and discounts. The net funds after issuance costs were used for the acquisition of our company’s first two investment properties. In addition, our company issued 125,000 operating partnership units, or OP Units, in exchange for $1,175,000 in contributions of equity in the Greensboro Hampton Inn. In January 2018, our company issued and sold 775,460 shares of common stock, and in February 2018 [/INST] Positive. </s>
2,019
6,105
1,654,595
Medalist Diversified REIT, Inc.
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 is based on, and should be read in conjunction with, the consolidated financial statements and the related notes thereto of Medalist Diversified REIT, Inc. for the years ended December 31, 2019 and December 31, 2018. This management’s discussion and analysis of financial condition and results of operations contains forward-looking statements that involve risks, uncertainties and assumptions. See “Cautionary Statement Regarding Forward-Looking Statements” for a discussion of the risks, uncertainties and assumptions associated with those statements. Our actual results may differ materially from those expressed or implied in the forward-looking statements as a result of various factors. Company Overview Medalist Diversified REIT Inc. is a Maryland corporation formed on September 28, 2015. Beginning with our taxable year ended December 31, 2017, we believe that we have operated in a manner qualifying us as a real estate investment trust (“REIT”), and we have elected to be taxed as a REIT for federal income tax purposes. Our company serves as the general partner of Medalist Diversified Holdings, LP which was formed as a Delaware limited partnership on September 29, 2015. Our company was formed to acquire, reposition, renovate, lease and manage income-producing properties, with a primary focus on (i) commercial properties, including flex-industrial, limited service hotels, and retail properties, (ii) multi-family residential properties and (iii) hotel properties in secondary and tertiary markets in the southeastern part of the United States, with an expected concentration in Virginia, North Carolina, South Carolina, Georgia, Florida and Alabama. We may also pursue, in an opportunistic manner, other real estate-related investments, including, among other things, equity or other ownership interests in entities that are the direct or indirect owners of real property, indirect investments in real property, such as those that may be obtained in a joint venture. While these types of investments are not intended to be a primary focus, we may make such investments in our Manager’s discretion. Our company is externally managed by Medalist Fund Manager, Inc. (the “Manager”). The Manager makes all investment decisions for our company. The Manager and its affiliated companies specialize in acquiring, developing, owning and managing value-added commercial real estate in the Mid-Atlantic and Southeast regions. The Manager oversees our company’s overall business and affairs and has broad discretion to make operating decisions on behalf of our company and to make investment decisions. Our company’s stockholders are not involved in its day-to-day affairs. As of December 31, 2019, our company owned and operated six investment properties, the Shops at Franklin Square (the “Franklin Square Property”), a 134,239 square foot retail property located in Gastonia, North Carolina, the Greensboro Hampton Inn (the “Hampton Inn Property”) a hotel with 125 rooms on 2.162 acres in Greensboro, North Carolina, the Hanover North Shopping Center (the “Hanover Square Property”), a 73,440 square foot retail property located in Mechanicsville, Virginia, the Ashley Plaza Shopping Center (the “Ashley Plaza Property”), a 160,356 square foot retail property located in Goldsboro, North Carolina, the Clemson Best Western University Inn (the “Clemson Best Western Property”), a hotel with 148 rooms on 5.92 acres in Clemson, South Carolina and Brookfield Center (the “Brookfield Center Property”), a 64,880 square foot mixed-use industrial/office property located in Greenville, South Carolina. As of December 31, 2019, we owned 64 percent of the Hampton Inn Property as a tenant in common with a noncontrolling owner which owned the remaining 36 percent interest. The tenants in common lease the Hampton Inn Property to a taxable REIT subsidiary that is also owned 64 percent by us and 36 percent by the noncontrolling owner. As of December 31, 2019, we owned 84 percent of the Hanover Square Property as a tenant in common with a noncontrolling owner which owned the remaining 16 percent interest. Reporting Segments We establish operating segments at the property level and aggregate individual properties into reportable segments based on product types in which we have Investments. As of December 31, 2019, we had the following reportable segments: retail center properties, flex center properties and hotel properties. Recent Trends and Activities There have been several significant events during 2017, 2018 and 2019 that have impacted our company. These events are summarized below. Equity Issuances Between January and June 2018, our company issued and sold 847,580 shares of common stock at an offering price of $10.00 per share. Net proceeds from the issuances totaled $7,749,992, which includes the impact of discounts and offering costs, including the underwriters' selling commissions and legal, accounting and other professional fees. The net funds after issuance costs were used to (i) retire the short-term notes payable used to finance the purchase of the Hampton Inn Property and (ii) fund our company’s acquisition of the Hanover Square Property, which closed on May 8, 2018. On November 30, 2018, we completed our initial registered public offering, or our IPO, pursuant to which we issued an aggregate of 240,000 shares of our common stock at an offering price of $10.00 per share and received approximately $1,838,727 in net proceeds. On May 8, 2019, our company issued and sold 1,666,667 shares of common stock at an offering price of $4.80 per share. Net proceeds from the issuance totaled $7,222,501, which includes the impact of discounts and offering costs, including the underwriter’s selling commissions and reimbursable legal fees and other expenses. On May 21, 2019, our company issued and sold 227,062 shares of common stock at an offering price of $4.80 per share, pursuant to its underwriter’s over-allotment option related to the May 8, 2019 offering. Net proceeds from the issuance totaled $991,807, which includes the impact of discounts and offering costs, including the underwriter’s selling commissions. On May 31, 2019, our company issued and sold 270,833 shares of common stock pursuant to a private placement at an offering price of $4.80 per share. Net proceeds from the issuance totaled $1,183,998, which includes the impact of discounts and offering costs, including the underwriter’s selling commissions and reimbursable legal fees. During the year ended December 31, 2019, our company also incurred $970,667 respectively, in offering costs, including legal, accounting, advisory and other professional fees. On August 31, 2018, our company’s Board of Directors approved a grant of 80,000 shares of our common stock to two employees of the Manager who also serve as directors of our company and a grant of 6,000 shares of our common stock to our company’s three independent directors. The shares were granted under our company’s 2018 Equity Incentive Plan (the “Plan”). The effective date of the grants was December 4, 2018, the date on which the registration of the Plan shares was effective. The shares vested immediately, but, pursuant to lock-up agreements executed in connection with our November 30, 2018 IPO, May 8, 2019 common stock issuance and February 19, 2020 Series A Preferred Stock issuance (see below), the holders of these shares have been and are restricted from selling any of their shares of our common stock. Specifically, the sale of any shares held by our directors was restricted for 180 days following the effective date of each of the registration statements. The effective date of our Series A Preferred Stock registration statement was February 13, 2020, so the sale of the shares will be restricted for 180 days from this date, or until August 11, 2020. In addition, the Plan includes other restrictions on the sale of shares issued under the Plan. Because the shares vested immediately, the fair value of the grants, or $790,340, was recorded to expense on the effective date of the grant. The fair value of the grants was determined by the market price of our company’s common stock on the effective date of the grant. On July 18, 2019, our company’s Board of Directors approved a grant of 14,000 shares of our common stock to our company’s five independent directors. The effective date of the grants was July 18, 2019. The shares granted vest immediately and are unrestricted. However, the Plan includes other restrictions on the sale of shares issued under the Plan. Because the shares vest immediately, the fair value of the grants, or $61,600, was recorded to expense on the effective date of the grant. The fair value of the grants was determined by the market price of our company’s common stock on the effective date of the grant. On February 19, 2020, our Company issued and sold 200,000 shares of 8.0% Series A Cumulative Redeemable Preferred Stock (“Series A Preferred Stock”) at $23.00 per share. Net proceeds from the issuance were $4,103,500, which includes the impact of the underwriter’s discounts, selling commissions and legal, accounting and other professional fees. Our company created an escrow for $371,111 for the first year of dividends, which will be reported as restricted cash on our Company’s consolidated balance sheet. Our company also incurred $212,896 in other offering costs, including legal, accounting and other fees associated with this offering. As part of this offering, our company granted the underwriters a 45-day option to purchase up to 23,000 additional Series A Preferred Stock at the public offering price, less the underwriting discount and commissions, to cover over-allotments, if any. Acquisition Hanover North Shopping Center On May 8, 2018, we completed our acquisition of an undivided 84 percent tenant-in-common interest in the Hanover Square Property through a wholly owned subsidiary. The contract purchase price for the Hanover Square Property was $12,173,000. We acquired the Hanover Square Property with $3,291,404 in cash, $648,120 in cash from an unaffiliated tenant-in-common noncontrolling owner, and the assumption of a secured loan of approximately $8,527,315 from Langley Federal Credit Union, which amount was increased by an additional $372,685. The Hanover Square Property is located in Mechanicsville, Virginia and consists of approximately 73,440 square feet of improvements located on an 8.766 acre parcel of land and a contiguous, undeveloped parcel of land totaling 0.864 acres. As of December 31, 2019, the Hanover Square Property was 100 percent leased. 2019 Acquisitions The Ashley Plaza Property On August 30, 2019, our company completed its acquisition of the Ashley Plaza Property, a 160,356 square foot retail property located in Goldsboro, North Carolina, through a wholly owned subsidiary. The Ashley Plaza Property, built in 1977 and fully renovated in 2018, was 98 percent leased as of December 31, 2019 and is anchored by Hobby Lobby, Harbor Freight and Ashley Home Store. The purchase price for the Ashley Plaza Property was $15,200,000 paid through a combination of cash provided by our company, the incurrence of new mortgage debt and funds from a line of credit, short term. Our company’s total investment, including acquisition and closing costs, escrows and lease reserves was $15,885,444, including $204,300 of loan issuance costs. Our company paid $357,823 of acquisition and closing costs which were capitalized and added to the tangible assets acquired. The Clemson Best Western Property On September 27, 2019, our company completed its acquisition of the Clemson Best Western Property, a 148 room hotel on 5.92 acres located in Clemson, South Carolina, through a wholly owned subsidiary. The Clemson Best Western Property was built in 1982 and substantially renovated in 2016 and 2017. The purchase price for the Clemson Best Western Property was $9,750,000 paid through a combination of cash provided by our company, the incurrence of new mortgage debt and funds from a line of credit, short term. Our total investment, including acquisition and closing costs, escrows and lease reserves was $10,786,782, including $269,254 of loan issuance costs. Our company paid $578,953 of acquisition and closing costs which were capitalized and added to the tangible assets acquired. The Brookfield Center Property On October 3, 2019, our company completed its acquisition of the Brookfield Center Property, a 64,880 square foot flex-industrial property located in Greenville, South Carolina, through a wholly owned subsidiary. The Brookfield Center Property, built in 2007, was 93.8 percent leased as of December 31, 2019. Major tenants include Gravitopia Trampoline Park and Summit Church. The purchase price for the Brookfield Center Property was $6,700,000 paid through a combination of cash provided by our company, the incurrence of new mortgage debt and funds from related party notes payable, short term. Our company’s total investment, including $113,505 of loan issuance costs, was $7,102,643. Our company paid $207,957 of acquisition and closing costs which were capitalized and added to the tangible assets acquired. Financing Activities Our company financed its acquisitions of its investment properties through mortgages, as follows: (a) The mortgage loan for the Hampton Inn Property bears interest at a variable rate based on LIBOR with a minimum rate of 6.1 percent. The interest rate payable is the USD LIBOR one-month rate plus 5 percent. As of December 31, 2019 and 2018, respectively, the rates in effect for the Hampton Inn Property mortgage loan were 6.75 percent and 7.50 percent. The mortgage loan for the Hampton Inn property matures on November 9, 2020. However, our company has options to extend the term of the mortgage loan for two successive 12 month terms. (b) As part of its acquisition of the Hanover Square Property, our company assumed a secured loan of $8,527,315 and incurred additional mortgage debt from the same lender of $372,685. The mortgage loan for the Hanover Square Property matures on December 1, 2027 and requires monthly payments of principal, on a 25-year amortization schedule, and interest during the term. The mortgage loan for the Hanover Square Property will bear interest at 4.90 percent through January 1, 2023, at which time the interest rate will be adjusted to the daily average yield on US Treasury securities adjusted to a constant maturity of five years, plus 3.10 percent with an interest rate floor of 4.90 percent. The fixed monthly payment includes principal and interest. (c) The mortgage loan for the Ashley Plaza Property bears interest at a fixed rate of 3.75 percent and is interest only for the first twelve months. Beginning on October 1, 2020, the monthly payment will be $52,795 for the remaining term of the loan, which will include interest at the fixed rate, and principal, based on a thirty year amortization schedule. (d) The mortgage loan for the Clemson Best Western Property bears interest at a variable rate based on LIBOR with a minimum rate of 7.15 percent. The interest rate payable is the USD LIBOR one-month rate plus 4.9 percent. As of December 31, 2019, the rate in effect for the Clemson Best Western Property mortgage was 7.15 percent. (e) The mortgage loan for the Brookfield Property bears interest at a fixed rate of 3.90 percent and is interest only for the first twelve months. Beginning on November 1, 2020, the monthly payment will be $22,876 for the remaining term of the loan, which will include interest at the fixed rate, and principal, based on a thirty year amortization schedule. As of December 31, 2019, our company had a line of credit, short term outstanding in the principal amount of $2,000,000. The line of credit, short term was established on August 21, 2019 to provide short term funding for our company’s acquisition of the Ashley Plaza Property and the Clemson Best Western Property. On August 29, 2019, our company received $1,000,000 in funding from the line of credit, short term, to fund a portion of its acquisition of the Ashley Plaza Property. On September 26, 2019, our company received an additional $1,000,000 to fund a portion of its acquisition of the Clemson Best Western Property. Our company paid $30,000 of loan fees, which were recorded as capitalized issuance costs and are presented as a direct reduction of the associated debt. The line of credit, short term, bears interest at a variable rate calculated at 250 basis points over USD 1-Month LIBOR as published in the Wall Street Journal. The rate adjusts on the first day of each month during which the loan is outstanding. As of December 31, 2019, the rate in effect for the line of credit, short term, was 4.285 percent. Interest expense includes amortization of the capitalized issuance costs using the straight-line method, which approximates to the effective interest method, over the six-month term of the loan. As of December 31, 2019 and 2018, our company had related party notes payable, short term, outstanding in the principal amount of $852,000 and $0, respectively. These notes were issued on September 30, 2019 in the principal amount of $183,000 and on October 2, 2019 in the principal amount of $80,000, both to fund a portion of our company’s acquisition of the Brookfield Center Property, which closed on October 3, 2019. In addition, our company issued a related party note payable in the principal amount of $589,000 on November 29, 2019 to pay dividends and fund working capital requirements. The related party notes payable are due on demand and bear interest at a rate of 5 percent annually. On February 20, 2020, the Company repaid the related party notes payable, short term, in the principal amount of $852,000 plus accrued interest of $11,710. In addition, during the year ended December 31, 2019 and 2018, our company repaid related party notes payable, short term, totaling $0 and $677,538 respectively. These short term notes to five related parties were issued on November 3, 2017 to fund a portion of the purchase price of the Hampton Inn Property. On February 20, 2020, our company repaid the line of credit, short term in the amount of $2,000,000 plus accrued interest of $21,437. Effective on February 21, 2020, the maturity date of the line of credit, short term, our company extended the line of credit, short term for 60 days. On March 3, 2020, our company received $550,000 in funding from the line of credit, short term to fund working capital and dividend payments. In addition, on February 20, 2020, our company repaid the related party notes payable, short term, in the principal amount of $852,000 plus accrued interest of $11,710. COVID-19 Impact The negative impact on room demand for our hotel properties and consumer demand for the goods and services of our retail tenants within our portfolio stemming from the novel coronavirus (COVID-19) may be significant. We have experienced declines in hotel revenue that began in March and expect this to continue as the novel coronavirus (COVID-19) continues to spread across the country. While intense efforts to reduce operating costs are underway, we cannot be certain as to what level of savings can be achieved overall to mitigate the material decline in hotel revenues we may experience. The impact on revenue from our retail properties and tenants remains uncertain, but we anticipate that revenue may be decreased until consumer demand for the goods and services of our retail tenants returns to levels prior to the virus outbreak. The federal government has announced its intention to provide various forms of aid to the industries negatively affected by the virus, including the hospitality industry, but we cannot be certain that such aid will be rendered or that any amount will help mitigate the material reduction in revenue we may experience. Until such time as the virus is contained or eradicated and room demand for our hotel properties and consumer demand for the goods and services of our retail tenants returns to more customary levels, we may experience material reductions in our operating revenue. Off-Balance Sheet Arrangements As of December 31, 2019 and 2018, we have no off-balance sheet arrangements. Summary of Critical Accounting Policies The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to use judgment in the application of accounting policies, including making estimates and assumptions. If our judgment or interpretation of the facts and circumstances relating to various transactions had been different, or different assumptions were made, it is possible that different accounting policies would have been applied, resulting in different financial results or a different presentation of our financial statements. Below is a discussion of the accounting policies that we consider critical to an understanding of our financial condition and operating results that may require complex or significant judgment in their application or require estimates about matters which are inherently uncertain. A discussion of our significant accounting policies, including further discussion of the accounting policies described below, can be found in Note 2, “Summary of Significant Accounting Policies,” of our Consolidated Financial Statements. We believe that the application of these policies on a consistent basis enables us to provide useful and reliable financial information about our operating results and financial condition. Revenue Recognition Principal components of our total revenues for our retail center properties and flex center properties include base rents and tenant reimbursements. We accrue minimum (base) rent on a straight-line basis over the terms of the respective leases which results in an unbilled rent asset or deferred rent liability being recorded on the balance sheet. Certain lease agreements contain provisions that grant additional rents based on tenants’ sales volumes (contingent or percentage rent) which we recognize when the tenants achieve the specified targets as defined in their lease agreements. We periodically review the valuation of the asset/liability resulting from the straight-line accounting treatment of our leases in light of any changes in lease terms, financial condition or other factors concerning our tenants. For our hotel property, revenues are recognized as earned, which is generally defined as the date upon which a guest occupies a room or utilizes the hotel’s services. Our company adopted Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers (Topic 606) effective on January 1, 2019 (see Recent Accounting Pronouncements in Note 2, “Summary of Significant Accounting Polices,” of our Consolidated Financial Statements). This adoption did not have a material impact on our company’s recognition of revenues from either its retail center properties, flex center property or hotel properties. Rents and Other Tenant Receivables For our retail center and flex center properties, we record a tenant receivable for amounts due from tenants such as base rents, tenant reimbursements and other charges allowed under the lease terms. We periodically review tenant receivables for collectability and determine the need for an allowance for the uncollectible portion of accrued rents and other accounts receivable based upon customer creditworthiness (including expected recovery of a claim with respect to any tenants in bankruptcy), historical bad debt levels and current economic trends. We consider a receivable past due once it becomes delinquent per the terms of the lease. A past due receivable triggers certain events such as notices, fees and other actions per the lease. Acquisition of Investments in Real Estate The adoption of ASU 2017-01, as discussed in Note 2, “Summary of Significant Accounting Policies” of the Consolidated Financial Statements included in this report, has impacted our accounting framework for the acquisition of investment properties. Upon acquisition of investment properties, our company estimates the fair value of acquired tangible assets (consisting of land, buildings and improvements, and furniture, fixtures and equipment) and identified intangible assets and liabilities, including in-place leases, above- and below-market leases, tenant relationships and assumed debt based on evaluation of information and estimates available at that date. Fair values for these assets are not directly observable and estimates are based on comparable market data and other information which is subjective in nature, including estimated cash flow projections that utilize appropriate discount and capitalization rates and available market information. Impairment of Long-Lived Assets We periodically review investment properties for impairment on a property-by-property basis to identify any events or changes in circumstances that indicate that the carrying value of investment properties may not be recoverable. These circumstances include, but are not limited to, declines in the property’s cash flows, occupancy and fair market value. If any such events or changes in circumstances are identified, we perform a formal impairment analysis. We measure any impairment of investment property when the estimated undiscounted operating income before depreciation and amortization, is less than the carrying value of the property. To the extent impairment has occurred, we charge to income the excess of carrying value of the property over its estimated fair value. We estimate fair value using data such as operating income, estimated capitalization rates or multiples, leasing prospects and local market information. Our company also reviews its intangible assets for impairment whenever events or changes in circumstances indicate that the carrying value of its intangible assets may not be recoverable, but at least annually. REIT Status We are a Maryland corporation that has elected to be treated, for U.S. federal income tax purposes, as a REIT. We elected to be taxed as a REIT under the Code for the year ended December 31, 2017 and have not revoked such election. A REIT is a corporate entity which holds real estate interests and must meet a number of organizational and operational requirements, including a requirement that it currently distribute at least 90 percent of its adjusted taxable income to stockholders. As a REIT, we generally will not be subject to corporate level federal income tax on our taxable income if we annually distribute 100 percent of our taxable income to our stockholders. If we fail to qualify as a REIT in any taxable year, we will be subject to regular federal and state corporate income taxes and may not be able to elect to qualify as a REIT for four subsequent taxable years. Our qualification as a REIT requires management to exercise significant judgment and consideration with respect to operational matters and accounting treatment. Therefore, we believe our REIT status is a critical accounting estimate. Liquidity and Capital Resources Our business model is intended to drive growth through acquisitions. Access to the capital markets is an important factor for our continued success. We expect to continue to issue equity in our company, with proceeds being used to acquire additional investment properties. Our liquidity needs are primarily to fund (i) operating expenses and cash dividends; (ii) property acquisitions; (iii) deposits and fees associated with long-term debt financing for our properties; (iv) recurring capital expenditures; (v) debt repayments; (vi) payment of principal of, and interest on, outstanding indebtedness; and (vii) corporate and administrative costs. Internal liquidity will be provided solely by the rental receipts from our real properties. The only external liquidity source we have currently identified is our ongoing efforts to raise capital by the issuance of shares of common or preferred stock. Our cash flow and liquidity may be materially adversely impacted by the novel coronavirus (COVID-19) pandemic. We have implemented a number of cost-cutting measures to reduce the impact of the reduction in revenue we may experience. We may have to take additional measures to fund continuing operations. Cash Flows At December 31, 2019, our consolidated cash and restricted cash on hand totaled $2,072,190 compared to consolidated cash on hand of $4,120,796 at December 31, 2018. Cash from operating activities, investing activities and financing activities for the year ended December 31, 2019 and 2018 are as follows: Operating Activities During the year ended December 31, 2019, our financial results include the impact of owning the Franklin Square Property, the Hampton Inn Property and the Hanover Square Property for the full year, Ashley Plaza for approximately four months, the Clemson Best Western Property for approximately three months and the Brookfield Center Property for approximately three months. During the year ended December 31, 2018, our company owned and operated the Franklin Square Property and the Hampton Inn Property for the full year and the Hanover Square Property for eight months. During the year ended December 31, 2019 our cash provided by operating activities was $805,689 compared to cash used in operating activities of $420,676 for the year ended December 31, 2018, an increase of cash provided by operating activities of $1,226,365. For the year ended December 31, 2019, this increase in cash provided by operating activities was largely driven by changes in working capital accounts, most significantly by a $1,162,764 increase to the change in accounts payable and accrued liabilities. Investing Activities During the year ended December 31, 2019, our cash used in investing activities was $34,930,405 compared to cash used in investing activities of $5,422,426 during the year ended December 31, 2018, an increase in cash used in investing activities of $29,507,979. During the year ended December 31, 2019, cash used in investing activities included $32,794,733 used for investment property acquisitions (the Ashley Plaza Property, the Clemson Best Western Property and the Brookfield Center Property, including tangible and intangible assets recorded as part of the Ashley Plaza Property and Brookfield Center Property acquisitions) and $2,135,672 in capital expenditures, consisting of $1,995,892 in interior and exterior construction costs and furniture, fixtures and equipment for the Property Improvement Plan for the Hampton Inn Property, $83,520 in tenant improvements, leasing commissions and building improvements for the Franklin Square Property, $2,598 in leasing commissions for the Hanover Square Property, $18,736 in leasing commissions for the Ashley Plaza Property, $30,066 in leasing commissions for the Brookfield Center property and $4,860 in equipment for the Clemson Best Western Property. During the year ended December 31, 2018, cash used in investing activities included $4,012,209 for the acquisition of the Hanover Square Property, $986,470 in capital expenditures, which included payment of leasing commissions for the Franklin Square Property and initial expenditures for the Hampton Inn Property’s Property Improvement Plan and $423,747 in advance deposits for the Hampton Inn Property’s Property Improvement Plan. Non-cash investing activities for the year ended December 31, 2019 that did not affect our cash used in investing activities were $423,747, representing advance deposits made for Hanover Square Property furniture, fixtures and equipment that was expended during the year ended December 31, 2018 and transferred to investment properties during the year ended December 31, 2019. Non-cash investing activities for the year ended December 31, 2018 that did not affect our cash used in investing activities were $137,714 in capital expenditures that were recorded but not yet paid as of December 31, 2018. Financing Activities During the year ended December 31, 2019, our cash provided by financing activities was $32,076,110 compared to cash provided by financing activities of $6,669,051 during the year ended December 31, 2018, an increase in cash provided by financing activities of $25,407,059. During the year ended December 31, 2019, we generated net proceeds, after offering costs, from our stock issuances of $8,427,639. Additionally, we incurred new mortgage debt (in connection with our acquisition of the Ashley Plaza Property, Clemson Best Western Property and the Brookfield Center Property) of $23,442,941 (net of capitalized loan issuance costs), we generated funds from a line of credit, short term, net, in the amount of $1,970,000 (net of capitalized loan issuance costs) and we issued related party notes payable, short term in the total amount of $852,000. We also paid dividends and distributions of $2,436,103 and repaid mortgage debt principal associated with the Hanover Square Property of $180,367. During the year ended December 31, 2018, our company generated net proceeds, after offering costs, from its common stock issuances, of $9,289,095. Additionally, we repaid short term notes payable of $2,177,538, paid dividends of $1,213,840, incurred new mortgage debt associated with the Hanover Square Property of $250,652 (net of capitalized loan issuance costs), in addition to the assumed mortgage debt of $8,527,315 (non-cash transaction), and repaid mortgage debt principal associated with the Hanover Square Property of $127,438. We also generated $648,120 from the investment of noncontrolling interests associated with the acquisition of the Hanover Square Property. Non-cash financing activities that did not affect our cash provided by financing activities were $0 for the year ended December 31, 2019. For the year ended December 31, 2018, non-cash financing activities were $8,527,315, representing a mortgage payable assumed for the acquisition of the Hanover Square Property and $49,890 for warrants issued. Future Liquidity Needs Liquidity for general operating needs and our company’s investment properties is provided solely by the rental receipts from those properties. Liquidity for growth (acquisition of new investment properties) will be provided by additional equity issuances, net of issuance costs. Results of Operations Revenues Total revenue was $8,268,768 for the year ended December 31, 2019, consisting of $4,186,745 in revenues from retail center properties, $3,898,254 from hotel properties and $183,769 from the flex center property. Total revenues for the year ended December 31, 2019 increased by $1,678,817 over the year ended December 31, 2018. Revenues from retail center properties were $4,186,745 for the year ended December 31, 2019, an increase of $1,272,963 over retail center property revenues for the year ended December 31, 2018 due to new tenant revenues from the Franklin Square Property, ownership of the Hanover Square Property for the full 12 months ended December 31, 2019, and the acquisition of the Ashley Plaza Property. Revenues from hotel properties were $3,898,254 for the year ended December 31, 2019, an increase of $222,085 over revenues from hotel properties for the year ended December 31, 2018. Revenues of $675,123 from the Clemson Best Western Property, which was acquired on September 27, 2019, offset a decline in revenues from the Hampton Inn Property of $453,038, resulting from increased competition in the market and the impact of construction at the hotel related to the Property Improvement Plan. Revenues from the flex center property were $183,769 for the year ended December 31, 2019 resulting from the acquisition of the Brookfield Center Property on October 3, 2019. Operating Expenses Total operating expenses were $9,517,088 for the year ended December 31, 2019, consisting of $1,134,718 in expenses from retail center properties, $3,156,664 in expenses from hotel properties, $55,266 in expenses from the flex center property, $61,600 in share based compensation expenses, $1,089,246 in legal, accounting and other professional fees, $261,934 in corporate general and administrative expenses, a $983,855 loss on disposition of furniture, fixtures and equipment, and $2,773,805 in depreciation and amortization. Operating expenses for retail center properties were $1,134,718 for the year ended December 31, 2019, an increase of $158,250 over retail center property operating expenses for the year ended December 31, 2018. A decline in operating expenses for the Franklin Square property resulting from reduced legal fees, utility costs and repairs was offset by the impact of increased expenses from owning the Hanover Square Property for the full 12 months of 2019 and the acquisition of the Ashley Plaza Property. Operating expenses for hotel properties were $3,156,664 for the year ended December 31, 2019, an increase of $547,839 over operating expenses from hotel properties for the year ended December 31, 2018. Operating expenses of $561,522 for the Clemson Best Western Property, which was acquired on September 27, 2019, offset a slight decline in operating expenses from the Hampton Inn Property of $13,713. Operating expenses from the flex center property were $55,266 for the year ended December 31, 2019 resulting from the acquisition of the Brookfield Center Property on October 3, 2019. Loss on Disposition of FF&E Our company allocated and recorded a portion of the acquisition cost of the Hampton Inn Property to furniture, fixtures and equipment (“FF&E”), a component of investment properties on the consolidated balance sheet, when it acquired the Hampton Inn Property in November 2017. As part of a property improvement plan for the Hampton Inn Property, we have replaced a significant portion of the FF&E we acquired. During the year ended December 31, 2019, our company recorded a loss on disposition of FF&E of $983,855, which represented the net book value of the assets that were disposed. No such losses were recorded during the year ended December 31, 2018. Operating Loss Operating loss for the year ended December 31, 2019 was $1,248,320, an increase of $183,407 over the operating loss of $1,064,913 for the year ended December 31, 2018. Increased operating income from (i) the retail center properties of $1,114,713 resulting from new tenant revenues at the Franklin Square Property, owning the Hanover Square Property for the full year ended December 31, 2019 and the acquisition of the Ashley Plaza Property, (ii) the flex center property of $128,503 and (iii) the Clemson Best Western Property of $113,751, were offset by (i) decreased operating income of $439,325 from the Hampton Inn Property due to the impact of construction at the hotel from the Property Improvement Plan, (ii) increased depreciation and amortization expense resulting from the 2019 property acquisitions, (iii) the loss on the disposition of furniture, fixtures and equipment, and (iv) increased corporate general and administrative expenses. Interest Expense Interest expense for the year ended December 31, 2019 was as follows: Total interest expense for the year ended December 31, 2019 increased by $555,445 over the year ended December 31, 2018. This increase was a result of owning the Hanover Square Property for the full 12 months of the year ended December 31, 2019, and new interest expense from the Ashley Plaza Property, Clemson Best Western Property and Brookfield Center Property. Net Loss Total net loss was $3,804,494 for the year ended December 31, 2019, before adjustments for net loss attributable to noncontrolling interests. After adjusting for noncontrolling interests, the net loss attributable to our common shareholders was $3,015,718. Total net loss was $2,991,153 for the year ended December 31, 2018, before adjustments for net loss attributable to noncontrolling interests. After adjusting for noncontrolling interests, the net loss attributable to Medalist common shareholders was $2,743,323. Total net loss for the year ended December 31, 2019 increased by $813,341 over the year ended December 31, 2018, before adjustments for net loss attributable to noncontrolling interests. After adjusting for noncontrolling interests, total net loss for the year ended December 31, 2019 increased by $272,395 over the year ended December 31, 2018. The increase in net loss was a result of (i) the loss on disposition of $983,855 recognized during the year ended December 31, 2019, (ii) increased depreciation and amortization of $730,482 for the year ended December 31, 2019 resulting from the acquisition of the Ashley Plaza Property, Clemson Best Western Property and the Brookfield Center Property, and owning the Hanover Square Property for the full year ended December 31, 2019, and (iii) increased interest expense of $555,445 resulting from owning the Hanover Square Property for the full 12 months of the year ended December 31, 2019, and new interest expense from the acquisitions of the Ashley Plaza Property, Clemson Best Western Property and Brookfield Center Property during the year ended December 31, 2019. These increased expenses were offset by decreased share based compensation expenses of $728,740 for the year ended December 31, 2019 and increased revenues of $1,678,817 for the year ended December 31, 2019 resulting from owning the Hanover Square Property for the full year ended December 31, 2019, and new interest expense from the Ashley Plaza Property, Clemson Best Western Property and Brookfield Center Property. Funds from Operations We use Funds from operations (“FFO”), a non-GAAP measure, as an alternative measure of our operating performance, specifically as it relates to results of operations and liquidity. We compute FFO in accordance with standards established by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”) in its March 1995 White Paper (as amended in November 1999, April 2002 and December 2018). As defined by NAREIT, FFO represents net income (computed in accordance with GAAP), excluding gains (or losses) from sales of property, plus real estate related depreciation and amortization (excluding amortization of loan origination costs and above and below market leases) and after adjustments for unconsolidated partnerships and joint ventures. Most industry analysts and equity REITs, including us, consider FFO to be an appropriate supplemental measure of operating performance because, by excluding gains or losses on dispositions and excluding depreciation, FFO is a helpful tool that can assist in the comparison of the operating performance of a company’s real estate between periods, or as compared to different companies. Management uses FFO as a supplemental measure to conduct and evaluate our business because there are certain limitations associated with using GAAP net income alone as the primary measure of our operating performance. Historical cost accounting for real estate assets in accordance with GAAP implicitly assumes that the value of real estate assets diminishes predictably over time, while historically real estate values have risen or fallen with market conditions. Accordingly, we believe FFO provides a valuable alternative measurement tool to GAAP when presenting our operating results. NAREIT’s December 2018 White Paper states, “FFO of a REIT includes the FFO of all consolidated properties, including consolidated, partially owned affiliates”. Additionally, since the adjustments to GAAP net income, such as depreciation and amortization, used in the reconciliation of net income (loss) to determine FFO are not allocated between shareholders and noncontrolling interests (i.e. 100 percent of depreciation and amortization are “added back” without reduction to reflect the noncontrolling owners’ interest in such items), our company believes that the appropriate starting point for the calculation is the net income (loss) before allocation to noncontrolling interests. This allows our company to use FFO as a tool to measure the overall performance of its investment properties, as a whole, not just the portion of the investment properties controlled by Company shareholders. Below is our company’s FFO, which is a non-GAAP measurement, for the year ended December 31, 2019: (1) Depreciation expense for buildings, site improvements and furniture and fixtures. (2) Depreciation of tenant improvements, including those (i) acquired as part of the purchase of the Franklin Square Property and Hanover Square Property and (ii) those constructed by our company subsequent to the acquisition of the properties. (3) Amortization of leasing commissions paid for the Franklin Square Property, Hanover Square Property, Ashley Plaza Property and Brookfield Center Property subsequent to the acquisition of the properties. (4) Amortization of tenant inducements paid for the Franklin Square Property during the year ended December 31, 2019. (5) Amortization of intangible assets acquired as part of the purchase of the Franklin Square Property, the Hanover Square Property, the Ashley Plaza Property and the Brookfield Center Property, including leasing commissions, leases in place and legal and marketing costs during the year ended December 31, 2019. (6) Adjustment to FFO for the non-cash loss recognized as a result of the disposition of FF&E at the Hampton Inn Property during the year ended December 31, 2019. NAREIT’s December 2018 White Paper provides guidance for the treatment of material non-cash revenues and expenses affecting their results, stating “NAREIT encourages those reporting FFO to make supplemental disclosure of all material non-cash revenues and expenses affecting their results for each period.” NAREIT’s December 2018 White Paper encourages companies reporting FFO to “make supplemental disclosure of all material non-cash revenues and expenses affecting their results for each period.” We believe that the computation of FFO in accordance with NAREIT’s definition includes certain items that are not indicative of the results provided by our operating portfolio and affect the comparability of our period-over-period performance. These items include non-cash items such as amortization of loans and above and below market leases, unbilled rent arising from applying straight line rent revenue recognition and share-based compensation expenses. Additionally, the impact of capital expenditures, including tenant improvement and leasing commissions, net of reimbursements of such expenditures by property escrow funds, is included in our calculation of AFFO. Therefore, in addition to FFO, management uses Adjusted FFO (“AFFO”), which we define to exclude such items. Management believes that these adjustments are appropriate in determining AFFO as their exclusion is not indicative of the operating performance of our assets. In addition, we believe that AFFO is a useful supplemental measure for the investing community to use in comparing us to other REITs as many REITs provide some form of adjusted or modified FFO. However, there can be no assurance that AFFO presented by us is comparable to the adjusted or modified FFO of other REITs. Total AFFO for the year ended December 31, 2019 was as follows: (1) Adjustment to FFO resulting from non-cash amortization of intangible assets recorded as part of the purchase of the Franklin Square Property, the Hanover Square Property, the Ashley Plaza Property and the Brookfield Center Property during the year ended December 31, 2019. (2) Adjustment to FFO resulting from non-cash amortization of intangible liabilities recorded as part of the Franklin Square Property, the Hanover Square Property, the Ashley Plaza Property and the Brookfield Center Property during the year ended December 31, 2019. (3) Adjustment to FFO resulting from non-cash revenues recognized as a result of applying straight line revenue recognition for the Franklin Square Property, the Hanover Square Property, the Ashley Plaza Property and the Brookfield Center Property during the year ended December 31, 2019. (4) Adjustment to FFO for capital expenditures, including capitalized leasing commissions, tenant improvements, building and site improvements and purchases of furniture, fixtures and equipment for the Franklin Square Property, the Hanover Square Property, Hampton Inn Property and Brookfield Center Property that will not be reimbursed by property escrow accounts. During the year ended December 31, 2019, our company paid $2,135,672 in costs for leasing commissions, tenant improvements and building improvements at the Franklin Square Property, leasing commissions at the Hanover Square Property, Ashley Plaza Property and Brookfield Center Property, and interior and exterior renovations and advance deposits for furniture and fixtures at the Hampton Inn Property. During the year ended December 31, 2019, our company received $1,706,885 in funds from property capital reserves held by the Hampton Inn Property and Franklin Square Property mortgage holders. (5) Adjustment to FFO resulting from non-cash expenses recognized as a result of decreases in the fair value of the interest rate caps for the Hampton Inn Property and the Clemson Best Western Property during the year ended December 31, 2019. (6) Adjustment to FFO for amortization of non-cash expenses recognized as a result of amortizing loan issuance costs over the terms of the respective mortgages during the year ended December 31, 2019. (7) Adjustment to FFO resulting from non-cash expenses recorded for share based compensation.
-0.004042
-0.003832
0
<s>[INST] This management’s discussion and analysis of financial condition and results of operations contains forwardlooking statements that involve risks, uncertainties and assumptions. See “Cautionary Statement Regarding ForwardLooking Statements” for a discussion of the risks, uncertainties and assumptions associated with those statements. Our actual results may differ materially from those expressed or implied in the forwardlooking statements as a result of various factors. Company Overview Medalist Diversified REIT Inc. is a Maryland corporation formed on September 28, 2015. Beginning with our taxable year ended December 31, 2017, we believe that we have operated in a manner qualifying us as a real estate investment trust (“REIT”), and we have elected to be taxed as a REIT for federal income tax purposes. Our company serves as the general partner of Medalist Diversified Holdings, LP which was formed as a Delaware limited partnership on September 29, 2015. Our company was formed to acquire, reposition, renovate, lease and manage incomeproducing properties, with a primary focus on (i) commercial properties, including flexindustrial, limited service hotels, and retail properties, (ii) multifamily residential properties and (iii) hotel properties in secondary and tertiary markets in the southeastern part of the United States, with an expected concentration in Virginia, North Carolina, South Carolina, Georgia, Florida and Alabama. We may also pursue, in an opportunistic manner, other real estaterelated investments, including, among other things, equity or other ownership interests in entities that are the direct or indirect owners of real property, indirect investments in real property, such as those that may be obtained in a joint venture. While these types of investments are not intended to be a primary focus, we may make such investments in our Manager’s discretion. Our company is externally managed by Medalist Fund Manager, Inc. (the “Manager”). The Manager makes all investment decisions for our company. The Manager and its affiliated companies specialize in acquiring, developing, owning and managing valueadded commercial real estate in the MidAtlantic and Southeast regions. The Manager oversees our company’s overall business and affairs and has broad discretion to make operating decisions on behalf of our company and to make investment decisions. Our company’s stockholders are not involved in its daytoday affairs. As of December 31, 2019, our company owned and operated six investment properties, the Shops at Franklin Square (the “Franklin Square Property”), a 134,239 square foot retail property located in Gastonia, North Carolina, the Greensboro Hampton Inn (the “Hampton Inn Property”) a hotel with 125 rooms on 2.162 acres in Greensboro, North Carolina, the Hanover North Shopping Center (the “Hanover Square Property”), a 73,440 square foot retail property located in Mechanicsville, Virginia, the Ashley Plaza Shopping Center (the “Ashley Plaza Property”), a 160,356 square foot retail property located in Goldsboro, North Carolina, the Clemson Best Western University Inn (the “Clemson Best Western Property”), a hotel with 148 rooms on 5.92 acres in Clemson, South Carolina and Brookfield Center (the “Brookfield Center Property”), a 64,880 square foot mixeduse industrial/office property located in Greenville, South Carolina. As of December 31, 2019, we owned 64 percent of the Hampton Inn Property as a tenant in common with a noncontrolling owner which owned the remaining 36 percent interest. The tenants in common lease the Hampton Inn Property to a taxable REIT subsidiary that is also owned 64 percent by us and 36 percent by the noncontrolling owner. As of December 31, 2019, we owned 84 percent of the Hanover Square Property as a tenant in common with a noncontrolling owner which owned the remaining 16 percent interest. Reporting Segments We establish operating segments at the property level and aggregate individual properties into reportable segments based on product types in which we have Investments. As of December 31, 2019, we had the following reportable segments: ret [/INST] Negative. </s>
2,020
7,643
1,731,289
VectoIQ Acquisition Corp.
2019-03-20
2018-12-31
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The statements in the discussion and analysis regarding industry outlook, our expectations regarding the performance of our business and the forward-looking statements are subject to numerous risks and uncertainties, including, but not limited to, the risks and uncertainties described in “Risk Factors” and “Cautionary Note Regarding Forward-Looking Statements.” Our actual results may differ materially from those contained in or implied by any forward-looking statements. You should read the following discussion together with the sections entitled “Risk Factors”,” “Business” and the audited consolidated financial statements, including the related notes, appearing elsewhere in this Form 10-K. All references to years, unless otherwise noted, refer to our fiscal years, which end on December 31. As used in this Form 10-K, unless the context suggests otherwise, “we,” “us,” “our,” “the Company” or “VectoIQ” refer to VectoIQ Acquisition Corp. Overview We are a newly organized company incorporated as a Delaware corporation on January 23, 2018 and formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, recapitalization reorganization or similar business combination with one or more businesses (the “Initial Business Combination”). We intend to effectuate our Initial Business Combination using cash from the proceeds of our initial public offering (the “Public Offering”) and the sale of private placement units that occurred simultaneously with the consummation of the Public Offering. The issuance of additional shares of our stock in a business combination: · may significantly dilute the equity interest of investors in the Public Offering; · 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 common stock and/or warrants. As indicated in the accompanying financial statements, at December 31, 2018, we had $1,168,600 in cash, $47,979 of cash held in Trust account, and investments held in Trust account of $235,243,004. 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 Initial Business Combination will be successful. Results of Operations For the period from January 23, 2018 (inception) to December 31, 2018, we had net income of $1,913,035. Our entire activity from January 23, 2018 (inception) through May 18, 2018, consisted of formation and preparation for the initial public offering, and as such, we had no operations and no significant operating expenses. Subsequent to the closing of the initial public offering on inception, our other income consists of interest and dividend income earned on the investments in our trust account and our operating costs include costs associated with obtaining directors and officers insurance and other general and administrative costs. Liquidity and Capital Resources In May 2018, we consummated the Public Offering, in which we sold 23,000,000 Units (including 3,000,000 Units subject to the exercise of the underwriters’ over-allotment option) at a price of $10.00 per Unit generating gross proceeds of $230,000,000 before underwriting discounts and expenses. The Sponsor, Cowen Investments, LLC and certain funds and accounts managed by subsidiaries of BlackRock, Inc. (collectively, the “Anchor Investor”) purchased an aggregate of 890,000 units at a price of $10.00 per unit in a private placement that occurred simultaneously with the initial public offering and the exercise of the over-allotment option. In connection with the initial public offering, we incurred transaction costs of $5,244,622, consisting of $4,600,000 of underwriting fees and $644,622 of other initial public offering costs. Prior to the Public Offering, our only sources of liquidity were an initial purchase of shares of our common stock for $25,000 and two related party loans from our Sponsor and Cowen Investments, LLC totaling $120,000 to cover expenses related to the Public Offering. These loans were repaid with the proceeds from the Public Offering. Prior to the completion of our Initial Business Combination, we will have available to us the approximately $1,168,600 of proceeds held outside the trust account. We will use these funds 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 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 $10.00 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 expect that we have sufficient resources to fund our operations for the 24 months following the closing of the Public Offering. 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 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, which may include a specified future issuance. 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 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. 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 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. We have entered into an Administrative Support Agreement with our Sponsor, pursuant to which the Company is billed a total of $10,000 per month for office space and general administrative services. Upon completion of the Initial Business Combination or the Company’s liquidation, the Company will cease incurring these monthly fees. As of December 31, 2018, the Company accrued $75,000 for office space and general administrative services. Controls and Procedures We are not currently required to maintain an effective system of internal controls as defined by Section 404 of the Sarbanes-Oxley Act. We will be required to comply with the internal control requirements of the Sarbanes-Oxley Act for the fiscal year ending December 31, 2019. We have not completed an assessment of internal controls. We expect to assess the internal controls of our target business or businesses prior to the completion of our initial business combination and, if necessary, to implement and test additional controls as we may determine are necessary in order to state that we maintain an effective system of internal controls. A target business may not be in compliance with the provisions of the Sarbanes-Oxley Act regarding the adequacy of internal controls. Many small and mid-sized target businesses we may consider for our initial business combination may have internal controls that need improvement in areas such as: · staffing for financial, accounting and external reporting areas, including segregation of duties; · reconciliation of accounts; · proper recording of expenses and liabilities in the period to which they relate; · evidence of internal review and approval of accounting transactions; · documentation of processes, assumptions and conclusions underlying significant estimates; and · documentation of accounting policies and procedures. Because it will take time, management involvement and perhaps outside resources to determine what internal control improvements are necessary for us to meet regulatory requirements and market expectations for our operation of a target business, we may incur significant expense in meeting our public reporting responsibilities, particularly in the areas of designing, enhancing, or remediating internal and disclosure controls. Doing so effectively also may take longer than we expect, thus increasing our exposure to financial fraud or erroneous financing reporting. Related Party Transactions In February 2018, our founders purchased an aggregate of 5,750,000 founder shares for an aggregate purchase price of $25,000, or approximately $0.004 per share. In March 2018, our sponsor transferred 15,000 founder shares to each of our initial director nominees. In May 2018, Cowen Investments forfeited 287,500 founder shares. Additionally, in May 2018, our sponsor purchased 254,829 founder shares for an aggregate purchase price of $1,108, or approximately $0.004 per share, and our anchor investor purchased 32,671 founder shares for an aggregate purchase price of $142, or approximately $0.004 per share. The number of founder shares issued was determined based on the expectation that such founder shares would represent 20% of the outstanding shares upon completion of the initial public offering (excluding the private shares). Prior to the initial investment of $25,000 by our founders, the Company had no assets, tangible or intangible. The purchase price of the founder shares was determined by dividing the amount of cash contributed to the company by the number of founder shares issued. If we increase or decrease the size of the offering pursuant to Rule 462(b) under the Securities Act, we will effect a stock dividend or share contribution back to capital or other appropriate mechanism, as applicable, immediately prior to the consummation of the offering in such amount as to maintain the representation by the founder shares of 20% of our issued and outstanding shares of common stock (excluding the private shares) upon the consummation of the initial public offering. Up to 750,000 founder shares will be subject to forfeiture, depending on the extent to which the underwriter’s over-allotment option is exercised. We are obligated, commencing on the date of the initial public offering, to pay our sponsor a monthly fee of an aggregate of $10,000 for office space and general and administrative services. Additionally, we have issued two promissory notes, one to our sponsor and a second to Cowen Investments, both dated as of March 1, 2018. Each of the individual notes is in the aggregate principal amount of $100,000. The notes both contain a drawdown feature such that at any time prior to the consummation of the initial public offering we may draw up to an aggregate of $100,000 on each of the notes for general working capital expenses. These loans are non-interest bearing and were repaid with the proceeds from the initial public offering. Our sponsor, officers and directors, or any of their respective affiliates, will be reimbursed for any out-of-pocket expenses incurred in connection with activities on our behalf such as identifying potential target businesses and performing due diligence on suitable business combinations. Our audit committee will review on a quarterly basis all payments that were made to our sponsor, officers, directors or our 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. We do not believe we will need to raise additional funds following the initial public offering in order to meet the expenditures required for operating our business. However, in order to finance transaction costs in connection with an intended initial business combination, our founders, 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. Up to $1,500,000 of such loans may be convertible into additional units of the post-business combination entity at a price of $10.00 per unit at the option of the lender. The units would be identical to the private units. 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. Our founders and anchor investor purchased an aggregate of 890,000 private units (including 90,000 private units in connection with the exercise of the over-allotment option), at $10.00 per unit in a private placement. Among the private units, 525,909 units were purchased by our Sponsor and/or its designees, 67,424 units were purchased by our anchor investor and/or its designees, and 296,667 units were purchased by Cowen Investments and/or its designees. All of the proceeds we received from the purchase of the private placement units were placed in the trust account. The forward purchase investor has entered into a contingent forward purchase agreement with us as described below. Pursuant to the contingent forward purchase agreement, we may elect (subject to the forward purchase investor’s right to be excused from any specific business combination as described below) to have the forward purchase investor purchase up to 2,500,000 shares of our common stock, plus one of our redeemable warrants for each forward purchase share, at a price of $10.00 per forward purchase share, for total gross proceeds of up to $25,000,000. While we may elect to have the forward purchase investor purchase no securities under the contingent forward purchase agreement, if we request that the forward purchase investor purchase securities and the forward purchase investor defaults on such purchase or the forward purchase investor exercises its right of refusal as described herein, the forward purchase investor will forfeit up to all of its ownership interest in our sponsor related to founder shares, and our sponsor will have the right to redeem the forward purchase investor’s remaining ownership interest in our sponsor at the original purchase price. Any funds from the sale of the forward purchase securities may be used as part of the consideration to the sellers in the initial business combination, for expenses in connection with the initial business combination or for the combined company’s working capital needs. This commitment is independent of the percentage of stockholders electing to redeem their public shares and could provide us with a minimum funding level for the initial business combination. Our anchor investor has expressed to us an interest to purchase $25 million of public units in the initial public offering and we have agreed to direct the underwriters to sell to our anchor investor such number of public units. Further, the anchor investor has agreed with us that, if it does not own the number of public shares equal to 2,500,000 public shares (which amount will be reduced on a pro rata basis if less than 20,000,000 units are sold in the initial public offering), at the time of any stockholder vote with respect to an initial business combination or the business day immediately prior to the consummation of our initial business combination, it will forfeit all or a portion of the 468,277 founder shares it purchased prior to the initial public offering on a pro rata basis. In such a case, our sponsor (or its designee), will have the right (but not the obligation) to repurchase all or a portion of the private placement units held by our anchor investor at their original purchase price. There can be no assurance that the anchor investor will acquire any public units in the initial public offering or what amount of equity the anchor investor will retain, if any, upon the consummation of our initial business combination. In the event that such anchor investor purchases such units (either in the initial public offering or after) and votes them in favor of our initial business combination, it is possible that no votes from other public stockholders would be required to approve our initial business combination, depending on the number of shares that are present at the meeting to approve such transaction. As a result of the founder shares and private placement units that our anchor investor may hold, it may have different interests with respect to a vote on an initial business combination than other public stockholders. Pursuant to a registration rights agreement entered into on May 15, 2018, the Founders, anchor investor, and the Company’s executive officers, directors and director nominees and their permitted transferees will be entitled to demand that the Company register for resale the Founder Shares, the Private Placement Units and underlying securities and any securities issued upon conversion of Working Capital Loans. The holders of these securities will be entitled to make up to three demands, excluding short form demands, that the Company register such securities. In addition, the holders will have certain “piggy-back” registration rights with respect to registration statements filed subsequent to the Company’s consummation of the initial Business Combination. The Company will bear the expenses incurred in connection with the filing of any such registration statements. Notwithstanding the foregoing, Cowen Investments may not exercise its demand and “piggyback” registration rights after five and seven years, respectively, after the effective date of the initial public offering and may not exercise its demand rights on more than one occasion. Please see “Certain Relationships and Related Party Transactions” for additional information. Critical Accounting Policies and Significant Judgments and Estimates This discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with generally accepted accounting principles in the U.S. (“GAAP”). The preparation of these financial statements requires us 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 the reported amounts of revenues and expenses during the reported period. In accordance with GAAP, we base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. Emerging Growth Company Section 102(b)(1) of the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”) exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that an emerging growth company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such an election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period, which means that when a standard is issued or revised, and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statement with another public company that is neither an emerging growth company nor an emerging growth company that has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used. Income Taxes We follow the asset and liability method of accounting for income taxes under FASB ASC 740, “Income Taxes.” Deferred tax assets and liabilities are recognized for the estimated 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. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that included the enactment date. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized. FASB ASC 740 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more likely than not to be sustained upon examination by taxing authorities. There were no unrecognized tax benefits as of December 31, 2018. We recognize accrued interest and penalties related to unrecognized tax benefits as income tax expense. No amounts were accrued for the payment of interest and penalties for the period from January 23, 2018 (inception) to December 31, 2018. We are currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position. We are subject to income tax examinations by major taxing authorities since inception. We may be subject to potential examination by federal, state and city taxing authorities in the areas of income taxes. These potential examinations may include questioning the timing and amount of deductions, the nexus of income among various tax jurisdictions and compliance with federal, state and city tax laws. Our management does not expect that the total amount of unrecognized tax benefits will materially change over the next twelve months. Recent Accounting Pronouncements Our management does not believe that there are any recently issued, but not yet effective, accounting pronouncements, if currently adopted, would have a material effect on our financial statements.
-0.007132
-0.006932
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<s>[INST] Overview We are a newly organized company incorporated as a Delaware corporation on January 23, 2018 and formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, recapitalization reorganization or similar business combination with one or more businesses (the “Initial Business Combination”). We intend to effectuate our Initial Business Combination using cash from the proceeds of our initial public offering (the “Public Offering”) and the sale of private placement units that occurred simultaneously with the consummation of the Public Offering. The issuance of additional shares of our stock in a business combination: · may significantly dilute the equity interest of investors in the Public Offering; · 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 common stock and/or warrants. As indicated in the accompanying financial statements, at December 31, 2018, we had $1,168,600 in cash, $47,979 of cash held in Trust account, and investments held in Trust account of $235,243,004. 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 Initial Business Combination will be successful. Results of Operations For the period from January 23, 2018 (inception) to December 31, 2018, we had net income of $1,913,035. Our entire activity from January 23, 2018 (inception) through May 18, 2018, consisted of formation and preparation for the initial public offering, and as such, we had no operations and no significant operating expenses. Subsequent to the closing of the initial public offering on inception, our other income consists of interest and dividend income earned on the investments in our trust account and our operating costs include costs associated with obtaining directors and officers insurance and other general and administrative costs. Liquidity and Capital Resources In May 2018, we consummated the Public Offering, in which we sold 23,000,000 Units (including 3,000,000 Units subject to the exercise of the underwriters’ overallotment option) at a price of $10.00 per Unit generating gross proceeds of $230,000,000 before underwriting discounts and expenses. The Sponsor, Cowen Investments, LLC and certain funds and accounts managed by subsidiaries of BlackRock, Inc. (collectively, the “Anchor Investor”) purchased an aggregate of 890,000 units at a price of $10.00 per unit in a private placement that occurred simultaneously with the initial public offering and the exercise of the overallotment option. In connection with the initial public offering, we incurred transaction costs of $5,244,622, consisting of $4,600,000 of underwriting fees and $644,622 of other initial public offering costs. Prior to the Public Offering, our only sources of liquidity were an initial purchase of shares of our common stock for $25,000 and two related party loans from our Sponsor and Cowen Investments, LLC totaling $120,000 to cover expenses related to the Public Offering. These loans were repaid with the proceeds from the Public Offering. Prior to the completion of our Initial Business Combination, we will have available to us the approximately $1,168,600 of proceeds held outside the trust account. We will use these funds to identify and evaluate target businesses, perform business due [/INST] Negative. </s>
2,019
3,949
1,731,289
VectoIQ Acquisition Corp.
2020-03-06
2019-12-31
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The statements in the discussion and analysis regarding industry outlook, our expectations regarding the performance of our business and the forward-looking statements are subject to numerous risks and uncertainties, including, but not limited to, the risks and uncertainties described in “Risk Factors” and “Cautionary Note Regarding Forward-Looking Statements.” Our actual results may differ materially from those contained in or implied by any forward-looking statements. You should read the following discussion together with the sections entitled “Risk Factors”," "Business" and the audited consolidated financial statements, including the related notes, appearing elsewhere in this Form 10-K. All references to years, unless otherwise noted, refer to our fiscal years, which end on December 31. As used in this Form 10-K, unless the context suggests otherwise, “we,” “us,” “our,” “the Company” or “VectoIQ” refer to VectoIQ Acquisition Corp. Overview We are a newly organized company incorporated as a Delaware corporation on January 23, 2018 and formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, recapitalization, reorganization or similar business combination with one or more businesses (the “Initial Business Combination”). We intend to effectuate our Initial Business Combination using cash from the proceeds of our initial public offering (the “Public Offering”) and the sale of private placement units that occurred simultaneously with the consummation of the Public Offering. The issuance of additional shares of our stock in a business combination: · may significantly dilute the equity interest of investors in the Public Offering; · 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 common stock and/or warrants. As indicated in the accompanying financial statements, we had $751,640 and $1,168,600 in cash, $10,316 and $47,979 of cash held in the trust account established for the benefit of the Company’s public stockholders at J.P. Morgan Chase Bank, N.A. (the “Trust Account”), and investments held in the Trust Account of $238,372,960 and $235,243,004 at December 31, 2019 and 2018, respectively. 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 Initial Business Combination will be successful. Proposed Business Combination Business Combination Agreement On March 2, 2020, we entered into the Business Combination Agreement with Merger Sub and Nikola, pursuant to which we will effect the Proposed Transaction. Pursuant to the Business Combination Agreement, at the Closing, Merger Sub will be merged with and into Nikola, with Nikola surviving the Merger as a wholly-owned direct subsidiary of us. Immediately prior to the Effective Time of the Merger), Nikola will cause the shares of Nikola’s preferred stock issued and outstanding immediately prior to the Effective Time to be automatically converted into shares of Nikola common stock, and each converted share of Nikola preferred stock will no longer be outstanding and will cease to exist. At the Effective Time, by virtue of the Merger, all shares of Nikola common stock issued and outstanding immediately prior to the Effective Time will be canceled and converted into the right to receive the number of shares of our common stock equal to the Exchange Ratio of 1.901 set forth in the Business Combination Agreement. Each Nikola stock option that is outstanding immediately prior to the Effective Time, whether vested or unvested, will be converted into an option to purchase a number of shares of our common stock equal to the product (rounded down to the nearest whole number) of (i) the number of shares of Nikola common stock subject to such option immediately prior to the Effective Time and (ii) the Exchange Ratio, at an exercise price per share (rounded up to the nearest whole cent) equal to (A) the exercise price per share of such option immediately prior to the Effective Time divided by (B) the Exchange Ratio. The Closing is subject to certain conditions, including but not limited to the approval of our stockholders and Nikola’s stockholders of the Business Combination Agreement. The Business Combination Agreement may also be terminated by either party under certain circumstances. Nikola has agreed to customary “no shop” obligations subject to a customary “fiduciary out,” and Nikola would be required to pay a termination fee in the amount of $82 million if the Business Combination Agreement is terminated under certain circumstances. The Closing will occur as promptly as practicable, but in no event later than three business days following the satisfaction or waiver of all of the closing conditions contained in the Business Combination Agreement. If, by May 1, 2020, we and Nikola determine that that the Closing is unlikely to be consummated on or before May 18, 2020, then we will take all actions necessary to obtain the approval of our stockholders to extend our deadline to consummate our initial business combination to a date after such date but prior to August 31, 2020 in accordance with our amended and restated certificate of incorporation. Stockholder Support Agreement Also on March 2, 2020, certain stockholders of Nikola holding the votes necessary to approve the Proposed Transaction entered into the Stockholder Support Agreement with us, pursuant to which such stockholders agreed to vote all of their shares of Nikola capital stock in favor of the approval and adoption of the Proposed Transaction. Additionally, such stockholders agreed not to (i) transfer any of their shares of Nikola capital stock (or enter into any arrangement with respect thereto) or (ii) enter into any voting arrangement that is inconsistent with the Stockholder Support Agreement. Registration Rights and Lock-Up Agreement Pursuant to the Business Combination Agreement and as a condition to the Closing, we and the Holders will enter into the Registration Rights and Lock-Up Agreement at the Closing. Pursuant to the terms of the Registration Rights and Lock-Up Agreement, we will be obligated to file a registration statement to register the resale of certain securities of VectoIQ held by the Holders. In addition, pursuant to the terms of the Registration Rights and Lock-Up Agreement and subject to certain requirements and customary conditions, including with regard to the number of demand rights that may be exercised, the Holders may demand at any time or from time to time, that we file a registration statement on Form S-3 (or on Form S-1 if Form S-3 is not available) to register our securities held by such Holders. The Registration Rights and Lock-Up Agreement will also provide the Holders with “piggy-back” registration rights, subject to certain requirements and customary conditions. The Registration Rights and Lock-Up Agreement further provides for the securities of VectoIQ held by the Holders to be locked-up for a period of time following the Closing, as described below, subject to certain exceptions. The securities held by the Original Holders will be locked-up for one year following the Closing, subject to earlier release if (i) the reported 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 the Closing or (ii) if we consummate a liquidation, merger, stock exchange or other similar transaction after the Closing which results in all of our stockholders having the right to exchange their shares of common stock for cash, securities or other property. The securities held by the New Holders, other than certain entities controlled by Trevor Milton, the current Chief Executive Officer of Nikola, will be locked-up for 180 days after the Closing. The securities held by certain entities controlled by Trevor Milton will be locked up for one year following the Closing, except that they would be permitted to sell or otherwise transfer an aggregate of $70.0 million shares of our common stock commencing 180 days after the Closing. Subscription Agreements In connection with the execution of the Business Combination Agreement, effective as of March 2, 2020, we entered into separate Subscription Agreements with the Subscribers, pursuant to which the Subscribers agreed to purchase, and we agreed to sell to the Subscribers, an aggregate of 52,500,000 PIPE Shares, for a purchase price of $10.00 per share and an aggregate purchase price of $525 million, in the PIPE. The closing of the sale of the PIPE Shares pursuant to the Subscription Agreements is contingent upon, among other customary closing conditions, the substantially concurrent consummation of the Proposed Transaction. The purpose of the PIPE is to raise additional capital for use by the combined company following the Closing. Pursuant to the Subscription Agreements, we granted certain registration rights to the Subscribers, including our agreement that, by the Filing Deadline, we will file with the SEC the Resale Registration Statement registering the resale of the PIPE Shares, and will use our commercially reasonable efforts to have the Resale Registration Statement declared effective as soon as practicable after the filing thereof. Under certain circumstances described in the Subscription Agreements, including if the Resale Registration Statement has not been filed with the SEC by the Filing Deadline, additional payments by us may be assessed with respect to the PIPE Shares The additional payments by us would accrue on the applicable registrable securities at a rate of 0.5% of the aggregate purchase price paid for such registrable securities per month, subject to certain terms and limitations (including a cap of 5.0% of the aggregate purchase price). Recent Developments On January 7, 2020, we received a written notice from the Listing Qualifications Department of Nasdaq indicating that we are not in compliance with listing Rule 5620(a), due to our failure to hold an annual meeting of stockholders within twelve months of the end of our fiscal year end. The notice was only a notification of deficiency, not of imminent delisting, and had no effect on the listing or trading of our securities on the NASDAQ Capital Market. The notice stated that we had until February 21, 2020 to submit a plan to regain compliance with Listing Rule 5620(a). We submitted a plan to regain compliance with Listing Rule 5620(a) within the required timeframe. If Nasdaq accepts our plan, Nasdaq may grant us an extension of up to 180 calendar days from the fiscal year end, or until June 29, 2020, to evidence compliance with Listing Rule 5620(a). If Nasdaq does not accept our plan, we will have the opportunity to appeal the decision in front of a Nasdaq Hearings Panel. We cannot assure you that we will be able to regain compliance with the annual meeting requirement or that our securities will continue to be listed on Nasdaq. Results of Operations Our entire activity from January 23, 2018 (inception) through May 18, 2018, consisted of formation and preparation for the initial public offering, and as such, we had no operations and no significant operating expenses. Subsequent to the closing of the initial public offering on inception, our other income consists of interest and dividend income earned on the investments in our trust account and our operating costs include costs associated with obtaining directors and officers insurance and other general and administrative costs. For the year ended December 31, 2019, we had net income of $2,730,459, which consisted of $5,033,038 in interest earned on investments and marketable securities held in the Trust Account, offset by $910,209 in general and administrative costs, and $1,392,370 in income tax expense. For the period from January 23, 2018 (inception) through December 31, 2018, we had net income of $1,913,035, which consisted of $2,990,983 in interest earned on investments and marketable securities held in the Trust Account, offset by $402,302 in general and administrative costs, and $675,646 in income tax expense. Liquidity and Capital Resources In May 2018, we consummated the Public Offering, in which we sold 23,000,000 Units (including 3,000,000 Units subject to the exercise of the underwriters’ over-allotment option) at a price of $10.00 per Unit generating gross proceeds of $230,000,000 before underwriting discounts and expenses. VectoIQ Holdings, LLC (the “Sponsor”), Cowen Investments, LLC and certain funds and accounts managed by subsidiaries of BlackRock, Inc. (collectively, the “Anchor Investor”) purchased an aggregate of 890,000 units (the “Private Placement Units”) at a price of $10.00 per unit in a private placement that occurred simultaneously with the initial public offering and the exercise of the over-allotment option. In connection with the Public Offering, we incurred transaction costs of $5,244,622, consisting of $4,600,000 of underwriting fees and $644,622 of other initial public offering costs. Prior to the Public Offering, our only sources of liquidity were an initial purchase of shares of our common stock for $25,000 and two related party loans from our Sponsor and Cowen Investments, LLC totaling $120,000 to cover expenses related to the Public Offering. These loans were repaid with the proceeds from the Public Offering. Prior to the completion of our Initial Business Combination, we will have available to us the approximately $751,640 of proceeds held outside the Trust Account. We will use these funds 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 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 additional units of the post-business combination entity, at a price of $10.00 per unit at the option of the lender. The units would be identical to the Private Placement Units. 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 expect that we have sufficient resources to fund our operations for the 24 months following the closing of the Public Offering. 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 Initial Business Combination, which may include a specified future issuance. Subject to compliance with applicable securities laws, we would only complete such financing simultaneously with the completion of our Initial 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. 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. In connection with the Company's 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 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 May 18, 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 entered into any non-financial assets. Contractual Obligations At December 31, 2019 and 2018, we did not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities. We have entered into an Administrative Support Agreement with our Sponsor, pursuant to which the Company is billed a total of $10,000 per month for office space and general administrative services. Upon completion of the Initial Business Combination or the Company’s liquidation, the Company will cease incurring these monthly fees. The Company accrued $195,000 and $75,000 for office space and general administrative services at December 31, 2019 and 2018, respectively. Controls and Procedures Section 404 of the Sarbanes-Oxley Act requires that we evaluate and report on our system of internal controls beginning with our Annual Report on Form 10-K for the year ending December 31, 2019. Only in the event we are deemed to be a large accelerated filer, or an accelerated filer will we be required to comply with the independent registered public accounting firm attestation requirement on our internal control over financial reporting. Further, for as long as we remain an emerging growth company, we will not be required to comply with the independent registered public accounting firm attestation requirement on our internal control over financial reporting. We expect to assess the internal controls of our target business or businesses prior to the completion of our Initial Business Combination and, if necessary, to implement and test additional controls as we may determine are necessary in order to state that we maintain an effective system of internal controls. A target business may not be in compliance with the provisions of the Sarbanes-Oxley Act regarding the adequacy of internal controls. Many small and mid-sized target businesses we may consider for our initial business combination may have internal controls that need improvement in areas such as: · staffing for financial, accounting and external reporting areas, including segregation of duties; · reconciliation of accounts; · proper recording of expenses and liabilities in the period to which they relate; · evidence of internal review and approval of accounting transactions; · documentation of processes, assumptions and conclusions underlying significant estimates; and · documentation of accounting policies and procedures. Because it will take time, management involvement and perhaps outside resources to determine what internal control improvements are necessary for us to meet regulatory requirements and market expectations for our operation of a target business, we may incur significant expense in meeting our public reporting responsibilities, particularly in the areas of designing, enhancing, or remediating internal and disclosure controls. Doing so effectively also may take longer than we expect, thus increasing our exposure to financial fraud or erroneous financing reporting. Related Party Transactions In February 2018, our founders purchased an aggregate of 5,750,000 shares (the “Founder Shares”) of the Company’s common stock, par value $0.0001, for an aggregate purchase price of $25,000, or approximately $0.004 per share. The Sponsor and Cowen Investments purchased 4,301,000 and 1,449,000 of the Founder Shares, respectively. In March 2018, our Sponsor transferred 15,000 Founder Shares to each of our initial director nominees. In April 2018, the sponsor forfeited 435,606 Founder Shares and the Anchor Investor purchased 435,606 Founder Shares for an aggregate purchase price of $1,894, or approximately $0.004 per share. In May 2018, Cowen Investments forfeited 287,500 Founder Shares, which were subsequently purchased by the Sponsor and our Anchor Investor. Additionally, in May 2018, our sponsor purchased 254,829 Founder Shares for an aggregate purchase price of $1,108, or approximately $0.004 per share, and our Anchor Investor purchased 32,671 Founder Shares for an aggregate purchase price of $142, or approximately $0.004 per share. The number of founder shares issued was determined based on the expectation that such founder shares would represent 20% of the outstanding shares upon completion of the Public Offering (excluding the private shares). Prior to the initial investment of $25,000 by our founders, the Company had no assets, tangible or intangible. The purchase price of the Founder Shares was determined by dividing the amount of cash contributed to the company by the number of Founder Shares issued. If we increase or decrease the size of the offering pursuant to Rule 462(b) under the Securities Act, we will effect a stock dividend or share contribution back to capital or other appropriate mechanism, as applicable, immediately prior to the consummation of the offering in such amount as to maintain the representation by the Founder Shares of 20% of our issued and outstanding shares of common stock (excluding the private shares) upon the consummation of the initial public offering. Up to 750,000 Founder Shares will be subject to forfeiture, depending on the extent to which the underwriter's over-allotment option is exercised. We are obligated, commencing on the date of the Public Offering, to pay our Sponsor a monthly fee of an aggregate of $10,000 for office space and general and administrative services. Additionally, we have issued two promissory notes, one to our Sponsor and a second to Cowen Investments, both dated as of March 1, 2018. Each of the individual notes is in the aggregate principal amount of $100,000. The notes both contain a drawdown feature such that at any time prior to the consummation of the Public Offering we may draw up to an aggregate of $100,000 on each of the notes for general working capital expenses. These loans are non-interest bearing and were repaid with the proceeds from the Public Offering. Our Sponsor, officers and directors, or any of their respective affiliates, will be reimbursed for any out-of-pocket expenses incurred in connection with activities on our behalf such as identifying potential target businesses and performing due diligence on suitable business combinations. Our audit committee will review on a quarterly basis all payments that were made to our Sponsor, officers, directors or our 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. We do not believe we will need to raise additional funds following the Public Offering in order to meet the expenditures required for operating our business. However, in order to finance transaction costs in connection with an intended Initial Business Combination, our Founders, 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. Up to $1,500,000 of such loans may be convertible into additional units of the post-business combination entity at a price of $10.00 per unit at the option of the lender. The units would be identical to the private units. 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. Our founders and anchor investor purchased an aggregate of 890,000 Private Units (including 90,000 Private Units in connection with the exercise of the over-allotment option), at $10.00 per unit in a Private Placement. Among the private units, 525,909 units were purchased by our Sponsor and/or its designees, 67,424 units were purchased by our Anchor Investor and/or its designees, and 296,667 units were purchased by Cowen Investments and/or its designees. All of the proceeds we received from the purchase of the Private Units were placed in the Trust Account. A fund affiliated with P. Schoenfeld Asset Management LP, which is referred to as the “forward purchase investor,” is a member of the Sponsor. The forward purchase investor has entered into a contingent forward purchase agreement with us (the “forward purchase agreement”) as described below. Pursuant to the contingent forward purchase agreement, we may elect (subject to the forward purchase investor's right to be excused from any specific business combination as described below) to have the forward purchase investor purchase up to 2,500,000 shares of our common stock, plus one of our redeemable warrants for each forward purchase share, at a price of $10.00 per forward purchase share, for total gross proceeds of up to $25,000,000. While we may elect to have the forward purchase investor purchase no securities under the contingent forward purchase agreement, if we request that the forward purchase investor purchase securities and the forward purchase investor defaults on such purchase or the forward purchase investor exercises its right of refusal as described herein, the forward purchase investor will forfeit up to all of its ownership interest in our sponsor related to founder shares, and our sponsor will have the right to redeem the forward purchase investor's remaining ownership interest in our sponsor at the original purchase price. Any funds from the sale of the forward purchase securities may be used as part of the consideration to the sellers in the Initial Business Combination, for expenses in connection with the Initial Business Combination or for the combined company's working capital needs. This commitment is independent of the percentage of stockholders electing to redeem their public shares and could provide us with a minimum funding level for the Initial Business Combination. Our Anchor Investor has expressed to us an interest to purchase $25 million of public units in the initial public offering and we have agreed to direct the underwriters to sell to our anchor investor such number of public units. Further, the anchor investor has agreed with us that, if it does not own the number of public shares equal to 2,500,000 public shares (which amount will be reduced on a pro rata basis if less than 20,000,000 units are sold in the Public Offering), at the time of any stockholder vote with respect to an Initial Business Combination or the business day immediately prior to the consummation of our Initial Business Combination, it will forfeit all or a portion of the 468,277 founder shares it purchased prior to the Public Offering on a pro rata basis. In such a case, our Sponsor (or its designee), will have the right (but not the obligation) to repurchase all or a portion of the Private Placement Units held by our Anchor Investor at their original purchase price. There can be no assurance that the Anchor Investor will acquire any public units in the Public Offering or what amount of equity the Anchor Investor will retain, if any, upon the consummation of our Initial Business Combination. In the event that such Anchor Investor purchases such units (either in the Public Offering or after) and votes them in favor of our Initial Business Combination, it is possible that no votes from other public stockholders would be required to approve our Initial Business Combination, depending on the number of shares that are present at the meeting to approve such transaction. As a result of the founder shares and Private Placement Units that our Anchor Investor may hold, it may have different interests with respect to a vote on an Initial Business Combination than other public stockholders. Pursuant to a registration rights agreement entered into on May 15, 2018, the Founders, Anchor Investor, and the Company’s executive officers, directors and director nominees and their permitted transferees will be entitled to demand that the Company register for resale the Founder Shares, the Private Placement Units and underlying securities and any securities issued upon conversion of Working Capital Loans. The holders of these securities will be entitled to make up to three demands, excluding short form demands, that the Company register such securities. In addition, the holders will have certain “piggy-back” registration rights with respect to registration statements filed subsequent to the Company’s consummation of the Initial Business Combination. The Company will bear the expenses incurred in connection with the filing of any such registration statements. Notwithstanding the foregoing, Cowen Investments may not exercise its demand and “piggyback” registration rights after five and seven years, respectively, after the effective date of the initial public offering and may not exercise its demand rights on more than one occasion. Please see "Certain Relationships and Related Party Transactions" for additional information. Critical Accounting Policies and Significant Judgments and Estimates This discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with generally accepted accounting principles in the U.S. (“GAAP”). The preparation of these financial statements requires us 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 the reported amounts of revenues and expenses during the reported period. In accordance with GAAP, we base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. Emerging Growth Company Section 102(b)(1) of the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”) exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that an emerging growth company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such an election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period, which means that when a standard is issued or revised, and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statement with another public company that is neither an emerging growth company nor an emerging growth company that has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used. Income Taxes We follow the asset and liability method of accounting for income taxes under FASB ASC 740, “Income Taxes.” Deferred tax assets and liabilities are recognized for the estimated 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. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that included the enactment date. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized. FASB ASC 740 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more likely than not to be sustained upon examination by taxing authorities. There were no unrecognized tax benefits as of December 31, 2019 or 2018. We recognize accrued interest and penalties related to unrecognized tax benefits as income tax expense. No amounts were accrued for the payment of interest and penalties for the year ended December 31, 2019 or for the period from January 23, 2018 (inception) to December 31, 2018. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position. We are subject to income tax examinations by major taxing authorities since inception. The Company may be subject to potential examination by federal, state and city taxing authorities in the areas of income taxes. These potential examinations may include questioning the timing and amount of deductions, the nexus of income among various tax jurisdictions and compliance with federal, state and city tax laws. The Company has recorded deferred tax liabilities relating to expenses deferred for income tax purposes as of December 31, 2019 and 2018 amounting to $101,521 and $102,777, respectively. On December 22, 2017, the Tax Cuts and Jobs Act of 2017 (“Tax Reform”) was signed into legislation. As part of the legislation, the U.S. corporate income tax rate was reduced from 35% to 21%, among other changes. Recent Accounting Pronouncements Our management does not believe that there are any recently issued, but not yet effective, accounting pronouncements, if currently adopted, would have a material effect on our financial statements.
-0.112309
-0.112173
0
<s>[INST] Overview We are a newly organized company incorporated as a Delaware corporation on January 23, 2018 and formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, recapitalization, reorganization or similar business combination with one or more businesses (the “Initial Business Combination”). We intend to effectuate our Initial Business Combination using cash from the proceeds of our initial public offering (the “Public Offering”) and the sale of private placement units that occurred simultaneously with the consummation of the Public Offering. The issuance of additional shares of our stock in a business combination: · may significantly dilute the equity interest of investors in the Public Offering; · 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 common stock and/or warrants. As indicated in the accompanying financial statements, we had $751,640 and $1,168,600 in cash, $10,316 and $47,979 of cash held in the trust account established for the benefit of the Company’s public stockholders at J.P. Morgan Chase Bank, N.A. (the “Trust Account”), and investments held in the Trust Account of $238,372,960 and $235,243,004 at December 31, 2019 and 2018, respectively. 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 Initial Business Combination will be successful. Proposed Business Combination Business Combination Agreement On March 2, 2020, we entered into the Business Combination Agreement with Merger Sub and Nikola, pursuant to which we will effect the Proposed Transaction. Pursuant to the Business Combination Agreement, at the Closing, Merger Sub will be merged with and into Nikola, with Nikola surviving the Merger as a whollyowned direct subsidiary of us. Immediately prior to the Effective Time of the Merger), Nikola will cause the shares of Nikola’s preferred stock issued and outstanding immediately prior to the Effective Time to be automatically converted into shares of Nikola common stock, and each converted share of Nikola preferred stock will no longer be outstanding and will cease to exist. At the Effective Time, by virtue of the Merger, all shares of Nikola common stock issued and outstanding immediately prior to the Effective Time will be canceled and converted into the right to receive the number of shares of our common stock equal to the Exchange Ratio of 1.901 set forth in the Business Combination Agreement. Each Nikola stock option that is outstanding immediately prior to the Effective Time, whether vested or unvested, will be converted into an option to purchase a number of shares of our common stock equal to the product (rounded down to the nearest whole number) of (i) the number of shares of Nikola common stock subject to such option immediately prior to the Effective Time and (ii) the Exchange Ratio, at an exercise price per share (rounded up to the nearest whole cent) equal to (A) the exercise price per share of such option immediately prior to the Effective Time divided by (B) the Exchange Ratio. The Closing is subject to certain conditions, including but not limited to the approval of our stockholders and Nikola’s stockholders of the Business Combination Agreement. The Business Combination Agreement may also be terminated by either party under certain circumstances. Nikola has agreed to customary “no shop” obligations subject to a customary “fiduciary out,” and Nikola would be required to pay a termination fee in the amount of $82 million if [/INST] Negative. </s>
2,020
5,739
1,735,041
Greenland Acquisition Corp.
2019-02-27
2018-11-30
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 December 28, 2017 in the British Virgin Islands with limited liability (meaning our shareholders have no liability, as members of the Company, for the liabilities of the Company over and above the amount already paid for their shares) formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, recapitalization, reorganization or similar Business Combination with one or more target businesses. We intend to effectuate our Business Combination using cash from the proceeds of our Initial Public Offering and the sale of the Private Units that occurred simultaneously with the completion of our Initial Public Offering, our capital stock, debt or a combination of cash, stock and debt. The issuance of additional shares of our stock in a Business Combination: ● may significantly dilute the equity interest of investors who would not have pre-emption rights in respect of any such issue; ● may subordinate the rights of holders of ordinary shares if the rights, preferences, designations and limitations attaching to the preferred shares are created by amendment of our memorandum and articles of association by resolution of the board of directors and preferred shares are issued with rights senior to those afforded our ordinary shares; ● could cause a change in control if a substantial number of ordinary shares 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 share ownership or voting rights of a person seeking to obtain control of us; and ● may adversely affect prevailing market prices for our ordinary shares. Similarly, if we issue debt securities or otherwise incur significant indebtedness, it could result in: ● default and foreclosure on our assets if our operating revenues after our 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 any document governing such debt contains covenants restricting our ability to obtain such financing while the debt security is outstanding; ● our inability to pay dividends on our ordinary shares; ● 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 ordinary shares 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 acquisition plans. We cannot assure you that our plans 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 inception to November 30, 2018 were organizational activities, those necessary to prepare for 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 held after the 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 a Business Combination. For the period from December 28, 2017 (inception) through November 30, 2018, we had a net loss of $66,784, which consisted of operating costs of $372,998, offset by interest income on marketable securities held in the Trust Account of $315,911, an unrealized loss on marketable securities held in the Trust Account of $8,524 and a change in the value of the deferred underwriting fee liability of $1,173. Liquidity and Capital Resources On July 27, 2018, we consummated the Initial Public Offering of 4,400,000 Units at a price of $10.00 per Unit, which includes a partial exercise by the underwriters of their over-allotment option in the amount of 400,000 Units at $10.00 per Unit, generating gross proceeds of $44,000,000. Simultaneously with the closing of the Initial Public Offering, we consummated the sale of 282,000 Private Units to the sponsor and Chardan at a price of $10.00 per unit, generating gross proceeds of $2,820,000. Following the Initial Public Offering and the sale of the Private Units, a total of $44,000,000 was placed in the Trust Account and we had $1,035,797 of cash held outside of the Trust Account, after payment of costs related to the Initial Public Offering, and available for working capital purposes. We incurred $2,752,449 in transaction costs, including $1,320,000 of underwriting fees, $978,314 of deferred underwriting fees and $454,135 of other costs. For the period from December 28, 2017 (inception) through November 30, 2018, cash used in operating activities was $426,265, resulting primarily from a net loss of $66,784, interest earned on marketable securities held in the Trust Account of $315,911, an unrealized loss on marketable securities held in the Trust Account of $8,524 an a change in the value of the deferred underwriting fee liability of $1,173. Changes in operating assets and liabilities used $53,267 of cash. At November 30, 2018, we had marketable securities held in the Trust Account of $44,307,387. 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 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 November 30, 2018, we had cash of $644,700 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 a Business Combination. In order to fund working capital deficiencies or 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. If we complete a Business Combination, we would repay such loaned amounts. In the event that a 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 Private Units, at a price of $10.00 per unit 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 a 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 Business Combination. Moreover, we may need to obtain additional financing either to consummate our Business Combination or because we become obligated to redeem a significant number of our public shares upon consummation of our 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 complete such financing simultaneously with the completion of our Business Combination. Following our 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 We have no obligations, assets or liabilities, which would be considered off-balance sheet arrangements as of November 30, 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 Puhui Wealth Investment Management (Beijing) Co., Ltd., an affiliate of a member of the sponsor a monthly fee of $10,000 for office space, utilities and administrative services to the Company. We began incurring these fees on July 24, 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 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 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 November 30, 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 sheet. 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 the Company’s financial statements.
0.000343
0.000712
0
<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 December 28, 2017 in the British Virgin Islands with limited liability (meaning our shareholders have no liability, as members of the Company, for the liabilities of the Company over and above the amount already paid for their shares) formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, recapitalization, reorganization or similar Business Combination with one or more target businesses. We intend to effectuate our Business Combination using cash from the proceeds of our Initial Public Offering and the sale of the Private Units that occurred simultaneously with the completion of our Initial Public Offering, our capital stock, debt or a combination of cash, stock and debt. The issuance of additional shares of our stock in a Business Combination: may significantly dilute the equity interest of investors who would not have preemption rights in respect of any such issue; may subordinate the rights of holders of ordinary shares if the rights, preferences, designations and limitations attaching to the preferred shares are created by amendment of our memorandum and articles of association by resolution of the board of directors and preferred shares are issued with rights senior to those afforded our ordinary shares; could cause a change in control if a substantial number of ordinary shares 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 share ownership or voting rights of a person seeking to obtain control of us; and may adversely affect prevailing market prices for our ordinary shares. Similarly, if we issue debt securities or otherwise incur significant indebtedness, it could result in: default and foreclosure on our assets if our operating revenues after our 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 any document governing such debt contains covenants restricting our ability to obtain such financing while the debt security is outstanding; our inability to pay dividends on our ordinary shares; 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 ordinary shares 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 deb [/INST] Positive. </s>
2,019
2,096
1,735,041
Greenland Technologies Holding Corp.
2020-04-03
2019-12-31
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OF GREENLAND TECHNOLOGIES HOLDING CORPORATION The following discussion and analysis of financial condition and results of operations relates to the operations and financial condition reported in the consolidated financial statements of the Company thereto, which appear elsewhere in this Report, and should be read in conjunction with such financial statements and related notes included in this Report. Except for the historical information contained herein, the following discussion, as well as other information in this Report, contain “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, and are subject to the “safe harbour” created by those sections. Actual results and the timing of the events may differ materially from those contained in these forward-looking statements due to many factors, including those discussed in the “Forward-Looking Statements” set forth elsewhere in this Report. Overview The registrant was incorporated on December 28, 2017 as a British Virgin Islands Company with limited liability. The registrant was incorporated as a blank check Company for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, recapitalization, reorganization or similar business combination with one or more target businesses. Following the Business Combination (as described and defined below) in October 2019, the registrant changed its name from Greenland Acquisition Corporation to Greenland Technologies Holding Corporation (“Greenland”). On July 27, 2018, we consummated our initial public offering of 4,400,000 units, including a partial exercise by the underwriters of their over-allotment option in the amount of 400,000 units. Each unit consists of one ordinary share, no par value, one warrant to purchase one-half of one ordinary share and one right to receive one-tenth of one ordinary share upon the consummation of our initial business combination, pursuant to a registration statement on Form S-1. Warrants must be exercised in multiples of two warrants, and each two warrants are exercisable for one ordinary share at an exercise price of $11.50 per share. The units were sold in our initial public offering at an offering price of $10.00 per unit, generating gross proceeds of $44,000,000 (before underwriting discounts and offering expenses). Simultaneously with the consummation of our initial public offering, we completed a private placement of 282,000 units, issued to Greenland Asset Management Corporation (the “Sponsor”) and Chardan Capital Markets, LLC, generating gross proceeds of $2,820,000. On October 24, 2019, we consummated our business combination with Zhongchai Holding (the “Business Combination”) following a special meeting of the shareholders where the shareholders of Greenland considered and approved, among other matters, a proposal to adopt a share exchange agreement (the “Share Exchange Agreement”), dated as of July 12, 2019 and entered into by and among (i) Greenland, (ii) Zhongchai Holding, (iii) the Sponsor in the capacity as the purchaser representative (the “Purchaser Representative”), and (iv) Cenntro Holding Limited, the sole member of Zhongchai Holding (the “Zhongchai Equity Holder” or the “Seller”). Pursuant to the Share Exchange Agreement, Greenland acquired from the Seller all of the issued and outstanding equity interests of Zhongchai Holding in exchange for 7,500,000 newly issued ordinary shares, no par value of Greenland, issued to the Seller (the “Exchange Shares”). As a result, the Seller became the controlling shareholder of Greenland, and Zhongchai Holding became a directly and wholly owned subsidiary of Greenland. The Business Combination was accounted for as a reverse merger effected by a share exchange, wherein Zhongchai Holding is considered the acquirer for accounting and financial reporting purposes. In connection with the Business Combination, all the outstanding rights of the Company were converted into 468,200 ordinary shares on a one-tenth (1/10) ordinary share per right basis if holders of the rights elected to convert their rights into the underlying ordinary shares. On December 17, 2019, the Company’s warrants, which were trading under the ticker symbol “GTECW,” were delisted from the Nasdaq Capital Market by the Nasdaq Listing Qualifications Staff. On January 14, 2020, Greenland Technologies Corp. was incorporated under the laws of the state of Delaware (“Greenland Tech”). Greenland Tech is the 100% owned subsidiary of the registrant. We aim to use it as the US operation site of the Company and promote sales of our robotic products for the North American market in the near future. Greenland serves as the parent Company for Zhongchai Holding (Hong Kong) Limited, a holding Company formed under the laws of Hong Kong on April 23, 2009. Through Zhongchai Holding and other subsidiaries, Greenland develops and manufactures traditional transmission products for material handling machineries in PRC, as well as develop models for robotic cargo carriers, which are expected to be produced in the near future in PRC. Greenland, through its subsidiaries, is: ● A leading developer and manufacturer of traditional transmission products for material handling machineries in PRC; and ● A developer of robotic cargo carrier, which is expected to be available for commercial use in the near future in PRC. Greenland’s transmission products are key components for forklift trucks used in manufacturing and logistic applications, such as factories, workshops, warehouses, fulfilment centers, shipyards and seaports. Forklifts play an important role in logistics systems of many enterprises across different industries in PRC and globally. Generally, the industries with the largest demand for forklifts include the transportation, warehousing logistics, electrical machinery and automobile industries. Greenland has experienced decreased demand for forklifts in the manufacturing industry in the PRC, as its revenue decreased from approximately $60.21 million in the fiscal year 2018 to approximately $52.40 million in the fiscal year 2019. The revenue decline of approximately $7.81 million was primarily due to the reduced output during the opening of the new factory. Based on revenues in the fiscal year ended December 31, 2019 and 2018, Greenland believes that it is one of the major developers and manufacturers of transmission products for small and medium-sized forklift trucks in PRC. Greenland’s transmission products are used in 1-ton to 15-ton forklift trucks, some with mechanical shift and some with automatic shift. Greenland sells these transmission products directly to forklift truck manufacturers. In the fiscal year ended December 31, 2019 and 2018, Greenland sold an aggregate of more than 83,567 and 92,374 sets of transmission products, respectively, to more than 100 forklift manufacturers in PRC. Through Zhongchai Holding and other subsidiaries, we have leveraged our industry and market experience to develop robotic cargo carriers. Greenland completed a conceptual prototype of a robotic cargo carrier in August 2018. Greenland also completed a production-ready sample in January 2020, which has been extensively tested under the sample-testing phase. Greenland expects its first product to be a robotic cargo carrier with payload capacity of approximately 500 kilograms. Greenland believes that this product will be more cost effective than existing automatic guided vehicles in the market. Due to the COVID-19 outbreak, there are uncertainties remain in the demand of new robotic carriers’ market. The Company expects to delay the launch of its new product, a robotic cargo carrier with payload capacity of approximately 500 kilograms. Moreover, the outbreak has significantly limited suppliers’ ability to provide low-cost, high-quality merchandise to the Company on a timely basis. As a result, the Company believes that its capability to produce transmission products has been significantly affected, and its business and results of operations could be significantly impacted. In the future, Greenland’s management plans to offer a robotic cargo carrier with payload capacity of approximately 100 kilograms. Results of Operations For the fiscal year ended December 31, 2019 and 2018 Overview Components of Results of Operations Revenue Greenland’s revenue decreased by approximately $7.81 million, or approximately 13.0%, to approximately $52.40 million for the fiscal year ended December 31, 2019, compared to approximately $60.21 million for the fiscal year ended December 31, 2018. The decrease was primarily attributable to the reduced output of Zhejiang Zhongchai as it was moving into its new factory in Meizhou, Zhejiang, PRC. The new factory was fully completed by the end of April 2019, and the Company started to settle into the new factory in June 2019, which caused production reduction in the third quarter of the fiscal year 2019. The Company fully settled into the new factory by the end of October 2019. On a RMB basis, revenue for the fiscal year ended December 31, 2019 decreased by approximately 8.9%. Cost of Goods Sold Greenland’s cost of goods sold consists primarily of material costs, freight charges, purchasing and receiving costs, inspection costs, warehousing costs, internal transfer costs, wages, employee compensation, amortization, depreciation and related costs, which are directly attributable to the production of products. The write down of inventory using NRV impairment test is also recorded in cost of goods sold. The total cost of goods sold decreased by approximately $6.12 million, or approximately 13.3%, to approximately $40.02 million for the fiscal year ended December 31, 2019, compared to approximately $46.14 million for the fiscal year ended December 31, 2018. Cost of goods sold decreased due to the decrease of sale volume. Gross Profit Greenland’s gross profit decreased by approximately $1.69 million, or 12.0%, to approximately $12.38 million for the fiscal year ended December 31, 2019, compared to approximately $14.07 million for the fiscal year ended December 31, 2018. For the fiscal year ended December 31, 2019 and 2018, Greenland’s gross margin was approximately 23.6% and 23.4%, respectively. Operating Expense Greenland’s operating expenses consist of selling expenses, general and administrative expenses and research and development expenses Selling Expense Selling expenses mainly include operating expenses such as sales staff payroll, traveling expenses and transportation expenses. Selling expenses decreased by $0.03 million or 2.4%, to approximately $1.19 million for the fiscal year ended December 31, 2019, as compared to approximately $1.22 million for the fiscal year ended December 31, 2018. The decrease of selling expense was primarily due to the decrease in the sales. General and Administrative Expenses General and administrative expenses include management and office staff salaries and employee benefits, depreciation for office facility and office furniture and equipment, travel and entertainment, legal and accounting, consulting fees and other office expenses. General and administrative expenses increased by approximately $0.58 million, or approximately 35.5%, to approximately $2.23 million for the fiscal year ended December 31, 2019, as compared to approximately $1.65 million for the fiscal year ended December 31, 2018. The increase of general and administrative expenses was primarily due to administrative and related professional fee expenses regarding to the Business Combination, which was consummated on October 24, 2019. Research and Development Expenses R&D expenses consist of R&D personnel compensation, costs of materials used in R&D projects, and depreciation costs for research-related equipment. R&D expenses decreased by approximately $0.15 million, or 6.3%, to approximately $2.36 million for the fiscal year ended December 31, 2019, as compared to approximately $2.51 million for the fiscal year ended December 31, 2018. The R&D expenses decreased primarily because Zhejiang Zhongchai started to settle into the new factory in June 2019, which caused decreased R&D activities. Income from Operations As a result of the foregoing, income from operations for the fiscal year ended December 31, 2019 was approximately $6.60 million, a decrease of approximately $2.10 million, as compared to the income from operations of approximately 8.70 million for the fiscal year ended December 31, 2018. Interest Income and Interest Expenses Greenland’s interest income was approximately $0.15 million for the fiscal year ended December 31, 2019, a decrease of approximately $0.15 million, or 50.3%, as compared to approximately $0.30 million for the fiscal year ended December 31, 2018. The decrease in interest income was primarily due to the decreased interest income of cash management products. Greenland’s interest expenses were approximately $1.29 million for the fiscal year ended December 31, 2019, a decrease of approximately $0.26 million, or 17.1%, as compared to approximately $1.55 million for the fiscal year ended December 31, 2018. The decrease was primarily due to the reduction of long-term loans by approximately $6.56 million in the fiscal year 2019, compared to the fiscal year 2018. Other Income Greenland’s other income was approximately $0.72 million for the fiscal year ended December 31, 2019, an increase of approximately $0.14 million, or 25.0%, as compared to approximately $0.58 million for the fiscal year ended December 31, 2018. Income Taxes Greenland’s income tax was approximately $0.85 million for the fiscal year ended December 31, 2019, compared to approximately $1.39 million for the fiscal year ended December 31, 2018. Under the Income Tax Laws of the PRC, companies are generally subject to income tax at a rate of 25%. However, Zhejiang Zhongchai, the 89.47%-owned subsidiary of Zhongchai Holding, obtained the “high-tech enterprise” tax status until the end of the fiscal year 2018, which reduced its statutory income tax rate to 15%. Zhejiang Zhongchai is currently applying to extend its “high-tech enterprise” tax status. During the period prior to receiving a decision on its application, Zhejiang Zhongchai will continue to enjoy the preferential tax rate of 15% for the fiscal years 2019, 2020, and 2021. Greenland’s other subsidiaries, Shengte and Hengyu, the wholly owned subsidiary of Zhejiang Zhongchai and the 62.5% owned subsidiary of Zhongchai Holding, are subject to the standard income tax rate of 10% for small and micro businesses and 25% for other PRC entities, respectively. Hangzhou Greenland, the wholly owned subsidiary of Zhongchai Holding, is subject to the standard income tax rate of 25%. Greenland is a holding Company registered in the British Virgin Islands and is not subject to tax on income or capital gains under current British Virgin Islands law. In addition, upon payments of dividend to its shareholders, the Company will not be subject to any British Virgin Islands withholding tax. Net Income As a result of the foregoing, net income was approximately $5.09 million for the fiscal year ended December 31, 2019, a decrease of approximately $1.53 million, as compared to a net income of approximately $6.62 million for the fiscal year ended December 31, 2018. Liquidity and Capital Resources Greenland is a holding Company incorporated in the British Virgin Islands. Current PRC regulations permit our PRC subsidiaries to pay dividends to us only out of their accumulated profits, if any, determined in accordance with PRC accounting standards and regulations. In addition, our PRC subsidiaries are required to set aside at least 10% of their respective accumulated profits each year, if any, to fund certain reserve funds until the total amount set aside reaches 50% of their respective registered capital. Our PRC subsidiaries may also allocate a portion of their after-tax profits based on PRC accounting standards to employee welfare and bonus funds at their discretion. These reserves are not distributable as cash dividends. We have funded working capital and other capital requirements primarily by equity contributions, cash flow from operations, short-term bank loans and bank acceptance notes, and long-term bank loans. Cash is required primarily to purchase raw materials, repay debts and pay salaries, office expenses, income taxes and other operating expenses. The outbreak of COVID-19, the coronavirus, has grown both in the United States and globally, and related government and private sector responsive actions have adversely affected the Company’s business operations. COVID-19 originated in Wuhan, China, in December 2019. Effective February 3, 2020, the Company announced the temporary closure of its all operating offices in Zhejiang Province, including the manufactory in response to the emergency measures imposed by the local government to slow down the spread of COVID-19. Since the local government has imposed pandemic prevention policy, the subsidiaries were temporary shut down until the end of February 2020. The Company’s launch on robotic cargo carriers are also expected to be delay due to the uncertainty on customer demand. Moreover, the outbreak has significantly limited suppliers’ ability to provide low-cost, high-quality merchandise to the Company on a timely basis. Zhejiang Province, where we conduct a substantial part of our business, is one of the most affected areas in China. The World Health Organization has declared Covid-19 to be a global pandemic, resulting in an economic downturn and changes in global economic policy that will reduce demand for the Company’s products and have an adverse impact on the Company’s business, operating results and financial condition. For the fiscal year ended December 31, 2019, our PRC subsidiary, Zhejiang Zhongchai, has paid off approximately $47.67 million bank loan, paid off approximately $5.43 million related parties loan, paid off approximately $2.90 million third parties loan, paid off approximately $1.81 million notes payable, and was able to maintain $ 2.12 million cash on hand by the end of the fiscal year 2019. Due to the recent COVID-19 outbreak in PRC, the PRC government has made available financial resources to support local business-related financing conditions. We expect that the loan financing terms and conditions of banks in PRC will be less restrictive and bank loans will be more easily attainable to local business. We plan to maintain the current debt structure and rely on governmentally supported loans with lower cost, if it is necessary. The government subsidy mainly consists of an incentive granted by the Chinese government to encourage transformation of fixed assets in China and other miscellaneous subsidy from the Chinese government. Government subsidies are recognized when there is reasonable assurance that the subsidy will be received and all attaching conditions will be complied with. Total government subsidies recorded in the long-term liabilities were $2.18 million and $1.99 million at December 31, 2019 and 2018, respectively. The Company currently plans to fund its operations mainly through cash flow from its operations, renewal of bank borrowings, additional equity financing, and the continuing financial support from its shareholders and affiliates controlled by its principal shareholders, if necessary. The Company might implement a stricter policy on sales to less creditworthy customers and plans to continue to improve its collection efforts on accounts with outstanding balances. The Company is actively working with customers and suppliers and expects to fully collect the remaining balance. We believe that the Company has sufficient cash, even though with the expected declining revenue consisting of uncertainty in the Company’s anticipated robotic carriers’ sale and decline on sale of transmission products. However, our capital contribution from existing funding sources, to operate for the next 12 months will be sufficient. We remain confident and are expected to generate positive cash flow from our operations. We may need additional cash resources in the future if the Company experiences failure in collecting receivables, any changed business condition, or other developments. We may also need additional cash resources in the future if the Company wishes to pursue opportunities for investment, acquisition, strategic cooperation or other similar actions. If the Company’s management and its Board determine that the cash required for specific corporate activities exceed Greenland’s cash and cash equivalents on hand, the Company may issue debt or equity securities to raise cash. We have expended considerable resources on building a new factory and paid off a considerable amount of debt, resulting in less available cash during past years. However, we anticipate that our cash flow will continue to improve in the fiscal year 2020, given that the construction of Zhejiang Zhongchai’s new factory is now completed and as discussed above we expect financing conditions to be less restrictive as a result of the recent COVID-19 outbreak in PRC. Furthermore, we pledged the deed of the new factory as a collateral to banks in order to obtain additional loans, refinance expiring loans, and restructure short-term loans to longer periods next year, if necessary, as well as fund other working capital needs to the extent additional funds are available upon terms acceptable to Greenland. Cash and Cash Equivalents Cash equivalents refers to all highly liquid investments purchased with original maturity of three months or less. As of December 31, 2019, Greenland had approximately $2.12 million of cash and cash equivalents, a decrease of approximately $3.44 million, or 61.8%, as compared to approximately $5.56 million as of December 31, 2018. The decrease of cash was mainly due to the decrease in positive cash flows from financing activities. Restricted Cash Restricted cash represents the amount held by a bank as security for bank acceptance notes and therefore is not available for use until the bank acceptance notes are fulfilled or expired, which typically takes less than twelve months. As of December 31, 2019, Greenland had approximately $3.59 million of restricted cash, an increase of approximately $0.18 million, or 5.5%, as compared to approximately $3.41 million as of December 31, 2018. The increase of restricted cash was due to the increase of bank acceptance notes compared to the balance as of December 31, 2018. Accounts Receivable As of December 31, 2019, Greenland had approximately $11.97 million of accounts receivables, an increase of approximately $1.79 million, or 17.6%, as compared to approximately $10.18 million as of December 31, 2018. The increase in accounts receivable was due to the lower turnover on receivable. Greenland recorded approximately $1.04 million of provision for doubtful accounts as of December 31, 2019. Greenland conducted an aging analysis of each customer’s delinquent payments to determine whether allowance for doubtful accounts is adequate. In establishing the allowance for doubtful accounts, Greenland considers historical experience, the economic environment, and the expected collectability of past due receivables. An estimate of doubtful accounts is recorded when collection of the full amount is no longer probable. When bad debts are identified, such debts are written off against the allowance for doubtful accounts. Greenland will continuously assess its potential losses based on the credit history of and relationships with its customers on a regular basis to determine whether its bad debt allowance on its accounts receivable is adequate. Greenland believes that its collection policies are generally in line with the transmissions industry in PRC. Due from Related Party Due from related party was $36.47 million and $36.64 million as of December 31, 2019 and December 31, 2018. The current portion of due from related party was $36.04 million as of December 31, 2019, the non-current portion of due from related party was $36.64 million as of December 31, 2018. We expect the amount due from our equity holder, Cenntro Holding will pay us back by the end of October 2020 as they promised. However, there is no guarantee that the amounts payable by Cenntro Holding will be repaid in whole or in part soon, if at all. Any such failure could have a material negative impact on Greenland’s balance sheet. Notes Receivable As of December 31, 2019, Greenland had approximately $16.16 million of notes receivables. These notes receivables will be collected within six months. The decrease was approximately $0.18 million, or 1.1%, as compared to approximately $16.34 million as of December 31, 2018. Working Capital Our working capital was approximately $24.25 million as of December 31, 2019, as compared to $(14.98) million at December 31, 2018. The working capital increase of $39.23 million in the fiscal year 2019 as compared with the same period in 2018 was primarily contributed to a recent due from a related party, which we expect to receive on October 2020. Cash Flow Operating Activities Greenland’s net cash provided by operating activities was approximately $8.00 million and $3.06 million for the fiscal years ended December 31, 2019 and 2018, respectively. In the fiscal year ended December 31, 2019, the main sources of cash inflow from operating activities were net income, change in depreciation and amortization, and inventories, of approximately $5.09 million, $2.30 million and $2.23 million, respectively. The main causes of cash outflow were change in account receivable and other current liability, of approximately $(2.13) million and $(1.65) million, respectively. In the fiscal year ended December 31, 2018, the main sources of cash inflow from operating activities were net income, change in depreciation and amortization, and other current and noncurrent assets, of approximately $ 6.62 million, $1.58 million, and $2.10 million, respectively. The main causes of cash outflow were change in accounts receivables and inventories, of approximately $(2.74) million and $(4.14) million, respectively. Investing Activities Net cash used in investing activities was approximately $(1.60) million for the fiscal year ended December 31, 2019. Cash used in investing activities for the fiscal year ended December 31, 2019 was mainly due to offset by approximately $ (1.28) million and $(0.91) million used for purchases of plant and equipment and equipment construction in process, respectively. Net cash used in investing activities was approximately $(5.98) million for the fiscal year ended December 31, 2018. Cash provided in investing activities for the fiscal year ended December 31, 2018 was mainly due to offset by approximately $(6.69) million cash used for constructing Zhejiang Zhongchai’s new factory. Financing Activities Net cash used in financing activities was approximately $(9.64) million for the fiscal year ended December 31, 2019, mainly attributable to approximately $38.67 million proceeds from short-term bank loans and approximately $5.21 million proceeds from long-term payables, offset by repayments of short-term bank loans for approximately $(41.14) million, repayments of long-term bank loans for approximately $(6.53) million, repayment of loans lent by third parties for approximately $(2.90) million, and repayment of loans lent by related parties for approximately $(5.43) million. Net cash used in financing activities was approximately $(0.16) million for the fiscal year ended December 31, 2018 mainly attributable to repayment of short-term and long-term bank loans for approximately $(18.04) million and $(0.30) million, respectively, repayment of loans lent by third parties for approximately $(4.09) million, mitigated by additional proceeds from short-term bank loans of approximately $20.30 million. Credit Risk Credit risk is one of the most significant risks for Greenland’s business. Accounts receivable are typically unsecured and derived from revenues earned from customers, thereby exposing Greenland to credit risk. Credit risk is controlled by the application of credit approvals, limits, and monitoring procedures. Greenland identifies credit risk collectively based on industry, geography, and customer type. This information is monitored regularly by the Company’s management. In measuring the credit risk of sales to customers, Greenland mainly reflects the “probability of default” by the customer on its contractual obligations and considers the current financial position of the customer and the exposures to the customer and its future development. Liquidity Risk Greenland is exposed to liquidity risk when it is unable to provide sufficient capital resources and liquidity to meet its commitments and/or business needs. Liquidity risk is managed by the application of financial position analysis to test if Greenland is in danger of liquidity issues and also by application of monitoring procedures to constantly monitor its conditions and movements. When necessary, Greenland resorts to other financial institutions to obtain additional short-term funding to meet the liquidity shortage. Inflation Risk Greenland is also exposed to inflation risk. Inflationary factors, such as increases in raw material and overhead costs, could impair Greenland’s operating results. Although Greenland does not believe that inflation has had a material impact on its financial position or results of operations to date, a high rate of inflation in the future may have an adverse effect on its ability to maintain current levels of gross margin and operating expenses as a percentage of sales revenues if the selling prices of its products do not increase with such increased costs. Critical Accounting Policies and Estimates We prepare our consolidated financial statements in accordance with U.S. GAAP. In applying accounting principles, it is often required to use estimates. These estimates consider the facts, circumstances and information available, and may be based on subjective inputs, assumptions and information known and unknown to us. Material changes in certain of the estimates that we use could potentially affect, by a material amount, our consolidated financial position and results of operations. Although results may vary, we believe our estimates are reasonable and appropriate. See Note 2 to our consolidated financial statements included in “Item 8 - Financial Statements and Supplementary Data” for a summary of our significant accounting policies. The following describes certain of our significant accounting policies that involve more subjective and complex judgments where the effect on our consolidated financial position and operating performance could be material. Revenue Recognition In accordance with ASC Topic 606, “Revenue from Contracts with Customers”, the Company recognizes revenues when goods or services are transferred to customers in an amount that reflects the consideration which the Company expects to receive in exchange for those goods or services. In determining when and how revenues are recognized from contracts with customers, the Company performs the following five-step analysis: (i) identification of contract with customer; (ii) determination of performance obligations; (iii) measurement of the transaction price; (iv) allocation of the transaction price to the performance obligations, and (v) recognition of revenues when (or as) the Company satisfies each performance obligation. The Company derives revenues from the processing, distribution and sale of its products. The Company recognizes its revenues net of value-added taxes (“VAT”). The Company is subject to VAT which had been levied at the rate of 17% on the invoiced value of sales until April 30, 2018, after which date the rate was reduced to 16%. VAT rate was further reduced to 13% starting from April 1, 2019. Output VAT is borne by customers in addition to the invoiced value of sales and input VAT is borne by the Company in addition to the invoiced value of purchases to the extent not refunded for export sales. Revenues are recognized at a point in time once the Company has determined that the customer has obtained control over the product. Control is typically deemed to have been transferred to the customer when the performance obligation is fulfilled, usually at the time of customers’ acceptance or consumption, at the net sales price (transaction price) and each of the criteria under ASC 606 have been met. Contract terms may require the Company to deliver the finished goods to the customers’ location or the customer may pick up the finished goods at the Company’s factory. International sales are recognized when shipment clears customs and leaves the port. The Company has adopted ASC 606 on January 1, 2018, using the transition method of Modified-Retrospective Method (“MRM”). The adoption of ASC 606 had no impact on the Company’s beginning balance of retained earnings. The Company’s contracts are predominantly short-term in nature with a contract term of one year or less. For those contracts, the Company has utilized the practical expedient in ASC Topic 606 exempting the Company from disclosure of the transaction price allocated to remaining performance obligations if the performance obligation is part of a contract that has an original expected duration of one year or less. Receivables are recorded when the Company has an unconditional right to consideration. Business Combination On October 24, 2019, we consummated our business combination with Zhongchai Holding (the “Business Combination”) following a special meeting of the shareholders where the shareholders of Greenland considered and approved, among other matters, a proposal to adopt an share exchange agreement (the “Share Exchange Agreement”), dated as of July 12, 2019 and entered into by and among (i) Greenland, (ii) Zhongchai Holding, (iii) the Sponsor in the capacity as the purchaser representative (the “Purchaser Representative”), and (iv) Cenntro Holding Limited, the sole member of Zhongchai Holding (the “Zhongchai Equity Holder” or the “Seller”). Pursuant to the Share Exchange Agreement, Greenland acquired from the Seller all of the issued and outstanding equity interests of Zhongchai Holding in exchange for 7,500,000 newly issued ordinary shares, no par value of Greenland, to the Seller (the “Exchange Shares”). As a result, the Seller became the controlling shareholder of Greenland, and Zhongchai Holding became a directly and wholly owned subsidiary of Greenland. The Business Combination was accounted for as a reverse merger effected by a share exchange, wherein Zhongchai Holding is considered the acquirer for accounting and financial reporting purposes. Pursuant to the Finder Agreement, 50,000 newly issued ordinary shares issued to Zhou Hanyi is the finder fee for business combination. Inventories Inventories are stated at the lower of cost or net realizable value, which is based on estimated selling prices less any further costs expected to be incurred for completion and disposal. Cost of raw materials is calculated using the weighted average method and is based on purchase cost. Work-in-progress and finished goods costs are determined using the weighted average method and comprise direct materials, direct labor and an appropriate proportion of overhead. Income Taxes The Company accounts for income taxes following the liability method pursuant to FASB ASC 740 “Income Taxes”. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial reporting and tax bases of assets and liabilities using enacted tax rates that will be in effect in the period in which the differences are expected to reverse. The Company records a valuation allowance to offset deferred tax assets if, based on the weight of available evidence, it is more-likely-than-not that some portion, or all, of the deferred tax assets will not be realized. The effect on deferred taxes of a change in tax rate is recognized in income in the period that includes the enactment date. The Company also follows FASB ASC 740, which addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements. The Company may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement. ASC 740 also provides guidance on recognition, classification, interest and penalties on income taxes, accounting in interim periods and requires increased disclosures. As of December 31, 2019, the Company did not have a liability for unrecognized tax benefits. It is the Company’s policy to include penalties and interest expense related to income taxes as a component of other expense and interest expense, respectively, as necessary. The Company’s historical tax years will remain open for examination by the local authorities until the statute of limitations has passed. Emerging growth Company Pursuant to the JOBS Act, an emerging growth Company is provided the option to adopt new or revised accounting standards that may be issued by FASB or the SEC either (i) within the same periods as those otherwise applicable to non-emerging growth companies or (ii) within the same time periods as private companies. We intend to continue to take advantage of the exemption for complying with new or revised accounting standards within the same time periods as private companies. Accordingly, the information contained herein may be different than the information you receive from other public companies. We also intend to continue to take advantage of some of the reduced regulatory and reporting requirements of emerging growth companies pursuant to the JOBS Act so long as we qualify as an emerging growth Company, including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404(b) of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation, and exemptions from the requirements of holding non-binding advisory votes on executive compensation and golden parachute payments. Off Balance Sheet Arrangements None.
-0.138091
-0.137962
0
<s>[INST] Overview The registrant was incorporated on December 28, 2017 as a British Virgin Islands Company with limited liability. The registrant was incorporated as a blank check Company for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, recapitalization, reorganization or similar business combination with one or more target businesses. Following the Business Combination (as described and defined below) in October 2019, the registrant changed its name from Greenland Acquisition Corporation to Greenland Technologies Holding Corporation (“Greenland”). On July 27, 2018, we consummated our initial public offering of 4,400,000 units, including a partial exercise by the underwriters of their overallotment option in the amount of 400,000 units. Each unit consists of one ordinary share, no par value, one warrant to purchase onehalf of one ordinary share and one right to receive onetenth of one ordinary share upon the consummation of our initial business combination, pursuant to a registration statement on Form S1. Warrants must be exercised in multiples of two warrants, and each two warrants are exercisable for one ordinary share at an exercise price of $11.50 per share. The units were sold in our initial public offering at an offering price of $10.00 per unit, generating gross proceeds of $44,000,000 (before underwriting discounts and offering expenses). Simultaneously with the consummation of our initial public offering, we completed a private placement of 282,000 units, issued to Greenland Asset Management Corporation (the “Sponsor”) and Chardan Capital Markets, LLC, generating gross proceeds of $2,820,000. On October 24, 2019, we consummated our business combination with Zhongchai Holding (the “Business Combination”) following a special meeting of the shareholders where the shareholders of Greenland considered and approved, among other matters, a proposal to adopt a share exchange agreement (the “Share Exchange Agreement”), dated as of July 12, 2019 and entered into by and among (i) Greenland, (ii) Zhongchai Holding, (iii) the Sponsor in the capacity as the purchaser representative (the “Purchaser Representative”), and (iv) Cenntro Holding Limited, the sole member of Zhongchai Holding (the “Zhongchai Equity Holder” or the “Seller”). Pursuant to the Share Exchange Agreement, Greenland acquired from the Seller all of the issued and outstanding equity interests of Zhongchai Holding in exchange for 7,500,000 newly issued ordinary shares, no par value of Greenland, issued to the Seller (the “Exchange Shares”). As a result, the Seller became the controlling shareholder of Greenland, and Zhongchai Holding became a directly and wholly owned subsidiary of Greenland. The Business Combination was accounted for as a reverse merger effected by a share exchange, wherein Zhongchai Holding is considered the acquirer for accounting and financial reporting purposes. In connection with the Business Combination, all the outstanding rights of the Company were converted into 468,200 ordinary shares on a onetenth (1/10) ordinary share per right basis if holders of the rights elected to convert their rights into the underlying ordinary shares. On December 17, 2019, the Company’s warrants, which were trading under the ticker symbol “GTECW,” were delisted from the Nasdaq Capital Market by the Nasdaq Listing Qualifications Staff. On January 14, 2020, Greenland Technologies Corp. was incorporated under the laws of the state of Delaware (“Greenland Tech”). Greenland Tech is the 100% owned subsidiary of the registrant. We aim to use it as the US operation site of the Company and promote sales of our robotic products for the North American market in the near future. Greenland serves as the parent Company for Zhongchai Holding (Hong Kong) Limited, a holding Company formed under the laws of Hong Kong on April [/INST] Negative. </s>
2,020
5,873
1,716,621
Ra Medical Systems, Inc.
2019-03-15
2018-12-31
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Investing in our common stock involves a high degree of risk. You should carefully consider the risks and uncertainties described below, together with all of the other information in this Annual Report on Form 10-K, before making an investment decision. The risks and uncertainties described below may not be the only ones we face. If any of the risks actually occur, our business, financial condition, operating results, cash flows and prospects could be materially and adversely affected. In that event, the market price of our common stock could decline, and you could lose part or all of your investment. Overview We are a commercial-stage medical device company leveraging our advanced excimer laser-based platform for use in the treatment of vascular and dermatological immune-mediated inflammatory diseases. We believe our products enhance patients’ quality of life by restoring blood-flow in arteries and clearing chronic skin conditions. Following the temporary placement period for DABRA and once our customers decide to continue using DABRA in their facilities, we typically enter into DABRA laser commercial usage agreements or DABRA laser placement acknowledgements with each customer, which we refer to collectively as Usage Agreements. The terms of the Usage Agreements vary by customer, but each Usage Agreement provides for the specific terms of continued use of DABRA, including periodic maintenance fees and do not provide for a minimum purchase obligation. As of December 31, 2018, we had 53 lasers at customer sites under signed Usage Agreements with varying volumes of purchases. DABRA is cleared by the U.S. Food and Drug Administration, or FDA, as a device for crossing chronic total occlusions, or CTOs, in patients with symptomatic infrainguinal lower extremity vascular disease and with an intended use for ablating a channel in occlusive peripheral vascular disease. DABRA is used as a tool in the treatment of peripheral artery disease, or PAD, a form of peripheral vascular disease, which commonly occurs in the legs. These procedures are typically referred to in the medical community as atherectomy procedures, which the medical community commonly defines as any removal by surgery or specialized catheterization of an atheroma, or blockage, in an artery. Even though the medical community refers to it as atherectomy, DABRA is not currently cleared by the FDA for atherectomy. Nevertheless, third-party health payers can reimburse a procedure performed by a device which is not cleared or approved for a specific indication or procedure, if the physician determines the device and procedure are medically appropriate for a particular patient. Payers and the medical community can take a broader view than FDA in recognizing the scope of appropriate device use. In order to address this perceived uncertainty regarding reimbursement, we currently are pursuing expanded indications for use for DABRA to include an atherectomy indication for use, which the FDA currently defines to include a prespecified improvement in luminal patency, or a prespecified increase in the openness of the artery at a pre-defined time point, and an indication for use for the treatment of in-stent restenosis. To satisfy the FDA’s data requirements to support an atherectomy indication, we plan to perform a new study designed to allow the FDA to evaluate the DABRA atherectomy procedure. The first subject is projected to be enrolled and treated in the second quarter of 2019, and we expect to have final results of the trial in the first quarter of 2020. We believe the incremental cost of obtaining the atherectomy indication will not be material. In the fourth quarter of 2018, we announced the prospective long-term revascularization study of DABRA titled REvascularization RateS and Clinical OUtcomes with DABRA Laser. A Long-Term 2-year Study (RESULTS). This registry is being conducted to measure the benefit and the safety profile of DABRA over a longer time frame (two years) than our pivotal trial, which had a 180 day follow up. We have case reports of patients with extended freedom from restenosis even out to over four years, which prompted us to study longer-term outcomes more closely. We intend to provide updates on a periodic basis throughout the study. In addition, we intend to pursue additional uses for DABRA, including seeking regulatory clearance or approval for the use of DABRA as a tool for the treatment of vascular blockages associated with coronary artery disease, or CAD, in-stent restenosis, and other venous and arterial occlusions, or blockages in the veins or arteries. However, there can be no assurance that DABRA will receive the necessary clearances for these additional indications. The DABRA laser system is based on the same core technology and utilizes a similar excimer laser as Pharos, a medical device that we have marketed as a tool for the treatment of proliferative skin conditions since October 2004. Pharos is designed for use in the treatment of inflammatory skin conditions and is FDA cleared as a tool used in the treatment of psoriasis, vitiligo, atopic dermatitis, and leukoderma. Because DABRA and Pharos are both based on our core excimer laser technology platform and deploy similar mechanisms of action, we benefit from economies of scale in product development, manufacturing, quality assurance and distribution. DABRA is our minimally-invasive excimer laser and single-use catheter system that is used by physicians as a tool in the endovascular treatment of vascular blockages resulting from lower extremity vascular disease, a form of PAD, both above- and below-the-knee, by breaking down plaque to its fundamental chemistry, such as proteins, lipids and other chemical compounds, eliminating blockages by essentially dissolving them without generating potentially harmful particulates. The accumulation of plaque in arteries, which is a result of lower extremity vascular disease, most commonly occurs in the pelvis and legs. Plaque accumulation, known as atherosclerosis, causes the narrowing of arteries, thereby reducing the flow of oxygenated blood to tissue and organs. If vascular blockages are left untreated, they can increase the risk of heart attack, stroke, amputation or death. Major risk factors for PAD include age, smoking, diabetes and obesity. Despite its prevalence, PAD is underdiagnosed and undertreated relative to many other serious vascular conditions, including CAD, in part because up to half of the PAD population is asymptomatic, or shows no symptoms, and many dismiss symptoms as normal signs of aging. Recent analysis suggests that approximately 17.6 million people in the U.S. suffer from PAD. However, only 20-30% of PAD patients are actively being treated. We anticipate revenue from this recently commercialized business segment to grow over time. Our sales strategy includes either selling the DABRA laser with a transfer in title or placing it in high-volume practices for a nominal periodic fee while we retain title. We sell extended warranties for our lasers that have been purchased. Each vascular procedure requires the one-time use of our proprietary catheters which we expect to be the primary source of revenue for the vascular segment. Therefore, under both the sale and periodic fee options, we anticipate recurring revenue in catheter sales for each laser in operation. We currently use our internal sales force to target the U.S. market and we utilize distributors outside the U.S. Pharos is our excimer laser device that emits highly concentrated ultraviolet light and is used as a tool in the treatment of dermatological skin disorders. Physicians use Pharos by applying 308 nanometer ultraviolet light to the skin. The FDA has granted 510(k) clearance to market Pharos in the U.S. for psoriasis, vitiligo, atopic dermatitis, and leukoderma. Pharos was granted CE mark approval in September of 2016 for use in the treatment of psoriasis, vitiligo, atopic dermatitis and leukoderma by the application of UVB ultraviolet light. We have also received clearance to market Pharos from the China Food and Drug Administration, or CFDA, and South Korea Ministry of Drug Safety (now called the Ministry of Food and Drug Safety, or MDFS), in the applicable jurisdictions. Pharos was commercialized in 2004 and we have shipped over 1,000 systems to customers globally through December 31, 2018. Pharos is in use in nearly every U.S. state and in over 20 markets including several non-U.S. countries. While we have entered into periodic fee arrangements, our primary strategy is to sell Pharos. We recognize additional recurring revenue from the sale of extended warranties for Pharos. We do not anticipate significant organic revenue growth in the near term from this mature product line. We incurred net losses of $30.8 million and $17.8 million for the years ended December 31, 2018 and December 31, 2017, respectively, and had an accumulated deficit of $60.2 million as of December 31, 2018. As of December 31, 2018, we had available cash and cash equivalents of approximately $64.3 million and had current liabilities of approximately $6.0 million and long-term liabilities of approximately $1.4 million. As of December 31, 2018, our liabilities included equipment financings of $0.9 million. Since inception, we have financed our operations primarily through sales of our products and services, the net proceeds from our initial public offering, and, to a lesser extent, private placements of our common stock and debt financing arrangements. We expect to continue to incur net losses for the near term as we commercialize our products in the U.S., including building our sales and marketing organization and expanding our manufacturing facilities, continuing research and development efforts, and seeking regulatory clearance for new products and product enhancements, including new indications, both in the U.S. and in select non-U.S. markets. We may need additional funding to pay expenses relating to our operating activities, including selling, general and administrative expenses and research and development expenses. If needed, adequate funding may not be available to us on commercially 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, financial condition, and results of operations. Recent Developments We experienced issues that had an impact on our fourth quarter revenue and into the first quarter of 2019. In particular, the hiring and training of qualified sales personnel was dependent on the onboarding of our Chief Commercial Officer, who joined in December 2018, and we also found that we needed a more robust training program for our newly hired sales personnel. In addition, we experienced production limitations in our manufacturing process as we scaled up catheter production. These production limitations affected the number of evaluation cases performed during the fourth quarter of 2018 and into the first quarter of 2019. We made changes in our production flow and we are now in the final stages of validating our manufacturing process. In addition, our Chief Commercial Officer implemented a new training program during the first quarter of 2019. Initial Public Offering On October 1, 2018, we closed on our initial public offering, or IPO, of 4,485,000 shares of common stock at an offering price of $17.00 per share, which included the full exercise of the underwriters’ option to purchase 585,000 additional shares of our common stock. We raised a total of $76.2 million in gross proceeds from the IPO, or approximately $67.3 million in net proceeds after deducting underwriting discount and commissions of $5.3 million and offering costs of $3.6 million. Our registration statement on Form S-1 relating to our IPO was declared effective by the Securities and Exchange Commission on September 26, 2018. Components of our Results of Operations Net revenue Product sales consist of the sale of DABRA and Pharos lasers, the sale of catheters for use with the DABRA laser and the sale of consumables and replacement parts. Service and other revenue consists primarily of sales of extended warranties, which we recognize over the contract period and billable services, including repair activity, which is recognized when the service is provided. It also includes income from the rental of our lasers. We currently use our internal sales force to target the U.S. market, and we utilize distributors outside the U.S. in markets where we have received regulatory approval. We expect to continue to seek regulatory approvals for our products in additional strategic markets. Cost of revenue and gross margin Cost of revenue for product sales consists primarily of costs of components for use in our products, the materials and labor that are used to produce our products, and the manufacturing overhead that directly support production. Cost of revenue for service and other includes the cost of maintaining and servicing the warranties on our products. We expect cost of revenue to increase to the extent our total revenue grows. We calculate gross margin as gross profit divided by total net revenue. Our gross margin has been and will continue to be affected by a variety of factors, primarily production volumes, the cost of direct materials, discounting practices, manufacturing costs, product yields, headcount and cost-reduction strategies. We expect our gross margin to increase over the long term as our production volume increases and certain costs remain fixed or increase at a slower rate. We intend to use our design, engineering and manufacturing capabilities to further advance and improve the efficiency of our manufacturing processes, which we believe will reduce costs and increase our gross margin. While we expect gross margin to increase over the long term as our production volume increases, it will likely fluctuate from quarter to quarter as we continue to introduce new products and adopt new manufacturing processes and technologies. Research and development expenses Research and development, or R&D, expenses consist of applicable personnel, consulting, materials and clinical trial expenses. R&D expenses include: • certain employee-related expenses, including salaries, benefits, travel expense and stock-based compensation expense; • cost of outside consultants who assist with technology development and clinical affairs; • cost of clinical studies to support new products and product enhancements, including expanded indications; and • supplies used for internal research and development and clinical activities. We expense R&D costs as incurred. In the future, we expect R&D expenses to increase as we continue to develop new products, enhance existing products and technologies and perform activities related to obtaining additional regulatory approval. However, we expect R&D expenses as a percentage of total revenue to vary over time depending on the level and timing of our new product development efforts, as well as our clinical development, clinical trials and studies and other related activities. Selling, general and administrative expenses Selling, general and administrative, or SG&A, expenses consist of employee-related expenses, including salaries, benefits, travel expense, sales commissions and stock-based compensation expense. Other SG&A expenses include promotional activities, marketing, conferences and trade shows, professional services fees, including legal, audit and tax fees, insurance costs, general corporate expenses, allocated facilities-related expenses and shipping and handling costs. We expect to continue to grow our sales force and increase marketing efforts as we continue commercializing DABRA in both domestic and international markets. We also expect increased costs due to the additional legal, accounting, insurance and other expenses associated with becoming a public company. Results of Operations Comparison of the Years Ended December 31, 2018 and 2017 The following table shows our results of operations for the years ended December 31, 2018, and 2017 (in thousands): Comparison of years ended December 31, 2018, and 2017-By reportable segments We organize our business into two operating segments based on the product specialties: the vascular segment and the dermatology segment. In deciding how to allocate resources and assess performance, we regularly evaluate the net revenue and gross profit of these segments. Amounts included within selling, general and administrative expense and research and development expense are general to us and not specific to a particular segment; therefore, these amounts are not evaluated by us on a segmented basis. Additional information on our reportable segments is contained in Note 13 to the financial statements appearing elsewhere in this Annual Report on Form 10-K. Net revenue The following table shows our net revenue from our two segments for the years ended December 31, 2018, and 2017 (in thousands): Vascular Net revenue was $1.6 million and $0.3 million for the years ended December 31, 2018 and 2017, respectively. The increase of approximately $1.3 million was primarily due to increased catheter sales following the completion of our initial 12-month commercial launch in June 2018. There were nominal sales during our initial commercial launch following FDA clearance of our DABRA system in May 2017 in the prior year. We expect our vascular revenue to increase over time as our growing sales force and marketing efforts establish a larger base of customers who regularly use the DABRA system. Dermatology Net revenue was $4.7 million and $5.6 million for the years ended December 31, 2018 and 2017, respectively. The decrease of approximately $0.9 million was due primarily to a decrease in direct unit product sales as a result of diverting some of our sales resources in 2018 to commercializing the DABRA system, aggregated in our vascular segment, partially offset by an increase of $0.3 million in revenue from service contracts on our dermatology lasers. Cost of revenue The following table shows our cost of revenue from our two segments for the years ended December 31, 2018 and 2017, (in thousands): Vascular Cost of revenue was $1.5 million and $0.2 million for the years ended December 31, 2018 and 2017. The $1.3 million increase was primarily due to increased labor, material and overhead costs to support the increased sales efforts of our vascular products, which increased following the completion of our initial 12-month commercial launch in June 2018. Dermatology Cost of revenue was $2.7 million and $4.0 million for the years ended December 31, 2018 and 2017, respectively. The decrease of $1.3 million was primarily due to fewer units manufactured as a result of lower sales and lower costs of the units that were manufactured due to efficiencies derived from the increase in total lasers manufactured, which included lasers manufactured to support the vascular segment. Gross profit The following table shows our gross profit from our two segments for the years ended December 31, 2018, and 2017 (in thousands): Vascular Gross profit was $31,000 for the year ended December 31, 2018 and $66,000 for the year ended December 31, 2017, respectively. Compared to the year ended December 31, 2017, the year ended December 31, 2018 included increased costs to scale up our manufacturing capacity following the completion of our initial 12-month commercial launch period in June 2018 compared to nominal catheter sales during our initial commercial launch in the same period in the prior year. We expect our gross profit to improve over time as our growing sales force and marketing efforts establish a larger customer base and our manufacturing volume increases. Dermatology Gross profit was $2.0 million and $1.6 million for the years ended December 31, 2018 and 2017, respectively. The increase of $0.4 million was primarily due to efficiencies derived from the increase in total lasers manufactured, which included lasers manufactured to support the vascular segment. Comparison of years ended December 31, 2018, and 2017-General Selling, general and administrative expenses. SG&A expenses were $30.4 million and $14.9 million for the years ended December 31, 2018 and 2017, respectively. The $15.5 million increase was related to increases of (i) $6.2 million in salary, benefits, recruiting expenses and other personnel-related costs due to expanding our sales force and hiring administrative staff to operate as a public company, (ii) $3.2 million in stock-based compensation expense primarily due to the modification accounting treatment of replacement awards and new grants, (iii) $2.1 million in legal and consulting fees to operate as a public company, (iv) $1.5 million in travel and trade shows, (v) $0.7 million in marketing and advertising costs, (vi) $0.6 million in sales training related costs (vii) $0.6 million in insurance due to being publicly traded, (viii) $0.3 million in shipping costs due to increased volume from the vascular product offering and (ix) $0.3 million in various other administrative costs. Notes 2 and 10 to the financial statements appearing elsewhere in this Annual Report on Form 10-K more fully describe the accounting treatment for stock-based compensation awards. Research and development expenses. R&D expenses were $2.8 million and $4.5 million for the years ended December 31, 2018 and 2017, respectively. The $1.7 million decrease was primarily due to a decrease of $1.3 million in stock-based compensation expense, primarily due to the impact of larger stock price increases in the prior year on share-based awards that were revalued at each reporting period, $0.4 million less in resources devoted to catheter research and development in 2018 as a result of the completion of our initial commercial product development in 2017. Notes 2 and 10 to the financial statements appearing elsewhere in this Annual Report on Form 10-K more fully describe the accounting treatment for stock-based compensation awards. Other income (expense), net. Other income, net was $0.3 million for the year ended December 31, 2018 and other expense was $4,000 for the year ended December 31, 2017. In 2018, other income was primarily comprised of interest income on the net proceeds from the IPO that were received in October 2018. In 2017, other expense related to interest expense on equipment financing. Non-GAAP Measures EBITDA and Adjusted EBITDA are performance measures that provide supplemental information we believe is useful to analysts and investors to evaluate our ongoing results of operations, when considered alongside other GAAP measures. These Non-GAAP Measures exclude the financial impact of items management does not consider in assessing our ongoing operating performance, and thereby facilitate review of our operating performance on a period-to-period basis. Comparability to our results of operations to other companies may be impacted by our stock-based compensation which was classified as a liability and revalued at each reporting period with the change in fair value recorded to compensation expense in the statement of operations. We believe that non-GAAP financial information, when taken collectively, may be helpful to investors because it provides consistency and comparability with past financial performance. However, non-GAAP financial information is presented for supplemental informational purposes only, has limitations as an analytical tool and should not be considered in isolation or as a substitute for financial information presented in accordance with U.S. GAAP. Some of these limitations are that: • EBITDA excludes certain recurring, non-cash charges such as depreciation of fixed assets, although these are non-cash charges, the assets being depreciated may have to be replaced in the future; and • Adjusted EBITDA further excludes stock-based compensation expense, which has been, and will continue to be for the foreseeable future, a significant recurring expense in our business and an important part of our compensation strategy. In addition, other companies, including companies in our industry, may calculate similarly-titled non-GAAP measures differently or may use other measures to evaluate their performance, all of which could reduce the usefulness of our non-GAAP financial measures as tools for comparison. A reconciliation for each non-GAAP financial measure to the most directly comparable financial measure stated in accordance with U.S. GAAP is included below. Investors are encouraged to review the related GAAP financial measures and the reconciliation of these non-GAAP financial measures to their most directly comparable GAAP financial measures, and not to rely on any single financial measure to evaluate our business. We define Adjusted EBITDA as our GAAP net loss as adjusted to exclude depreciation, interest income, interest expense, income tax expense and stock-based compensation. The following is a reconciliation of Net loss to Adjusted EBITDA: Adjusted EBITDA was negative $15.8 million compared to negative $4.8 million for the years ended December 31, 2018 and 2017, respectively. The decrease in Adjusted EBITDA primarily reflects higher selling, general and administrative costs, including salary, benefits, recruiting expenses, legal fees and consulting costs due to increased personnel, costs associated with increasing the sales force, and the costs of preparing for and operating as a public company. Liquidity and Capital Resources As of December 31, 2018, we had cash and cash equivalents of $64.3 million and an accumulated deficit of $60.2 million. Our primary sources of capital have been from the sale of our products and services, the net proceeds from our initial public offering, and, to a lesser extent, private placements of common stock and debt financing arrangements. In the year ended December 31, 2018, we raised an aggregate of $7.9 million in proceeds from private placements of our common stock. On October 1, 2018, we completed our initial public offering, including the underwriters full exercise of their over-allotment option, selling 4,485,000 shares of our common stock at $17.00 per share. Net proceeds from our initial public offering were $67.3 million, after deducting underwriting discounts and commissions and offering expenses. We believe that our cash and cash equivalents as of December 31, 2018 will be sufficient to fund our operations for at least the next 12 months. As we continue to commercialize DABRA, we expect our costs to increase in the future as we continue the development of a direct sales force, the expansion of our manufacturing facilities, and as we continue to make substantial expenditures on research and development, including the costs of any current and future clinical studies. Additionally, we are incurring additional costs as a result of operating as a public company. Our future capital requirements will depend on many factors, including: • the revenue generated by sales of our DABRA and Pharos products, related consumables, and other products that may be approved in the U.S. and select non-U.S. markets; • the costs of expanding our U.S. and international sales and marketing infrastructure and our manufacturing operations; • the extent to which our products are adopted by the physician community; • the ability of our customers to obtain adequate reimbursement from third-party payors for procedures performed using DABRA; • the degree of success we experience in commercializing our excimer lasers and related consumables; • the costs, timing and outcomes of any future clinical studies and regulatory reviews, including to seek and obtain approvals for new indications for our products; • the costs and timing of developing variations of our excimer lasers, and, if necessary, obtaining FDA clearance to market such variations; • the emergence of competing or complementary technologies; • the number and types of future products we develop and commercialize; • the cost, timing and outcomes of any litigation involving our company, products, and business activities; • the costs of preparing, filing and prosecuting patent applications and maintaining, enforcing and defending intellectual property-related claims; and • the level of our selling, general and administrative expenses. Cash Flows Net cash used in operating activities During the year ended December 31, 2018, net cash used in operating activities was $18.5 million, consisting primarily of a net loss of $30.8 million and an increase in net operating assets of $3.3 million primarily related to decreases in accounts receivables, accrued expenses and inventories partially offset by increases in accounts payable. These items were partially offset by non-cash charges of $15.6 million consisting of depreciation, stock-based compensation expense and provision for doubtful accounts. During the year ended December 31, 2017, net cash used in operating activities was $5.5 million, consisting primarily of a net loss of $17.8 million and an increase in net operating assets of $0.8 million, primarily related to decreases in accounts receivable, inventory and deferred revenue. These items were partially offset by non- cash charges of $13.1 million, consisting of depreciation, stock-based compensation expense, common stock issued in exchange for services and a loss on disposal of property and equipment. Net cash used in investing activities During the year ended December 31, 2018, net cash used in investing activities was $0.6 million consisting primarily of purchases of manufacturing equipment and computer hardware and software. During the year ended December 31, 2017, net cash used in investing activities was $0.5 million consisting primarily of purchases of manufacturing equipment. Net cash provided by financing activities During the year ended December 31, 2018, net cash provided by financing activities was $75.2 million, consisting primarily of net proceeds of $67.3 million from the issuance of common stock related to our IPO and $7.9 million received from the issuance of common stock related to a private placement financing, partially offset by payments of $0.1 million in equipment financing payments. During the year ended December 31, 2017, net cash provided by financing activities was $10.4 million from the issuance of common stock related to a private placement financing. Off-Balance Sheet Arrangements We do not engage in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, as a part of our ongoing business. Accordingly, we did not have any off-balance sheet arrangements during any of the periods presented. Contractual Obligations Our principal obligations consist of the operating leases for our facilities. The following table sets out, as of December 31, 2018, our contractual obligations due by period: (1) Consists of obligations under multi-year, non-cancelable building leases for our facilities in Carlsbad, California. (2) Consists primarily of obligations under the equipment financing for automobiles. 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 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. We have previously identified a material weakness in our internal control over financial reporting. For additional information, see the risk factor in Item 1A entitled “Failure to maintain effective internal controls could cause our investors to lose confidence in us and adversely affect the market price of our common stock. If our internal controls are not effective, we may not be able to accurately report our financial results or prevent fraud.” Revenue recognition Product Sales We recognize revenue from product sales when the following four criteria have been met: (i) the product has been shipped or services have been performed and we have no significant remaining obligations; (ii) persuasive evidence of an arrangement exists; (iii) the price to the buyer is fixed or determinable; and (iv) collection is reasonably assured. Revenues from product sales are recorded net of cash discounts. None of our sales contain right-of-return provisions and we have historically only experienced nominal returns. We also offer certain cash discounts associated with the sales of our products. These discounts are negotiated on a transaction by transaction basis and therefore do not include any estimate at the time of sale. The discounts are recorded as a reduction to accounts receivable and product sales. For shipment of our products, we take into account the time at which to recognize revenue, generally this is when title and risk of loss is transferred. Multiple Element Arrangements We regularly enter into contracts where revenue is derived from multiple deliverables, including products or services. These contracts typically include a device and extended service contracts. Revenue recognition for contracts with multiple deliverables is based on the individual units of accounting determined to exist in the contract. A delivered item is considered a separate unit of accounting when the delivered item has value to the customer on a stand-alone basis. Items are considered to have stand-alone value when they are sold separately by any vendor or when the customer could resell the item on a stand-alone basis. Arrangement consideration is then allocated to those separate units of account based on their relative selling price. When applying the relative selling price method, the selling price for each deliverable is determined using the following hierarchy: (i) vendor-specific objective evidence, or VSOE, of the selling price; (ii) third-party evidence of selling price; or (iii) best estimated selling price. We record revenue related to these multiple deliverables as products are delivered and services are performed. In order to establish VSOE of selling price, we must regularly sell the product or service on a standalone basis with a substantial majority priced within a relatively narrow range. In cases where there are not a sufficient number of standalone sales and VSOE of selling price cannot be determined, then we utilize third-party evidence of selling price, if available, or best estimated selling price, or BESP. We determine BESP for an individual element based on our average selling price of that discrete element during the annual period, excluding transactions that are not representative of standalone sales. We regularly review and maintain our BESP and update these estimates at least annually. Billable Service Arrangements Revenue from billable services, including repair activity, is recognized when the service is provided. Extended Warranty Arrangements Revenues received with respect to extended warranties on products are recognized over the duration of the extended warranty period on a straight-line basis. Lease Arrangements We also derive revenue pursuant to product lease agreements. These leases are classified as operating leases in accordance with the relevant accounting guidelines, and the related revenue is recognized on a straight-line basis. Distributor Transactions In certain markets, we sell products and provide services to customers through distributors that specialize in medical device products. In cases where the product is delivered to a distributor, revenue recognition generally occurs when title transfers to the distributor. The terms of sales transactions through distributors are generally consistent with the terms of direct sales to customers. These transactions are accounted for in accordance with our revenue recognition policy described herein. Stock-based compensation We evaluate whether an award should be classified and accounted for as a liability award or equity award for all stock-based compensation awards granted. Stock-based compensation for liability awards issued to employees, directors, consultants, and other service providers is measured based on fair value of the award using the Black Scholes option pricing model. Changes in the fair value of a liability incurred under a share-based payment arrangement that occur during the requisite service period are recognized as compensation cost over that period. The percentage of the fair value that is accrued as compensation cost at the end of each period is equal to the percentage of the requisite service that has been rendered at that date. Any difference between the amount for which a liability award is settled and its fair value at the settlement date is recorded as an adjustment to compensation cost in the period of settlement. There were no liability awards outstanding at December 31, 2018. Stock-based compensation expense for equity instruments issued to employees and directors is measured based on estimating the fair value of each stock option on the date of grant using the Black Scholes option pricing model. Equity instruments issued to nonemployee consultants and service providers are valued using the Black Scholes option pricing model and are subject to revaluation as the underlying equity instruments vest. We recognize stock-based compensation expense as follows: Employees Nonemployees Service condition only Straight-line Re-value through the performance commitment date Performance criterion is probable of being met: Service criterion is complete Recognize the grant date fair value of the award once the performance criterion is considered probable of occurrence Re-value the award once the performance criterion is considered probable of occurrence and recognize expense for the then fair value of the award Service criterion is not complete Straight-line Straight-line, except the award is re-valued through the performance commitment date Performance criterion is not probable of being met No expense is recognized until the performance criterion is considered probable, at which point expense is recognized per above No expense is recognized until the performance criterion is considered probable, at which point expense is recognized per above As of December 31, 2017, all stock-based compensation awards were classified as liabilities in the financial statements which were revalued at each reporting period with the change in fair value recorded to compensation expense. The fair value of the stock-based compensation liability was estimated using the Black Scholes option pricing model and the assumptions used in the model are noted below: • Fair value of our common stock-Our shares were not traded in any public market. The common stock value as of the date of grant was based on the share price of recent equity issuances, if available. If there were no such recent transactions, our share valuation was estimated using both the income and market approaches, which were weighted 50% each. A discount of 35% was then applied for lack of marketability for our common stock. As of the reporting date for each period presented, the dates at which the stock-based compensation liability was remeasured at fair value, the common stock price was based on the recent equity issuances with new third party investors who were not previous shareholders of Ra Medical. • Risk-free interest rate-The risk-free interest rate approximated the implied yield available on United States Treasury securities with an equivalent remaining term. • Volatility-Expected volatility was based on the historical volatilities of certain “guideline” companies. • Expected dividend yield-Expected dividend yield was based on dividends historically paid by us. • Expected life-The expected life was based on the “simplified” method using the average of the term and vesting period. As described in Note 10 of the financial statements, on June 4, 2018, our board of directors authorized replacement equity awards of stock options and, effective June 8, 2018, restricted stock units, or collectively, the Replacement Awards. The issuance of the Replacement Awards and cancellation of the stock-based compensation awards classified as liabilities was treated as a modification. As of the date of the modification, which resulted in the settlement of the stock-based compensation liability, the fair value of the stock-based compensation liability was estimated using the Black Scholes option pricing model and the assumptions used in the model are noted below: • Fair value of our common stock-The common stock price was estimated utilizing a hybrid method, a combination of the Probability Weighted Expected Return Method, or PWERM, and Option Pricing Model, or OPM. The estimate incorporated a near-term IPO scenario using PWERM weighted at 80%. Other near-term exit events, a long-term stay private case, and dissolution were all considered as non-IPO scenarios using OPM, and were weighted at 20%. The estimate also reflected a 10% and 15% discount for lack of marketability under PWERM and OPM, respectively. • Risk-free interest rate-The risk-free interest rate approximated the implied yield available on United States Treasury securities with an equivalent remaining term. • Volatility-Expected volatility was based on the historical volatilities of certain “guideline” companies. • Expected dividend yield-Expected dividend yield was based on dividends historically paid by us. • Expected life-The expected life was based on the “simplified” method using the average of the term and vesting period. For stock awards following our initial public offering, our board of directors determined 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. If factors change and we employ different assumptions, stock-based compensation expense may differ significantly from what we have recorded in the past. If there are any modifications or cancellations of the underlying unvested securities, we may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense. To the extent that our assumptions are incorrect, the amount of stock-based compensation recorded will change. Income taxes We account for income taxes using the asset and liability method. Under this method, deferred tax assets and liabilities are determined based on differences between the financial reporting and tax basis of assets and liabilities and are measured using enacted tax rates and laws that are expected to be in effect when the differences reverse. Any resulting net deferred tax assets are evaluated for recoverability and, accordingly, a valuation allowance is provided when it is more likely than not that all or some portion of the deferred tax asset will not be realized. The Company accounts for uncertainty in income taxes using a two-step approach to recognizing and measuring uncertain tax positions. The first step is to evaluate the tax position for recognition by determining whether it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount that is more than 50% likely of being realized upon ultimate settlement. An uncertain tax position is considered effectively settled on completion of an examination by a taxing authority if certain other conditions are satisfied. Should the Company incur interest and penalties relating to tax uncertainties, such amounts would be classified as a component of interest expense and other expense, respectively. Jobs Act Accounting Election In April 2012, the 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 to avail ourselves of this exemption and, therefore, we are not subject to the same new or revised accounting standards as other public companies that are not emerging growth companies. 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. See Note 2 to the financial statements included elsewhere in this Annual Report on Form 10-K for a description of relevant new accounting pronouncements.
-0.431787
-0.43166
0
<s>[INST] Investing in our common stock involves a high degree of risk. You should carefully consider the risks and uncertainties described below, together with all of the other information in this Annual Report on Form 10K, before making an investment decision. The risks and uncertainties described below may not be the only ones we face. If any of the risks actually occur, our business, financial condition, operating results, cash flows and prospects could be materially and adversely affected. In that event, the market price of our common stock could decline, and you could lose part or all of your investment. Overview We are a commercialstage medical device company leveraging our advanced excimer laserbased platform for use in the treatment of vascular and dermatological immunemediated inflammatory diseases. We believe our products enhance patients’ quality of life by restoring bloodflow in arteries and clearing chronic skin conditions. Following the temporary placement period for DABRA and once our customers decide to continue using DABRA in their facilities, we typically enter into DABRA laser commercial usage agreements or DABRA laser placement acknowledgements with each customer, which we refer to collectively as Usage Agreements. The terms of the Usage Agreements vary by customer, but each Usage Agreement provides for the specific terms of continued use of DABRA, including periodic maintenance fees and do not provide for a minimum purchase obligation. As of December 31, 2018, we had 53 lasers at customer sites under signed Usage Agreements with varying volumes of purchases. DABRA is cleared by the U.S. Food and Drug Administration, or FDA, as a device for crossing chronic total occlusions, or CTOs, in patients with symptomatic infrainguinal lower extremity vascular disease and with an intended use for ablating a channel in occlusive peripheral vascular disease. DABRA is used as a tool in the treatment of peripheral artery disease, or PAD, a form of peripheral vascular disease, which commonly occurs in the legs. These procedures are typically referred to in the medical community as atherectomy procedures, which the medical community commonly defines as any removal by surgery or specialized catheterization of an atheroma, or blockage, in an artery. Even though the medical community refers to it as atherectomy, DABRA is not currently cleared by the FDA for atherectomy. Nevertheless, thirdparty health payers can reimburse a procedure performed by a device which is not cleared or approved for a specific indication or procedure, if the physician determines the device and procedure are medically appropriate for a particular patient. Payers and the medical community can take a broader view than FDA in recognizing the scope of appropriate device use. In order to address this perceived uncertainty regarding reimbursement, we currently are pursuing expanded indications for use for DABRA to include an atherectomy indication for use, which the FDA currently defines to include a prespecified improvement in luminal patency, or a prespecified increase in the openness of the artery at a predefined time point, and an indication for use for the treatment of instent restenosis. To satisfy the FDA’s data requirements to support an atherectomy indication, we plan to perform a new study designed to allow the FDA to evaluate the DABRA atherectomy procedure. The first subject is projected to be enrolled and treated in the second quarter of 2019, and we expect to have final results of the trial in the first quarter of 2020. We believe the incremental cost of obtaining the atherectomy indication will not be material. In the fourth quarter of 2018, we announced the prospective longterm revascularization study of DABRA titled REvascularization RateS and Clinical OUtcomes with DABRA Laser. A LongTerm 2year Study (RESULTS). This registry is being conducted to measure the benefit and the safety profile of DABRA over a longer time frame (two years) than our pivotal trial, which had a 180 day follow up. We have case reports of patients with extended freedom from restenosis even out to over four years, which prompted us to study longerterm outcomes more closely. We intend to provide updates on a periodic basis throughout the study. In addition, we intend to pursue additional uses for D [/INST] Negative. </s>
2,019
7,054
1,716,621
Ra Medical Systems, Inc.
2020-03-11
2019-12-31
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Investing in our common stock involves a high degree of risk. You should carefully consider the risks and uncertainties described below, together with all of the other information in this Annual Report on Form 10-K, before making an investment decision. The risks and uncertainties described below may not be the only ones we face. If any of the risks actually occur, our business, financial condition, operating results, cash flows and prospects could be materially and adversely affected. In that event, the market price of our common stock could decline, and you could lose part or all of your investment. Overview We are a commercial-stage medical device company leveraging our advanced excimer laser-based platform for use in the treatment of vascular and dermatological immune-mediated inflammatory diseases. We believe our products enhance patients’ quality of life by restoring blood-flow in arteries and clearing chronic skin conditions. The DABRA laser system and single-use catheter, together referred to as DABRA, is cleared by the U.S. Food and Drug Administration, or FDA, as a device for crossing chronic total occlusions, or CTOs, in patients with symptomatic infrainguinal lower extremity vascular disease and with an intended use for ablating a channel in occlusive peripheral vascular disease. DABRA is used as a tool in the treatment of peripheral artery disease, or PAD, a form of peripheral vascular disease, which commonly occurs in the legs. We currently are pursuing an atherectomy indication for use, which the FDA currently defines to include a prespecified improvement in luminal patency, or a prespecified increase in the openness of the artery at a pre-defined time point. To satisfy the FDA’s data requirements to support an atherectomy indication, we are performing a pivotal study designed to allow the FDA to evaluate the DABRA atherectomy procedure. We received final IDE approval in January 2020 and enrolled the first patient in the study in February 2020. In the fourth quarter of 2018 and into 2019, we experienced inconsistencies in our DABRA catheter performance. After collecting field data and performing internal testing, we observed that while catheters can perform satisfactorily up to one year, catheters that were more than two months from sterilization, had a significantly higher rate of non-calibration than catheters that were within two months from sterilization. As a result, in September 2019, we initiated a voluntary recall of our catheters to replace 12-month shelf life labeled catheters with two-month shelf life labeled catheters. In addition, in the third quarter of 2019 we implemented certain operational efficiency and cost-savings initiatives intended to align our resources with our product strategy, reduce our operating expenses, and manage our cash flows. These cost efficiency initiatives included targeted workforce reductions of our sales and marketing teams. We reduced the size of our DABRA sales force from 34 employees as of June 30, 2019 to five clinical specialists as of December 31, 2019. In the near term, we are focusing on servicing core accounts while we prioritize remedying the inconsistencies in our DABRA catheter performance. We are encouraged by the results, as we have seen significant decreases in the rates of non-calibrations following the voluntary recall. Our business strategy is focused on continuing to service our core accounts while we complete initiatives that are key to relaunching DABRA to the broader market. Key components of our DABRA relaunch strategy include: • A longer shelf life; • A braided overjacket designed to reduce kinking, and that will also allow the physician to apply more pressure when advancing the DABRA catheter; • A rapid exchange designed to allow physicians to use more standard techniques, including a guidewire, to navigate the vasculature more easily; and • An atherectomy indication for use. As these initiatives are at or near completion, we intend to begin expanding our sales force to prepare for a commercial relaunch. In the future, we may pursue additional uses for DABRA, including seeking regulatory clearance or approval for the use of DABRA as a tool for the treatment of vascular blockages associated with coronary artery disease, or CAD, in-stent restenosis, and other vascular-related indications. However, there can be no assurance that DABRA will receive the necessary clearances for these additional indications. The DABRA laser system is based on the same core technology and utilizes a similar excimer laser as Pharos, a medical device that we have marketed as a tool for the treatment of proliferative skin conditions since October 2004. Pharos is designed for use in the treatment of inflammatory skin conditions and is FDA cleared as a tool used in the treatment of psoriasis, vitiligo, atopic dermatitis, and leukoderma. Because DABRA and Pharos are both based on our core excimer laser technology platform and deploy similar mechanisms of action, we benefit from economies of scale in product development, manufacturing, quality assurance and distribution. DABRA is our minimally-invasive excimer laser and single-use catheter system that is used by physicians as a tool in the endovascular treatment of vascular blockages resulting from lower extremity vascular disease, a form of PAD, both above- and below-the-knee, by breaking down plaque to its fundamental chemistry, such as proteins, lipids and other chemical compounds, eliminating blockages by essentially dissolving them without generating potentially harmful particulates. The accumulation of plaque in arteries, which is a result of lower extremity vascular disease, most commonly occurs in the pelvis and legs. Plaque accumulation, known as atherosclerosis, causes the narrowing of arteries, thereby reducing the flow of oxygenated blood to tissue and organs. If vascular blockages are left untreated, they can increase the risk of heart attack, stroke, amputation or death. Major risk factors for PAD include age, smoking, diabetes and obesity. Despite its prevalence, PAD is underdiagnosed and undertreated relative to many other serious vascular conditions, including CAD, in part because up to half of the PAD population is asymptomatic, or shows no symptoms, and many dismiss symptoms as normal signs of aging. Recent analysis suggests that approximately 17.6 million people in the U.S. suffer from PAD. However, only 20-30% of PAD patients are actively being treated. We anticipate revenue from this recently commercialized business segment to grow over time. Our sales strategy includes either selling the DABRA laser with a transfer in title or placing it in high-volume practices for a nominal periodic fee while we retain title. We sell extended warranties for our lasers that have been purchased. Each vascular procedure requires the one-time use of our proprietary catheters which we expect to be the primary source of revenue for the vascular segment. Therefore, under both the sale and periodic fee options, we anticipate recurring revenue in catheter sales for each laser in operation. We currently use our internal sales force to target the U.S. market and we utilize distributors outside the U.S. Pharos is our excimer laser device that emits highly concentrated ultraviolet light and is used as a tool in the treatment of dermatological skin disorders. Physicians use Pharos by applying 308 nanometer ultraviolet light to the skin. The FDA has granted 510(k) clearance to market Pharos in the U.S. for psoriasis, vitiligo, atopic dermatitis, and leukoderma. Pharos was granted CE mark approval in Europe in September of 2016 for use in the treatment of psoriasis, vitiligo, atopic dermatitis and leukoderma by the application of UVB ultraviolet light. We have also received clearance to market Pharos from the China Food and Drug Administration, or CFDA. While we have entered into periodic fee arrangements, our primary strategy is to sell Pharos. We recognize additional recurring revenue from the sale of extended warranties for Pharos. We do not anticipate significant organic revenue growth in the near term from this mature product line. We incurred net losses of $57.0 million and $30.8 million for the years ended December 31, 2019 and December 31, 2018, respectively, and had an accumulated deficit of $117.2 million as of December 31, 2019. As of December 31, 2019, we had available cash and cash equivalents and short-term investments of approximately $30.6 million and had current liabilities of approximately $6.8 million and long-term liabilities of approximately $4.1 million, which includes operating lease liabilities relating to our building leases of $2.6 million and equipment financings of $0.3 million. Since inception, we have financed our operations primarily through sales of our products and services, the net proceeds from our initial public offering, and, to a lesser extent, private placements of our common stock and debt financing arrangements. We expect to continue to incur net losses for the near term as we commercialize our products in the U.S., including building our sales and marketing organization and expanding our manufacturing facilities, continuing research and development efforts, and seeking regulatory clearance for new products and product enhancements, including new indications, both in the U.S. and in select non-U.S. markets. We may need additional funding to pay expenses relating to our operating activities, including selling, general and administrative expenses and research and development expenses. If needed, adequate funding may not be available to us on commercially 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, financial condition, and results of operations. Initial Public Offering On October 1, 2018, we closed on our initial public offering, or IPO, of 4,485,000 shares of common stock at an offering price of $17.00 per share, which included the full exercise of the underwriters’ option to purchase 585,000 additional shares of our common stock. We raised a total of $76.2 million in gross proceeds from the IPO, or approximately $67.3 million in net proceeds after deducting underwriting discount and commissions of $5.3 million and offering costs of $3.6 million. Our registration statement on Form S-1 relating to our IPO was declared effective by the Securities and Exchange Commission on September 26, 2018. Components of our Results of Operations Net revenue Product sales consist of the sale of DABRA and Pharos lasers, the sale of catheters for use with the DABRA laser and the sale of consumables and replacement parts. Service and other revenue consists primarily of sales of extended warranties, which we recognize over the contract period and billable services, including repair activity, which is recognized when the service is provided. It also includes income from the rental of our lasers. We currently use our commercial team to service the U.S. market, and we utilize distributors outside the U.S. in markets where we have received regulatory approval. We expect to continue to seek regulatory approvals for our products in additional strategic markets. Cost of revenue and gross profit (loss) Cost of revenue for product sales consists primarily of costs of components for use in our products, the labor that are used to produce our products, and the manufacturing overhead that support production. Cost of revenue for service and other includes the cost of maintaining and servicing the warranties on our products, including the depreciation on lasers we own. We expect cost of revenue to increase to the extent our total revenue grows. We calculate gross profit (loss) as revenue less cost of revenue. Our gross profit (loss) has been and will continue to be affected by a variety of factors, primarily production volumes, the cost of direct materials, discounting practices, manufacturing costs, product yields, headcount and cost-reduction strategies. We expect our gross loss to reduce and become gross profit over the long term as our production volume increases and certain costs remain fixed or increase at a slower rate. We intend to use our design, engineering and manufacturing capabilities to further advance and improve the efficiency of our manufacturing processes, which we believe will reduce costs. While we expect gross profit (loss) to improve over the long term as our production volume increases, it will likely fluctuate from quarter to quarter as we continue to introduce new products and adopt new manufacturing processes and technologies. Research and development expenses Research and development, or R&D, expenses consist of applicable personnel, clinical trial expenses, materials and consulting. R&D expenses include: • certain employee-related expenses, including salaries, benefits, travel expense and stock-based compensation expense; • cost of clinical studies to support new products and product enhancements, including expanded indications; • supplies used for internal research and development and clinical activities; and • cost of outside consultants who assist with technology development and clinical affairs. We expense R&D costs as incurred. In the future, we expect R&D expenses to increase as we continue to develop new products, enhance existing products and technologies and perform activities related to obtaining additional regulatory approval. However, we expect R&D expenses as a percentage of total revenue to vary over time depending on the level and timing of our new product development efforts, as well as our clinical development, clinical trials and studies and other related activities. Selling, general and administrative expenses Selling, general and administrative, or SG&A, expenses consist of employee-related expenses, including salaries, benefits, travel expense, sales commissions and stock-based compensation expense. Other SG&A expenses include promotional activities, marketing, conferences and trade shows, professional services fees, including legal, audit and tax fees, insurance costs, general corporate expenses, facilities-related expenses and shipping and handling costs. We expect continued increased costs due to the additional legal, accounting, insurance and other expenses associated with being a public company compared to when we were privately held. We also expect continued legal costs associated with ongoing litigation. Results of Operations Comparison of the Years Ended December 31, 2019 and 2018 The following table shows our results of operations (in thousands): Comparison of years ended December 31, 2019, and 2018-By reportable segments We organize our business into two operating segments based on the product specialties: the vascular segment and the dermatology segment. In deciding how to allocate resources and assess performance, we regularly evaluate the net revenue and gross profit (loss) of these segments. Amounts included within selling, general and administrative expense and research and development expense are general to us and not specific to a particular segment; therefore, these amounts are not evaluated by us on a segmented basis. Additional information on our reportable segments is contained in Note 15 to the financial statements appearing elsewhere in this Annual Report on Form 10-K. Net revenue The following table shows our net revenue from our two segments (in thousands): Vascular Net revenue was $1.3 million and $1.6 million for the years ended December 31, 2019 and 2018, respectively. The decrease of approximately $0.3 million was due to decreased catheter unit sales. We do not expect our net revenue to increase in the near term with our reduced sales force and as we focus on remedying the inconsistencies in our DABRA catheter performance. Over the longer term, if we are able to improve the consistency of our catheter performance and introduce design changes to the catheter, we believe we will be able to increase our vascular revenue. Dermatology Net revenue was $5.9 million and $4.7 million for the years ended December 31, 2019 and 2018, respectively. The increase of approximately $1.2 million was due primarily to an increase of $1.0 million in direct unit product sales and $0.2 million in service revenue. Cost of revenue The following table shows our cost of revenue from our two segments (in thousands): Vascular Cost of revenue was $4.0 million and $1.5 million for the years ended December 31, 2019 and 2018. The $2.5 million increase was due to (i) increased labor, material and overhead costs to support the continued efforts to remedy the inconsistencies in our DABRA catheter performance and warranty costs of replacement units, including $0.2 million relating to the voluntary recall of catheters, (ii) stock-based compensation expense due to continued expenses related to the modification accounting treatment of replacement awards that took place in the second quarter of 2018 and (iii) maintenance costs and depreciation expense related to our lasers at our customer sites. Dermatology Cost of revenue was $4.8 million and $2.7 million for the years ended December 31, 2019 and 2018, respectively. The increase of $2.1 million was due to an increase in direct unit product sales and increased service costs due to increases in stock-based compensation expense as a result of continued expenses related to the modification accounting treatment of replacement awards that took place in the second quarter of 2018, depreciation expense and maintenance costs. Gross (loss) profit The following table shows our gross (loss) profit from our two segments (in thousands): Vascular Gross loss was $2.8 million for the year ended December 31, 2019 and gross profit was $31.0 thousand for the year ended December 31, 2018. The decrease of $2.8 million is due to (i) increased labor, material and overhead costs to support the continued efforts to remedy the inconsistencies in our DABRA catheter performance and warranty costs of replacement units, including $0.2 million relating to the voluntary recall of catheters, (ii) stock-based compensation expense due to continued expenses related to the modification accounting treatment of replacement awards that took place in the second quarter of 2018 and (iii) maintenance costs and depreciation expense related to our lasers at our customer sites. We expect our gross profit (loss) to be negatively impacted in the short term with our reduced sales force and as we continue efforts to remedy the inconsistencies in our DABRA catheter performance. Dermatology Gross profit was $1.1 million and $2.0 million for the years ended December 31, 2019 and 2018, respectively. The decrease of $0.9 million was primarily due increased costs of service including non-cash charges relating to depreciation and stock-based compensation. Comparison of years ended December 31, 2019, and 2018-General Selling, general and administrative expenses. SG&A expenses were $51.5 million and $30.4 million for the years ended December 31, 2019 and 2018, respectively. The $21.1 million increase primarily related to increases of (i) $8.5 million in stock-based compensation expense primarily due to continued expenses related to the modification accounting treatment of replacement awards that took place in the second quarter of 2018 and new grants, (ii) $4.8 million increase in legal expense primarily due to the Audit Committee investigation and securities litigation, (iii) $4.4 million in salary, benefits, recruiting expenses and other personnel-related costs due to expanding our sales force in the first half of the year (later reduced in the second half of the year) and hiring administrative staff to operate as a public company, (iv) $1.4 million in insurance due to being publicly traded, (v) $1.2 million in outside services to operate as a public company, including audit, consulting, board of directors and investor relations fees including $0.4 million related to the investigation conducted by the Audit Committee, (vi) $0.4 million in sales training related costs, (vii) $0.3 million in other costs including depreciation, and (viii) $0.1 million in travel and trade shows. Note 12 to the financial statements appearing elsewhere in this Annual Report on Form 10-K more fully describes the accounting treatment for stock-based compensation awards. Research and development expenses. R&D expenses were $4.5 million and $2.8 million for the years ended December 31, 2019 and 2018, respectively. The $1.7 million increase was primarily due to increases of $1.6 million in personnel costs, supplies and consulting expenses to understand the inconsistencies in our DABRA catheter performance and efforts on the next generation of products, $0.6 million in clinical study expenses offset by a decrease of $0.4 million in stock-based compensation expense. Other income (expense), net. Other income (expense), net was net other income of $0.8 million and $0.3 million for the years ended December 31, 2019 and 2018, respectively. Other income was primarily comprised of interest income on one year of the net proceeds from the IPO that were received in October 2018. Other income is offset by interest expense primarily related to the significant financing component for multi-year warranty service contracts. Non-GAAP Measures EBITDA and Adjusted EBITDA are performance measures that provide supplemental information we believe is useful to analysts and investors to evaluate our ongoing results of operations, when considered alongside other GAAP measures. These Non-GAAP Measures exclude the financial impact of items management does not consider in assessing our ongoing operating performance, and thereby facilitate review of our operating performance on a period-to-period basis. Comparability to our results of operations to other companies may be impacted by our stock-based compensation which was classified as a liability and revalued at each reporting period with the change in fair value recorded to compensation expense in the statement of operations in 2018. We believe that non-GAAP financial information, when taken collectively, may be helpful to investors because it provides consistency and comparability with past financial performance. However, non-GAAP financial information is presented for supplemental informational purposes only, has limitations as an analytical tool and should not be considered in isolation or as a substitute for financial information presented in accordance with U.S. GAAP. Some of these limitations are that: • EBITDA excludes certain recurring, non-cash charges such as depreciation and amortization of long-lived assets, although these are non-cash charges, the assets being depreciated and amortized may have to be replaced in the future; and • Adjusted EBITDA further excludes stock-based compensation expense, which has been, and will continue to be for the foreseeable future, a significant recurring expense in our business and an important part of our compensation strategy. In addition, other companies, including companies in our industry, may calculate similarly-titled non-GAAP measures differently or may use other measures to evaluate their performance, all of which could reduce the usefulness of our non-GAAP financial measures as tools for comparison. A reconciliation for each non-GAAP financial measure to the most directly comparable financial measure stated in accordance with U.S. GAAP is included below. Investors are encouraged to review the related GAAP financial measures and the reconciliation of these non-GAAP financial measures to their most directly comparable GAAP financial measures, and not to rely on any single financial measure to evaluate our business. We define Adjusted EBITDA as our GAAP net loss as adjusted to exclude depreciation and amortization, interest income, interest expense, income tax expense and stock-based compensation. The following is a reconciliation of Net loss to Adjusted EBITDA: Adjusted EBITDA was negative $32.4 million compared to negative $15.8 million for the years ended December 31, 2019 and 2018, respectively. The decrease in Adjusted EBITDA primarily reflects higher selling, general and administrative costs, including salary, benefits, recruiting expenses, legal fees and consulting costs due to increased personnel, costs associated with increasing the sales force, costs associated with efforts to remedy the inconsistencies in our DABRA catheter performance, and the costs of operating as a public company, including the investigation conducted by the Audit Committee. Liquidity and Capital Resources As of December 31, 2019, we had cash and cash equivalents and short-term investments of $30.6 million and an accumulated deficit of $117.2 million. Our primary sources of capital have been from the sale of our products and services, the net proceeds of $67.3 million from our initial public offering, and, to a lesser extent, private placements of common stock and equipment financing arrangements. Management expects operating losses and negative cash flows to continue for the foreseeable future with the our reduced commercial footprint, and as we continue to incur costs related to our atherectomy clinical trial, engineering efforts to improve the shelf-life of its catheters and develop next generation products and legal costs associated with ongoing litigation. In the third quarter of 2019, we began implementing certain operational efficiency and cost savings initiatives intended to align our resources with our product strategy, reduce our operating expenses, and manage our cash flows. These cost efficiency initiatives included targeted workforce reductions of our sales and marketing teams. We reduced the size of our DABRA sales force from 34 employees as of June 30, 2019 to five clinical specialists employees as of December 31, 2019. In addition, we may need to decrease or defer capital expenditures and development activities to further optimize our operations. Such measures may impair our ability to invest in developing, marketing and selling new and existing products. We are incurring additional costs as a result of operating as a public company, including increases in legal, accounting, insurance and other expenses. Additionally, we expect legal and related expenses to remain high in the near term in connection with the legal proceedings discussed in Note 14, "Commitments and Contingencies," in the notes to the financial statements. Our future capital requirements will depend on many factors, including: • the revenue generated by sales of our DABRA and Pharos products, related consumables, and other products that get approved in the U.S. and select non-U.S. markets, as well as the amount of sales personnel required to generate the revenue; • our ability to remedy the inconsistencies in our DABRA catheter performance; • following our voluntary product recall, our ability to achieve market acceptance of DABRA; • matters arising out of our completed Audit Committee investigation; • the cost, timing and outcomes of any litigation involving our company, products, and business activities, including securities class actions and derivative lawsuits, and government investigations in which we are involved; • the extent to which our products are adopted by the physician community; • the ability of our customers to obtain adequate reimbursement from third-party payors for procedures performed using DABRA; • the degree of success we experience in commercializing our excimer lasers and related consumables; • the costs, timing and outcomes of any future clinical studies and regulatory reviews, including to seek and obtain approvals for new indications for our products; • the costs and timing of developing variations of our excimer lasers, and, if necessary, obtaining FDA clearance to market such variations; • the emergence of competing or complementary technologies; • 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 level of our selling, general and administrative expenses. Management estimates that based on our liquidity resources, there is substantial doubt about our ability to continue as a going concern within 12 months from the date of issuance of the financial statements. Our ability to continue as a going concern is dependent upon our ability to raise additional funding. We plan to raise additional capital through public or private equity or debt financings to fulfill our operating and capital requirements for at least 12 months from the date of the issuance of the financial statements. However, we may not be able to secure such financing in a timely manner or on favorable terms, if at all. Furthermore, if we issue equity securities to raise additional funds, its existing stockholders may experience dilution, and the new equity securities may have rights, preferences and privileges senior to those of our existing stockholders. Our financial statements include explanatory disclosures regarding substantial doubt about our ability to continue as a going concern. Future reports on our financial statements may also include explanatory disclosures with respect to our ability to continue as a going concern. Our financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or amounts of liabilities that might be necessary should we be unable to continue our operations. Cash Flows Net cash used in operating activities During the year ended December 31, 2019, net cash used in operating activities was $33.2 million, consisting primarily of a net loss of $57.0 million and an increase in net operating assets of $1.9 million, partially offset by non-cash charges of $25.7 million consisting of primarily stock-based compensation expense, depreciation and amortization and allowance for doubtful accounts. During the year ended December 31, 2018, net cash used in operating activities was $18.5 million, consisting primarily of a net loss of $30.8 million and an increase in net operating assets of $3.3 million primarily related to decreases in accounts receivables, accrued expenses and inventories partially offset by increases in accounts payable. These items were partially offset by non-cash charges of $15.6 million consisting of depreciation, stock-based compensation expense and provision for doubtful accounts. Net cash used in investing activities During the year ended December 31, 2019, net cash used in investing activities was $16.0 million, consisting of $36.5 million to purchase short-term investments and $0.3 million to purchase manufacturing equipment and vehicles for our sales force to transport our laser equipment, partially offset by $21.0 million from proceeds of sales of investments. During the year ended December 31, 2018, net cash used in investing activities was $0.6 million consisting primarily of purchases of manufacturing equipment and computer hardware and software. Net cash (used in) provided by financing activities During the year ended December 31, 2019, net cash used in financing activities was $0.5 million due to payments on our financed equipment of $0.3 million and payments for taxes on the settlement of restricted stock units of $0.2 million, partially offset by proceeds from issuance of common stock related to the employee stock purchase plan of $37,000. During the year ended December 31, 2018, net cash provided by financing activities was $75.2 million, consisting primarily of net proceeds of $67.3 million from the issuance of common stock related to our IPO and $7.9 million received from the issuance of common stock related to a private placement financing, partially offset by payments of $0.1 million in equipment financing payments. Off-Balance Sheet Arrangements We do not engage in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, as a part of our ongoing business. Accordingly, we did not have any off-balance sheet arrangements during any of the periods presented. Contractual Obligations Our principal obligations consist of the operating leases for our facilities. The following table sets out, as of December 31, 2019, our contractual obligations due by period (in thousands): (1) Consists of obligations under multi-year, non-cancelable building leases for our facilities in Carlsbad, California. (2) Consists primarily of obligations under the equipment financing for automobiles. 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 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. We have previously identified material weaknesses in our internal control over financial reporting, which are now remediated. For additional information, see Item 9A, “Controls and Procedures.” Revenue recognition We adopted ASC Topic 606 (Topic 606), Revenue from Contracts with Customers, on January 1, 2019 using the modified retrospective method to all contract agreements not completed as of January 1, 2019. Results for reporting periods beginning after January 1, 2019 are presented under Topic 606 while, as permitted by Topic 606, prior period amounts are not adjusted and continue to be reported under the accounting standards in effect for the prior period. We recorded a cumulative catch up adjustment to beginning accumulated deficit to reflect the impact of adopting Topic 606. The adoption of Topic 606 did not have a material effect on our results of operations for the year ended December 31, 2019. We generate revenue from the sale of products and services. Product sales consist of the sale of DABRA and Pharos laser systems, the sale of catheters for use with the DABRA laser, and the sale of consumables and replacement parts. Our sales agreements generally do not include right-of-return provisions for any form of consideration including partial refund or credit against amounts owed to us. Services and other revenue primarily consist of sales of extended warranty and billable services, including repair activity and income from rental of lasers. We determine revenue recognition incorporating the following steps: • Identification of each contract with a customer; • Identification of the performance obligations in the contract; • Determination of the transaction price; • Allocation of the transaction price to the performance obligations in the contract; and • Recognition of revenue when, or as, performance obligations are satisfied. We account for a contract with a customer when we have a legally enforceable contract with the customer, the arrangement identifies the rights of the parties, the contract has commercial substance, and we determine it is probable that it will collect the contract consideration. We recognize revenue when control of the promised goods or services transfers to customers, in an amount that reflects the consideration we expect to be entitled to in exchange for those goods or services. Taxes collected from customers relating to goods or services and remitted to governmental authorities are excluded from revenue. Catheter Revenue We enter into a DABRA laser commercial usage agreement or DABRA laser placement acknowledgement with each customer that is supplied a DABRA laser, collectively the “usage agreement”. The usage agreement provides for specific terms of continued use of DABRA laser, including a nominal periodic fee. The terms of a usage agreement typically allow us to place a DABRA laser at a customer’s specified location without a specified contract term. Under the usage agreement terms, we retain all ownership rights to the DABRA laser and are permitted to request the return of the equipment within 10 business days of notification. While the laser periodic fees are nominal, the laser usage agreements provide us the exclusive rights to supply related single-use catheters to the customer which aggregate the majority of the vascular segment revenue. There are no specified minimum purchase commitments for the catheters. We recognize revenue associated with the usage agreement and catheter supply arrangements in accordance with Topic 606 as the contract primarily includes variable payments, the catheters are priced at their standalone selling price and the laser equipment is insignificant in the context of the contract. Revenue is recognized when the performance obligation is satisfied, which is generally upon shipment of the catheter. Laser Sales Laser sales consist of sales of DABRA and Pharos laser systems and are included in product sales in the statements of operations. We recognize revenue on laser sales at the point in time that control transfers to the customer. Control of the product typically transfers upon shipment. Warranty Service Revenue We typically provide a 12-month warranty with the purchase of our laser systems. Customers can extend the warranty period through the purchase of extended warranty service contracts. Extended warranty service contracts are sold with contract terms ranging from 12 to 60 months and cover periods after the end of the initial 12-month warranty period. The warranty provides the customer with maintenance services in addition to the assurance that the laser product complies with agreed-upon specifications. Therefore, the warranty service is treated as a separate performance obligation from the laser system. Warranty services are a stand-ready obligation, and we recognize revenue on a straight-line basis over the service contract term. Warranty service revenue is included in service and other revenue in the statements of operations. Distributor Transactions In certain markets outside the U.S., we sell products and provide services to customers through distributors that specialize in medical device products. The terms of sales transactions through distributors are generally consistent with the terms of direct sales to customers. We account for these transactions in accordance with our revenue recognition policy described herein. Contracts with multiple performance obligations Certain of our contracts with customers contain multiple performance obligations. For these contracts, we account for individual products and services as separate performance obligations if they are distinct, which is if (i) a product or service is separately identifiable from other items in the arrangement and (ii) the customer can benefit from the product or service on its own or with other readily available resources. The transaction price is allocated to the separate performance obligations on a relative standalone selling price basis. We determine standalone selling prices based on observable prices of products or services sold separately in comparable circumstances to similar customers. Significant Financing Component For multi-year warranty service contracts in which there is a difference between the cash selling price and the consideration in the contract and a significant amount of time between the payment, which is due up-front, and delivery of the services (greater than one year), we record an adjustment for significant financing to reflect the time value of money. We recognize revenue associated with the cash selling price and interest expense using the effective interest method as we satisfy our performance obligation(s). The amount of interest expense we recognize over the contract term is based on the contract liability balance, which increases for the accrual of interest and decreases as services are provided. For services contracts that have an original duration of one year or less, we use the practical expedient applicable to such contracts and does not adjust the transaction price for the time value of money. Practical expedients elected As part of our adoption of Topic 606, we elected to use the following practical expedients: • not to adjust the promised amount of consideration for the effects of a significant financing component when we expect, at contract inception, that the period between our transfer of a promised product or service to a customer and when the customer pays for that product or service will be one year or less; • to expense costs as incurred for costs to obtain a contract when the amortization period would have been one year or less; • to exclude government assessed taxes from the transaction price; and • not to recast revenue for contracts that begin and end in the same fiscal year. Contract Costs We capitalize costs to obtain contracts that are considered incremental and recoverable, such as sales commissions. The capitalized costs are amortized to selling, general and administrative expense over the estimated period of benefit of the asset, which is the contract term. We elected to use the practical expedient to expense the costs to obtain a contract when the amortization period is less than one year. Rental Income We also adopted ASC Topic 842, Leases, on January 1, 2019 using the optional transitional method. There was no adjustment to accumulated deficit at January 1, 2019. We derive income pursuant to product lease agreements for our Pharos laser systems, as operating leases. Consequently, we retain title to the equipment and the equipment remains on our balance sheet within property and equipment. Depreciation expense on these leased lasers is recorded to cost of revenues on a straight-line basis. The costs to maintain these leased lasers are charged to cost of revenues as incurred. These lease arrangements contain one lease component (the laser) and one nonlease component (warranty service) for which we elected the practical expedient to not separate the nonlease component from the lease component. We account for the combined lease component as an operating lease and recognizes lease income on a straight-line basis over the lease term. Stock-based compensation We evaluate whether an award should be classified and accounted for as a liability award or equity award for all stock-based compensation awards granted. Stock-based compensation for liability awards issued to employees, directors, consultants, and other service providers were measured based on fair value of the award using the Black Scholes option pricing model. Changes in the fair value of a liability incurred under a share-based payment arrangement that occur during the requisite service period are recognized as compensation cost over that period. The percentage of the fair value that is accrued as compensation cost at the end of each period is equal to the percentage of the requisite service that has been rendered at that date. Any difference between the amount for which a liability award is settled and its fair value at the settlement date is recorded as an adjustment to compensation cost in the period of settlement. There were no liability awards outstanding at December 31, 2019 or 2018. Stock-based compensation expense for equity instruments issued to employees and directors is measured based on estimating the fair value of each stock option on the date of grant using the Black Scholes option pricing model. Equity instruments issued to nonemployee consultants and service providers are valued using the Black Scholes option pricing model and are subject to revaluation as the underlying equity instruments vest. We recognize stock-based compensation expense as follows: Employees Nonemployees Service condition only Straight-line In the same period and in the same manner as if we paid cash for services. Performance criterion is probable of being met: Service criterion is complete Recognize the grant date fair value of the award once the performance criterion is considered probable of occurrence Recognize the grant date fair value of the award once the performance criterion is considered probable of occurrence Service criterion is not complete Straight-line Straight-line unless a performance condition is not probable Performance criterion is not probable of being met No expense is recognized until the performance criterion is considered probable, at which point expense is recognized per above No expense is recognized until the performance criterion is considered probable, at which point expense is recognized per above As described in Note 12 of the financial statements, on June 4, 2018, our board of directors authorized replacement equity awards of stock options and, effective June 8, 2018, restricted stock units, or collectively, the “Replacement Awards.” The issuance of the Replacement Awards and cancellation of the stock-based compensation awards classified as liabilities was treated as a modification. As of the date of the modification, which resulted in the settlement of the stock-based compensation liability, the fair value of the stock-based compensation liability was estimated using the Black Scholes option pricing model and the assumptions used in the model are noted below: • Fair value of our common stock-The common stock price was estimated utilizing a hybrid method, a combination of the Probability Weighted Expected Return Method, or PWERM, and Option Pricing Model, or OPM. The estimate incorporated a near-term IPO scenario using PWERM weighted at 80%. Other near-term exit events, a long-term stay private case, and dissolution were all considered as non-IPO scenarios using OPM, and were weighted at 20%. The estimate also reflected a 10% and 15% discount for lack of marketability under PWERM and OPM, respectively. • Risk-free interest rate-The risk-free interest rate approximated the implied yield available on United States Treasury securities with an equivalent remaining term. • Volatility-Expected volatility was based on the historical volatilities of certain “guideline” companies. • Expected dividend yield-Expected dividend yield was based on dividends historically paid by us. • Expected life-The expected life was based on the “simplified” method using the average of the term and vesting period. For stock awards following our initial public offering, the fair value of each share of underlying common stock is based on the closing price of our common stock as reported on the date of grant. If factors change and we employ different assumptions, stock-based compensation expense may differ significantly from what we have recorded in the past. If there are any modifications or cancellations of the underlying unvested securities, we may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense. To the extent that our assumptions are incorrect, the amount of stock-based compensation recorded will change. Income taxes We account for income taxes using the asset and liability method. Under this method, deferred tax assets and liabilities are determined based on differences between the financial reporting and tax basis of assets and liabilities and are measured using enacted tax rates and laws that are expected to be in effect when the differences reverse. Any resulting net deferred tax assets are evaluated for recoverability and, accordingly, a valuation allowance is provided when it is more likely than not that all or some portion of the deferred tax asset will not be realized. We account for uncertainty in income taxes using a two-step approach to recognizing and measuring uncertain tax positions. The first step is to evaluate the tax position for recognition by determining whether it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount that is more than 50% likely of being realized upon ultimate settlement. An uncertain tax position is considered effectively settled on completion of an examination by a taxing authority if certain other conditions are satisfied. Should we incur interest and penalties relating to tax uncertainties, such amounts would be classified as a component of interest expense and other expense, respectively. Jobs Act Accounting Election 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 to avail ourselves of this exemption and, therefore, we are not subject to the same new or revised accounting standards as other public companies that are not emerging growth companies. 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. See Note 2 to the financial statements included elsewhere in this Annual Report on Form 10-K for a description of relevant new accounting pronouncements.
0.032776
0.033022
0
<s>[INST] Investing in our common stock involves a high degree of risk. You should carefully consider the risks and uncertainties described below, together with all of the other information in this Annual Report on Form 10K, before making an investment decision. The risks and uncertainties described below may not be the only ones we face. If any of the risks actually occur, our business, financial condition, operating results, cash flows and prospects could be materially and adversely affected. In that event, the market price of our common stock could decline, and you could lose part or all of your investment. Overview We are a commercialstage medical device company leveraging our advanced excimer laserbased platform for use in the treatment of vascular and dermatological immunemediated inflammatory diseases. We believe our products enhance patients’ quality of life by restoring bloodflow in arteries and clearing chronic skin conditions. The DABRA laser system and singleuse catheter, together referred to as DABRA, is cleared by the U.S. Food and Drug Administration, or FDA, as a device for crossing chronic total occlusions, or CTOs, in patients with symptomatic infrainguinal lower extremity vascular disease and with an intended use for ablating a channel in occlusive peripheral vascular disease. DABRA is used as a tool in the treatment of peripheral artery disease, or PAD, a form of peripheral vascular disease, which commonly occurs in the legs. We currently are pursuing an atherectomy indication for use, which the FDA currently defines to include a prespecified improvement in luminal patency, or a prespecified increase in the openness of the artery at a predefined time point. To satisfy the FDA’s data requirements to support an atherectomy indication, we are performing a pivotal study designed to allow the FDA to evaluate the DABRA atherectomy procedure. We received final IDE approval in January 2020 and enrolled the first patient in the study in February 2020. In the fourth quarter of 2018 and into 2019, we experienced inconsistencies in our DABRA catheter performance. After collecting field data and performing internal testing, we observed that while catheters can perform satisfactorily up to one year, catheters that were more than two months from sterilization, had a significantly higher rate of noncalibration than catheters that were within two months from sterilization. As a result, in September 2019, we initiated a voluntary recall of our catheters to replace 12month shelf life labeled catheters with twomonth shelf life labeled catheters. In addition, in the third quarter of 2019 we implemented certain operational efficiency and costsavings initiatives intended to align our resources with our product strategy, reduce our operating expenses, and manage our cash flows. These cost efficiency initiatives included targeted workforce reductions of our sales and marketing teams. We reduced the size of our DABRA sales force from 34 employees as of June 30, 2019 to five clinical specialists as of December 31, 2019. In the near term, we are focusing on servicing core accounts while we prioritize remedying the inconsistencies in our DABRA catheter performance. We are encouraged by the results, as we have seen significant decreases in the rates of noncalibrations following the voluntary recall. Our business strategy is focused on continuing to service our core accounts while we complete initiatives that are key to relaunching DABRA to the broader market. Key components of our DABRA relaunch strategy include: A longer shelf life; A braided overjacket designed to reduce kinking, and that will also allow the physician to apply more pressure when advancing the DABRA catheter; A rapid exchange designed to allow physicians to use more standard techniques, including a guidewire, to navigate the vasculature more easily; and An atherectomy indication for use. As these initiatives are at or near completion, we intend to begin expanding our sales force to prepare for a commercial relaunch. In the future, we may pursue additional uses for DABRA, including seeking regulatory clearance or approval for the use of DABRA as a tool for the treatment of vascular [/INST] Positive. </s>
2,020
7,720
1,564,824
Allakos Inc.
2019-03-14
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 financial statements and the other financial information appearing elsewhere in this Annual Report on Form 10-K. These statements generally relate to future events or to our future financial performance and involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. The following discussion and analysis contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Our actual results and the timing of events may differ materially from those discussed in our forward-looking statements as a result of various factors, including those discussed below and those discussed in the section entitled “Risk Factors” included in this Annual Report on Form 10-K. If we do update one or more forward-looking statements, no inference should be drawn that we will make additional updates with respect to those or other forward-looking statements. Additional information concerning these and other risks and uncertainties is contained in our other periodic filings with the SEC. Forward-looking statements include, but are not limited to, statements about: • the impact that the adoption of new accounting pronouncements will have on our financial statements; • the ability of our clinical trials to demonstrate safety and efficacy of our product candidates, and other positive results; • the timing and focus of our future clinical trials, and the reporting of data from those trials; • our plans relating to commercializing AK002, if approved, including the geographic areas of focus and sales strategy; • the size of the market opportunity for AK002 in each of the diseases we are targeting; • the number of diseases represented in the patient population enrolled in our clinical trials, and our ability to evaluate response to treatment of AK002 in diseases other than the primary indication in our clinical trials; • our estimates of the number of patients in the United States who suffer from the diseases we are targeting and the number of patients that will enroll in our clinical trials; • the beneficial characteristics, safety, efficacy and therapeutic effects of AK002; • the timing or likelihood of regulatory filings and approvals, including our expectation to seek special designations, such as orphan drug designation, for AK002 or our other product candidates for various diseases; • our ability to obtain and maintain regulatory approval of AK002 or our other product candidates; • our plans relating to the further development of AK002 and our other product candidates; • existing regulations and regulatory developments in the United States and other jurisdictions; • our plans and ability to obtain or protect intellectual property rights, including extensions of existing patent terms where available; • our continued reliance on third-parties to conduct additional clinical trials of AK002 and our other product candidates, and for the manufacture of our product candidates for preclinical studies and clinical trials; • the need to hire additional personnel and our ability to attract and retain such personnel; • the accuracy of our estimates regarding expenses, future revenue, capital requirements and needs for additional financing; • our financial performance; • the sufficiency of our existing cash, cash equivalents and marketable securities to fund our future operating expenses and capital expenditure requirements; • our expectations regarding the period during which we will qualify as an emerging growth company under the JOBS Act; and • our anticipated use of the proceeds from our initial public offering and the concurrent private placement. These forward-looking statements are subject to a number of risks, uncertainties, and assumptions, including, but not limited to, those described in “Risk Factors.” In some cases, you can identify these statements by terms such as “anticipate,” “believe,” “could,” “estimate,” “expects,” “intend,” “may,” “plan,” “potential,” “predict,” “project,” “should,” “will,” “would” or the negative of those terms, and similar expressions that convey uncertainty of future events or outcomes. These forward-looking statements reflect our beliefs and views with respect to future events and are based on estimates and assumptions as of the date of this Annual Report on Form 10-K and are subject to risks and uncertainties. We discuss many of these risks in greater detail in the section entitled “Risk Factors” included in Part I, Item 1A and elsewhere in this Report. Moreover, we operate in a very competitive and rapidly changing environment. New risks emerge from time to time. It is not possible to predict all risks, nor can we assess the impact of all factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements we may make. Given these uncertainties, you should not place undue reliance on these forward-looking statements. We qualify all of the forward-looking statements in this Annual Report on Form 10-K by these cautionary statements. Except as required by law, we assume no obligation to update these forward-looking statements publicly, or to update the reasons actual results could differ materially from those anticipated in any forward-looking statements, whether as a result of new information, future events or otherwise. Overview We are a clinical stage biotechnology company developing AK002, our wholly owned monoclonal antibody, for the treatment of various eosinophil and mast cell related diseases. AK002 selectively targets both eosinophils and mast cells, white blood cells that are widely distributed in the body and play a central role in the inflammatory response. Inappropriately activated eosinophils and mast cells have been identified as key drivers in a number of severe diseases affecting the gastrointestinal tract, eyes, skin, lungs and other organs. As such, AK002 has the potential to treat a large number of severe diseases. AK002 has demonstrated activity in clinical trials. In these trails, AK002 depleted blood eosinophils and improved symptoms in patients with three forms of chronic urticaria (“CU”) and indolent systemic mastocytosis (“ISM”), all mast cell driven diseases. The activity observed in ISM and CU suggest that AK002 could provide significant benefit to patients suffering from these diseases and highlight AK002’s potential to broadly inhibit mast cells in different disease settings. We are developing AK002 for the treatment of eosinophilic gastritis (“EG”), eosinophilic gastroenteritis (“EGE”), and eosinophilic esophagitis (“EoE”). In addition, we have or are currently conducting studies in ISM, CU, and severe allergic conjunctivitis (“SAC”) and are evaluating additional indications for future development. Despite the knowledge that eosinophils and mast cells drive many pathological conditions, there are no approved therapies that selectively target both eosinophils and mast cells. AK002 binds to Siglec-8, an inhibitory receptor found on eosinophils and mast cells, which represents a novel way to selectively deplete or inhibit these important immune cells and thereby resolve inflammation. We believe AK002 is the only Siglec-8 targeting antibody currently in clinical development and has the potential to have advantages over current treatments for the diseases we are pursuing. Since our inception in 2012, we have devoted substantially all of our resources and efforts towards the research and development of our product candidates. We initially began developing two product candidates, AK001 and AK002, both of which are monoclonal antibodies targeting Siglec-8. These compounds entered clinical trials in 2015 and 2016, respectively. Due to the greater activity of AK002, we decided to focus our development efforts on AK002 and discontinued the development of AK001 in 2017. We have no current plans to continue development of AK001 at this time but may choose to do so in the future. In addition to activities conducted internally at our facilities, we have utilized significant financial resources to engage contractors, consultants and other third-parties to conduct various preclinical and clinical development activities on our behalf. To date, we have not had any products approved for sale and have not generated any revenue nor been profitable. Further, we do not expect to generate revenue from product sales until such time, if ever, that we are able to successfully complete the development and obtain marketing approval for one of our product candidates. We will continue to require additional capital to develop our product candidates and fund operations for the foreseeable future. We have incurred significant operating losses to date and expect to incur significant operating losses for the foreseeable future. Our net losses were $43.5 million, $23.6 million and $17.1 million for the years ended December 31, 2018, 2017 and 2016, respectively. As of December 31, 2018, we had an accumulated deficit of $104.1 million. Our operations have been financed primarily through the private placements of convertible debt instruments and convertible preferred stock. These private placements provided gross proceeds of $146.9 million. As of December 31, 2018, we had cash, cash equivalents and marketable securities of $178.9 million, which we believe will be sufficient to fund our planned operations for at least the next 12 months from the issuance of our financial statements. Initial Public Offering On July 23, 2018, we completed an initial public offering (“IPO”), selling 8,203,332 shares of common stock at $18.00 per share. Proceeds from our IPO, net of underwriting discounts and commissions, were $137.3 million. Concurrently with our IPO, we completed a private placement of 250,000 shares of common stock at $18.00 per share to an existing stockholder. Proceeds from this private placement were $4.5 million. In connection with the completion of our IPO on July 23, 2018, all then outstanding shares of convertible preferred stock converted into 30,971,627 shares of common stock. Components of Operating Results Revenue We have not generated any revenue from product sales or otherwise, and do not expect to generate any revenue for at least the next several years. Operating Expenses We classify operating expenses into two categories: (i) research and development and (ii) general and administrative. Research and Development Expenses Research and development expenses represent the following costs incurred by us for the discovery, development and manufacturing of our product candidates: • consultant and personnel-related costs including salaries, benefits, travel and stock-based compensation expense; • costs incurred under service agreements with contract research organizations (“CROs”) that conduct nonclinical and clinical research activities on our behalf; • costs incurred under service agreements with contract development and manufacturing organizations (“CDMOs”) for the manufacture and fill finish of our preclinical and clinical materials; • costs related to in-house research and development activities conducted at our facilities including laboratory supplies, non-capital laboratory equipment and depreciation of capital laboratory equipment and leasehold improvements to laboratories; • costs incurred under exclusive and non-exclusive license agreements with third-parties; and • allocated facility and other costs including the rent and maintenance of our facilities, insurance premiums, depreciation of shared-use leasehold improvements and general office supplies. We expense research and development costs as incurred. We recognize costs for certain development activities, such as clinical trials, based on an evaluation of the progress to completion of specific tasks using data such as clinical site activations, patient enrollment or information provided to us by our vendors and our clinical investigative sites, along with analysis by our in-house clinical operations personnel. Advance payments for goods or services to be received in the future for use in research and development activities are deferred and capitalized as prepaid expenses, even when there is no alternative future use for the research and development. The capitalized amounts are expensed as the related goods are delivered or the services are performed. The successful development of our product candidates is highly uncertain. Accordingly, it is difficult to estimate the nature, timing and extent of costs necessary to complete the remainder of the development of our product candidates. We are also unable to predict when, if ever, we will be able to generate revenue from our product candidates. This is due to the numerous risks and uncertainties associated with developing drugs, including the uncertainty surrounding: • demonstrating sufficient safety and tolerability profiles of product candidates; • successful enrollment and completion of clinical trials; • requisite clearance and approvals from applicable regulatory authorities; • establishing and maintaining commercial manufacturing capabilities with CDMOs; • obtaining and maintaining protection of intellectual property; and • commercializing product candidates, if and when approved, alone or in collaboration with third-parties. A change pertaining to any of these variables would significantly impact the timing and extent of costs incurred with respect to the development and commercialization of our product candidates. External costs incurred from third-party CROs and CDMOs have comprised a significant portion of our research and development expenses since inception. We track external CRO and CDMO costs on a program-by-program basis following the advancement of a product candidate into clinical development. To date, we have advanced two product candidates, AK001 and AK002, into clinical development, although we discontinued the development of AK001 in 2017. Residual costs related to AK001 incurred after discontinuation in 2017 are primarily related to the winding down of historically contracted research and development activities and as such, we do not anticipate incurring significant expenses related to AK001 development in future periods. Consulting and personnel-related costs, laboratory supplies and non-capital equipment utilized in the conduct of in-house research, in-licensing fees and general overhead, are not tracked on a program-by-program basis, nor are they allocated, as they commonly benefit projects in our pipeline or span multiple programs. The following table summarizes our research and development expenses for the periods indicated (in thousands): General and Administrative Expenses General and administrative expenses consist of fees paid to consultants, salaries, benefits and other personnel-related costs, including stock-based compensation, for our personnel in executive, finance, accounting and other administrative functions, legal costs, fees paid for accounting and tax services and facility costs not otherwise included in research and development expenses. Legal costs include general corporate and patent legal fees and related costs. We anticipate that our general and administrative expenses will increase in the future to support our continued research and development activities including costs related to personnel, outside consultants, attorneys and accountants, among others. Additionally, we expect to incur incremental costs associated with operating as a public company, including expenses related to maintaining compliance with the rules and regulations of the Securities and Exchange Commission (“SEC”), and those of any national securities exchange on which our securities are traded, additional insurance premiums, investor relations activities and other ancillary administrative and professional services. Interest Income (Expense), Net Interest income (expense), net, primarily consists of stated interest on outstanding principal amounts drawn under our historical debt facility with SVB, amortization of debt discounts and beneficial conversion feature associated with convertible notes payable to related parties and the amortization and accretion of debt discounts and deferred issuance costs associated with amounts drawn under our historical debt facility with SVB. Also included within interest income (expense), net, is interest and investment income earned on our cash, cash equivalents and marketable securities included on the balance sheets. Other Income (Expense), Net Other income (expense), net, primarily consists of charges related to the extinguishment of our historical debt facility with SVB, as well as amounts realized from gains and losses related to fluctuations in foreign currencies. In-Licensing Agreements We have entered into a number of exclusive and nonexclusive, royalty bearing license agreements with third-parties for certain intellectual property. Under the terms of the license agreements described below, we are obligated to pay milestone payments upon the achievement of specified clinical, regulatory and commercial milestones. Actual amounts due under the license agreements vary depending on factors including, but not limited to, the number of product candidates we develop and our ability to successfully develop and commercialize our product candidates covered under the respective agreements. In addition to milestone payments, we are also subject to future royalty payments based on sales of our product candidates covered under the agreements, as well as certain minimum annual royalty and commercial reservation fees. Because the achievement of milestones and the timing and extent of future royalties is not fixed and determinable, these contingent amounts have not been included on our balance sheets or as part of Contractual Obligations and Commitments discussion below. We recognized $0.3 million of milestone expense for the year ended December 31, 2018 and did not recognize any milestone expense during the year ended December 31, 2017. Milestone payments are not creditable against royalties. As of December 31, 2018, we have not incurred any royalty liabilities related to our license agreements, as product sales have not yet commenced. Exclusive License Agreement with The Johns Hopkins University In December 2013, we entered into a license agreement with The Johns Hopkins University, (“JHU”) for a worldwide exclusive license to develop, use, manufacture and commercialize covered product candidates including AK001 and AK002, which was amended in September 30, 2016. Under the terms of the agreement, we have made upfront and milestone payments of $0.3 million through December 31, 2018 and we may be required to make aggregate additional milestone payments of up to $4.0 million. We also issued 88,887 shares of common stock as consideration under the JHU license agreement. In addition to milestone payments, we are also subject to single-digit royalties to JHU based on future net sales of each licensed therapeutic product candidate by us and our affiliates and sublicensees, with up to a low six-digit dollar minimum annual royalty payment. Non-exclusive License Agreement with BioWa Inc. and Lonza Sales AG In October 2013, we entered into a tripartite agreement with BioWa Inc. (“BioWa”), and Lonza Sales AG (“Lonza”), for the non-exclusive worldwide license to develop and commercialize product candidates including AK002 that are manufactured using a technology jointly developed and owned by BioWa and Lonza. Under the terms of the agreement, we have made milestone payments of $0.4 million through December 31, 2018 and we may be required to make aggregate additional milestone payments of up to $41.0 million. In addition to milestone payments, we are also subject to minimum annual commercial license fees of $40,000 per year to BioWa until such time as BioWa receives royalty payments, as well as low single-digit royalties to BioWa and to Lonza. Royalties are based on future net sales by us and our affiliates and sublicensees and vary dependent on Lonza’s participation as sole manufacturer for commercial production. Critical Accounting Policies and Use of 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 generally accepted accounting principles in the United States (“U.S. GAAP”). The preparation of our 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. We believe that the accounting policies discussed below are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving management’s judgments and estimates. Research and Development Expenses As part of the process of preparing our financial statements, we estimate our accrued research and development expenses at each balance sheet date. This process involves reviewing purchase orders and open contracts, communicating with our personnel to identify services that have been performed on our behalf and estimating the level of service performed and the associated costs incurred for the services 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; however, some require advance payments. 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 as necessary. The significant estimates in our accrued research and development expenses include the costs incurred for services performed by CROs and CDMOs in connection with research and development activities for which we have not yet been invoiced. We base our expenses related to research and development activities on our estimates of the services received and efforts expended pursuant to quotes and contracts with vendors that conduct research and development 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 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 accordingly. Non-refundable 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 incurred, our understanding of the status and timing of services performed relative to the actual status and timing of services performed may vary and may result in us reporting amounts that are too high or too low in any period. To date, there have been no material differences between our estimates of such expenses and the amounts incurred. Stock-Based Compensation We account for stock-based compensation expense resulting from stock-based awards granted to employees and directors in accordance with ASC 718, Compensation-Stock Compensation, (“ASC 718”). Per ASC 718, we measure the fair value of stock-based awards on the date of grant and recognize the associated compensation expense, net of impact from estimated forfeitures, over the requisite service period on a straight-line basis. The vesting period of the stock-based award has historically served as the requisite service period for the respective grants to our employees and directors. At each subsequent reporting date, we are required to evaluate whether the achievement of any associated vesting conditions is probable and whether or not any such events have occurred that would have resulted in the acceleration of vesting. Determining the amount of stock-based compensation expense to be recorded requires us to develop estimates of the fair value of stock options as of the date of grant. We estimate the fair value of each stock-based award using the Black-Scholes option-pricing model. The Black-Scholes option-pricing model uses highly subjective inputs such as the fair value of our common stock, as well as other assumptions including the expected volatility of our common stock, the expected term of the respective stock-based award, the risk-free interest rate for a period that approximates the expected term of the stock-based award being valued and the expected dividend yield on our common stock over the expected term. Expected volatility. As we do not have sufficient trading history for our common stock, we have based our computation of expected volatility on the historical volatility of a representative group of public life science companies with similar characteristics to us, including company age and stage of product development. The historical volatility data is calculated based on a period of time commensurate with the expected term of the stock-based award being valued. We will continue to utilize this approach until a sufficient amount of historical information regarding the volatility of our own stock price becomes available or until other relevant circumstances change, such as our assessment that our identified entities are no longer appropriate to use as representative companies. In the latter case, more suitable, similar entities with publicly available stock prices will be incorporated in the calculation. Expected term. In order to estimate the expected term of a stock-based award, we use the simplified method prescribed by SEC Staff Accounting Bulletin No. 107, Share-Based Payment, as we do not have sufficient historical exercise data to provide a reasonable basis upon which to estimate the expected term. Under this approach, the expected term is presumed to be the average of the contractual term (ten years) and the vesting term (generally four years) of the stock-based award. We have not historically experienced, nor do we expect there to be substantially different exercise or post-vesting termination behavior among our employees and directors. Risk-free interest rate. The risk-free interest rate is based on publicly available yields of U.S. Treasury instruments with maturities consistent with the expected term of the stock-based award. Expected dividend yield. The expected dividend yield is assumed to be zero as we have never paid dividends and have no current plans to pay any dividends on our common stock. Determination of Fair Value of Common Stock on Grant Dates prior to our IPO The estimated fair value of the common stock underlying our stock options was determined at each grant date by our board of directors, with input from management. All options to purchase shares of our common stock are intended to be exercisable at a price per share not less than the per-share fair value of our common stock underlying those options on the date of grant. As a private company with no active public market for our common stock, our board of directors has periodically determined the estimated per-share fair value of our common stock considering, among other things, contemporaneous valuations performed by independent valuation specialists 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, (the “Practice Aid”). The Practice Aid identifies various available methods for allocating enterprise value across classes and series of capital stock in order to determine the estimated fair value of common stock at each valuation date. In accordance with the Practice Aid, our board of directors considered a number of available methods including those described below. Each of these methods requires the use of significant judgments including making assumptions regarding our future operating performance, as well as the timing and probability of future financing and liquidity events. The relative probabilities and timing surrounding each future event were determined based on an analysis of our prospects and market conditions at the time. The enterprise valuations utilized in each method were historically determined using either the guideline public company method, the similar transaction method or backsolved using a contemporaneous transaction of our convertible preferred stock. For valuations derived using the guideline public company method and similar transaction method, we focused on life science companies at similar stages of development that recently completed initial public offerings or had recently consummated a liquidation event. Resulting valuations associated with these future scenarios were discounted back to the valuation date using an appropriate risk-adjusted discount rate. Finally, we applied discounts for lack of marketability to our common stock to account for the lack of access to an active public market. If different methodologies or assumptions were used, our stock-based compensation expense, net loss and net loss per share applicable to common stockholders could have been significantly different. Option-Pricing Method. The option-pricing method (“OPM”), treats the various classes of capital stock as call options on the total equity value of a company, with exercise prices determined using thresholds for each equity value that results in a change in the allocation to each class of capital stock. Accordingly, common stock only has value if the funds available for distribution to stockholders exceeds all current and future preferred stock liquidation preferences modeled at the time of a liquidity event, such as a strategic sale, merger or disposition of the Company. In order to calculate the fair value of the various call options, the OPM incorporates the Black-Scholes option-pricing model. The Black-Scholes option-pricing model requires management to make additional assumptions such as the expected volatility of the underlying equity securities. Expected volatility utilized in our valuation models was based on the historical trading volatility of our publicly traded peer companies, which we assess for reasonableness and update on a continuous basis as necessary. Probability-Weighted Expected Return Method. The probability-weighted expected return method (“PWERM”), is a scenario-based analysis that estimates value per share based upon an analysis of future values for the company, assuming various outcomes. The common stock value is based on the probability-weighted present value of expected future investment returns considering each of the possible outcomes available as well as the rights of each class of stock. The future value of the common stock under each outcome is discounted back to the valuation date at an appropriate risk-adjusted discount rate and probability weighted to arrive at an indication of value for the common stock. Hybrid Method. The Hybrid Method is a blended approach using aspects of both the PWERM and OPM, in which the equity value in one of the scenarios is calculated using an OPM. In the hybrid method used by us, two types of future-event scenarios were considered: an IPO and an unspecified liquidity event. Based on our early stage of development and other relevant factors, we determined that an OPM was the most appropriate method for allocating enterprise value for our November 2015 common stock valuation. For the common stock valuation that we performed in December 2016, we determined the PWERM to be the most appropriate as we were within twelve to eighteen months from a potential IPO. We determined the Hybrid Method to be the most appropriate for subsequent valuations performed in August 2017, December 2017 and March 2018, as our expectations around the timing and form of liquidity became better understood. The dates of our contemporaneous valuations have not always coincided with the dates of our stock option grants. In determining the exercise prices of the stock options, our board of directors considered, among other things, the most recent contemporaneous valuations of our common stock and our assessment of additional objective and subjective factors we believed were relevant as of the grant date. The additional factors considered when determining any changes in fair value between the most recent contemporaneous valuation and the grant dates included our stage of research and development, our operating and financial performance and current business conditions. Determination of the fair value of our common stock on grant dates following our IPO The fair value of each share of common stock underlying our stock-based awards is based on the closing price of our common stock as reported by the NASDAQ Global Select Market on the date of grant. Income Taxes We account for income taxes under the asset and liability method. Current income tax expense or benefit represents the amount of income taxes we expect to pay or have refunded in the current year. Our deferred income tax assets and liabilities are determined based on differences between financial statement reporting and tax basis accounting of assets and liabilities and net operating loss and credit carryforwards, which we measure using the enacted tax rates and laws that will be in effect when such items are expected to reverse. We reduce deferred income tax assets, as necessary, by applying a valuation allowance to the extent that we determined it is more likely than not that some or all of our tax benefits will not be realized. We account for uncertain tax positions in accordance with ASC 740-10, Accounting for Uncertainty in Income Taxes. We assess all material positions reflected in our income tax returns, including all significant uncertain positions, for all tax years that are subject to assessment or challenge by relevant taxing authorities. Upon determining the sustainability of our positions, we measure the largest amount of benefit possessing greater than fifty percent likelihood of being realized upon ultimate settlement. We reassess such positions at each balance sheet date to determine whether any factors underlying the sustainability assertion have changed and whether or not the amount of the recognized tax benefit is still appropriate. As of December 31, 2018, our gross deferred tax assets were $28.9 million. Due to our lack of earnings history and uncertainties surrounding our ability to generate future taxable income, we have offset the total net deferred tax assets with a full valuation allowance. The deferred tax assets were primarily comprised of federal and state tax net operating losses, (“NOLs”), which may be limited by certain rules governing changes in ownership, as defined in Section 382 of the Internal Revenue Code of 1986, as amended. Similar rules may apply under state tax laws. Our ability to use our remaining NOLs may be further limited if we experience future ownership changes. The recognition and measurement of tax benefits requires significant judgment, especially in assessing uncertain tax positions. Judgments concerning the recognition and measurement of our tax benefits, as well as limitations surrounding their realizability, might change as new information becomes available. Recent Accounting Pronouncements See Note 2 to our financial statements for recently issued accounting pronouncements, including the respective effective dates of adoption and effects on our results of operations and financial condition. JOBS Act In April 2012, the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), was enacted. Section 107 of the JOBS Act provides that an emerging growth company (“EGC”), 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. Thus, an EGC can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have irrevocably 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. We will remain an emerging growth company until the earliest of (i) the last day of our first fiscal year in which we have total annual gross revenues of $1.07 billion or more, (ii) the date on which we are deemed to be a “large accelerated filer” under the rules of the SEC with at least $700.0 million of outstanding equity securities held by non-affiliates, (iii) the date on which we have issued more than $1.0 billion in non-convertible debt securities during the previous three years or (iv) the last day of our fiscal year following the fifth anniversary of the date of the completion of our IPO . Results of Operations Comparison of the Years Ended December 31, 2018, 2017 and 2016 The following table summarizes our results of operations for the periods indicated (in thousands): Research and Development Expenses Research and development expenses were $33.3 million for the year ended December 31, 2018 compared to $18.5 million for the year ended December 31, 2017, an increase of $14.8 million. The increase in research and development expenses was attributable to an additional $8.1 million in consulting and personnel-related costs resulting primarily from our increased employee headcount, $7.9 million of incremental AK002 contract research and development costs attributable to the expansion of our clinical development efforts including our Phase 2 trials in patients with EG and CU and our Phase 1 trial in patients with SAC, and an increase of $1.7 million in other unallocated research and development costs primarily related to the conduct of in-house research, including activities supporting the continued development of antibodies in our pipeline. The increases were partially offset by a period-over-period decrease of $2.9 million in AK001 contract research and development costs as a result of our discontinuation of AK001 development efforts during the year ended December 31, 2017. Residual costs incurred during the year ended December 31, 2018 were related to the winding down of historically contracted research and development activities. Research and development expenses were $18.5 million for the year ended December 31, 2017 compared to $14.7 million for the year ended December 31, 2016, an increase of $3.8 million. The increase in research and development expenses was primarily attributable to an additional $2.6 million in consulting and personnel-related costs resulting primarily from our increased employee headcount, as well as $2.1 million of incremental AK002 contract research and development costs, primarily attributable to the production of clinical material during the year ended December 31, 2017. Further increases of $0.7 million in other unallocated research and development costs were primarily related to the conduct of in-house research, including activities supporting the continued development of antibodies in our pipeline Increases were offset by a year-over-year decrease of $1.6 million in AK001 contract research and development costs as a result of our discontinuation of AK001 development efforts during the year ended December 31, 2017. General and Administrative Expenses General and administrative expenses were $12.4 million for the year ended December 31, 2018 compared to $3.7 million for the year ended December 31, 2017, an increase of $8.7 million. The increase in general and administrative expenses was primarily attributable to an additional $6.6 million in personnel-related costs as a result of our increase in employee headcount, as well as $0.8 million of incremental expense incurred from outside professional service providers for legal, information technology, and investor relations activities associated with becoming a publicly traded company in July 2018. Additionally, we incurred incremental facilities and other administrative costs of $1.3 million, such as general business insurance premiums, not otherwise included in research and development expenses. General and administrative expenses were $3.7 million for the year ended December 31, 2017 compared to $2.4 million for the year ended December 31, 2016, an increase of $1.3 million. The increase in general and administrative expenses was primarily attributable to an additional $1.1 million in personnel-related costs as a result of our increase in employee headcount, as well as an additional $0.2 million in other allocated costs. Interest Income (Expense), Net Interest income (expense), net, was $2.4 million for the year ended December 31, 2018 compared to $(1.3) million for the year ended December 31, 2017. The period-over-period change of $3.7 million was attributable to increased interest income of $2.4 million earned on capital raised by our Series B preferred stock financing and IPO in November 2017 and July 2018, respectively, along with decreased interest expense of $1.3 million resulting from the repayment and termination of our historical debt facility and conversion of our convertible promissory notes payable to related parties during the year ended December 31, 2017. Interest income (expense), net was $(1.3) million for the year ended December 31, 2017 compared to $(0.1) million for the year ended December 31, 2016. The period-over-period change of $1.2 million was primarily attributable to increased interest expense of $1.1 million associated with convertible promissory notes payable to related parties that were outstanding during the year ended December 31, 2017, as well as additional interest expense of $0.2 million associated with our debt facility with SVB. Other Income (Expense), Net There were no significant period-over-period changes in other income (expense), net, for the years ended December 31, 2018 and 2017. Provision for (Benefit from) Income Taxes There was no benefit from income taxes during the year ended December 31, 2018. Benefit from income taxes was $0.3 million for the year ended December 31, 2017, which was solely attributable to the intra-period tax accounting effect related to the beneficial conversion feature associated with our convertible promissory notes payable to related parties. See Note 7 to our financial statements. We did not record a benefit from income taxes for the year ended December 31, 2016. Liquidity and Capital Resources Sources of Liquidity We are a clinical stage biotechnology company with a limited operating history. As a result of our significant research and development expenditures, we have generated net losses since our inception. Prior to completing our IPO, we historically financed our operations primarily through the private placement of convertible preferred stock. These private placements provided gross proceeds of $146.9 million. We also had a debt facility with SVB, for an aggregate of $5.0 million, which was fully repaid and terminated during 2017. On July 23, 2018, we completed our IPO, selling 8,203,332 shares of common stock at a price of $18.00 per share. Proceeds from the initial public offering, net of underwriting discounts and commissions, were $137.3 million. Concurrently with our IPO, we completed a private placement of 250,000 shares of common stock at $18.00 per share to an existing stockholder. Proceeds from this private placement were $4.5 million. As of December 31, 2018, we had cash, cash equivalents and marketable securities of $178.9 million. Based on our existing business plan, we believe that our current cash, cash equivalents and marketable securities will be sufficient to fund our anticipated level of operations through at least the next 12 months from the issuance of our financial statements. Summary Cash Flows Comparison of the Years Ended December 31, 2018, 2017 and 2016 The following table summarizes the primary sources and uses of our cash, cash equivalents, and restricted cash for the periods indicated (in thousands): Cash Used in Operating Activities Net cash used in operating activities was $38.5 million for the year ended December 31, 2018, which was primarily attributable to our net loss of $43.5 million adjusted for net noncash charges of $3.4 million and net changes in operating assets and liabilities of $1.6 million. Noncash charges included $4.6 million in stock-based compensation expense and $0.2 million in depreciation and amortization expense, partially offset by $1.3 million in net amortization of premiums and discounts on marketable securities and $0.1 million accretion of tenant improvement allowances. Net cash used in operating activities was $22.6 million for the year ended December 31, 2017, which was primarily attributable to our net loss of $23.6 million. Cash used in operating activities included a net decrease of $0.7 million in operating assets and liabilities, offset by non-cash charges related to the amortization of the beneficial conversion feature associated with convertible promissory notes payable to related parties of $0.9 million, stock-based compensation of $0.4 million, depreciation and amortization of $0.2 million, stated interest on convertible promissory notes payable to related parties of $0.2 million and our loss on extinguishment of debt of $0.2 million. Net cash used in operating activities was $17.6 million for the year ended December 31, 2016, which was primarily attributable to our net loss of $17.1 million. Cash used in operating activities included a net decrease of $0.8 million in operating assets and liabilities, offset by non-cash charges related to stock-based compensation of $0.2 million and depreciation and amortization of $0.1 million. Cash Used in Investing Activities Net cash used in investing activities was $151.0 million for the year ended December 31, 2018, which consisted of $236.6 million for the purchases of marketable securities and $6.9 million for the purchases of property and equipment, partially offset by $92.5 million for maturities of marketable securities. Net cash used in investing activities was $0.3 million for the year ended December 31, 2017, which was entirely attributable to purchases of property and equipment. Net cash used in investing activities was $0.2 million for the year ended December 31, 2016, which was entirely attributable to purchase of property and equipment. Cash Provided by Financing Activities Net cash provided by financing activities was $138.8 million for the year ended December 31, 2018, which consisted primarily of $138.4 million in proceeds from the issuance of common stock, $0.3 million in proceeds received from employees for the exercise of stock options and $0.1 million in proceeds from the repayment of recourse promissory notes. Net cash provided by financing activities was $94.6 million for the year ended December 31,2017, which was primarily the result of $92.3 million of net proceeds received from private placements of our convertible preferred stock, as well as $7.4 million of net proceeds received from the issuance of convertible promissory notes payable to related parties and $0.2 million of net proceeds from the exercise of employee stock options. Cash used in financing activities included $5.3 million of repayments of historical debt facility with SVB. Net cash provided by financing activities was $24.0 million for the year ended December 31,2016, which was primarily the result of $19.0 million of net proceeds received from private placements of our convertible preferred stocks as well as $5.0 million of borrowings drawn as part of our historical debt facility with SVB. Funding Requirements We will continue to require additional capital to develop our product candidates and fund operations for the foreseeable future. We may seek to raise funding through private or public equity or debt financings, or other sources such as strategic collaborations. Adequate additional funding may not be available to us on acceptable terms or at all. Our failure to raise capital as and when needed could have a negative impact on our financial condition and our ability to pursue our business strategies. The timing and amount of our capital expenditures will depend on many factors, including: • the number and scope of clinical indications and clinical trials we decide to pursue; • the scope and costs of commercial manufacturing activities; • the extent to which we acquire or in-license other product candidates and technologies, if any; • the cost, timing and outcome of regulatory review of our product candidates; • the cost and timing of establishing sales and marketing capabilities for product candidates receiving marketing approval, if any; • the costs of preparing, filing and prosecuting patent applications, maintaining and enforcing our intellectual property rights and defending intellectual property-related claims; • our efforts to enhance operational systems and our ability to attract, hire and retain qualified personnel, including personnel to support the development of our product candidates; and • the costs associated with being a public company. If we are unable to raise additional funds when needed, we may be required to delay, reduce or terminate some or all of our development and commercialization efforts. We may also be required to sell or license to others rights to our product candidates in certain territories or indications that we would prefer to develop and commercialize ourselves. The issuance of additional equity securities may cause our stockholders to experience dilution. Future equity or debt financings may contain terms that are not favorable to us or our stockholders including debt instruments imposing covenants that restrict our operations and limit our ability to incur liens, issue additional debt, pay dividends, repurchase our common stock, make certain investments or engage in certain merger, consolidation, licensing or asset sale transactions. Contractual Obligations and Commitments The following table outlines our contractual obligations and commitments at December 31, 2018 (in thousands): (1) Operating lease obligations represent future minimum lease payments due under our current facility lease. (2) Purchase obligations represent noncancelable minimum service fees due to counterparties under various master service agreements. In addition to the amounts included in the table above, the we enter into contracts in the normal course of business with CROs and other counterparties assisting with our preclinical studies and clinical trials. Such contracts are generally cancellable, with varying provisions regarding termination. In the event of a contract being terminated, we would only be obligated for services received as of the effective date of the termination, along with cancellation fees, as applicable. Off-Balance Sheet Arrangements Since our inception, we have not entered into any off-balance sheet arrangements as defined in the rules and regulations of the SEC.
-0.010728
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0
<s>[INST] Forwardlooking statements include, but are not limited to, statements about: the impact that the adoption of new accounting pronouncements will have on our financial statements; the ability of our clinical trials to demonstrate safety and efficacy of our product candidates, and other positive results; the timing and focus of our future clinical trials, and the reporting of data from those trials; our plans relating to commercializing AK002, if approved, including the geographic areas of focus and sales strategy; the size of the market opportunity for AK002 in each of the diseases we are targeting; the number of diseases represented in the patient population enrolled in our clinical trials, and our ability to evaluate response to treatment of AK002 in diseases other than the primary indication in our clinical trials; our estimates of the number of patients in the United States who suffer from the diseases we are targeting and the number of patients that will enroll in our clinical trials; the beneficial characteristics, safety, efficacy and therapeutic effects of AK002; the timing or likelihood of regulatory filings and approvals, including our expectation to seek special designations, such as orphan drug designation, for AK002 or our other product candidates for various diseases; our ability to obtain and maintain regulatory approval of AK002 or our other product candidates; our plans relating to the further development of AK002 and our other product candidates; existing regulations and regulatory developments in the United States and other jurisdictions; our plans and ability to obtain or protect intellectual property rights, including extensions of existing patent terms where available; our continued reliance on thirdparties to conduct additional clinical trials of AK002 and our other product candidates, and for the manufacture of our product candidates for preclinical studies and clinical trials; the need to hire additional personnel and our ability to attract and retain such personnel; the accuracy of our estimates regarding expenses, future revenue, capital requirements and needs for additional financing; our financial performance; the sufficiency of our existing cash, cash equivalents and marketable securities to fund our future operating expenses and capital expenditure requirements; our expectations regarding the period during which we will qualify as an emerging growth company under the JOBS Act; and our anticipated use of the proceeds from our initial public offering and the concurrent private placement. These forwardlooking statements are subject to a number of risks, uncertainties, and assumptions, including, but not limited to, those described in “Risk Factors.” In some cases, you can identify these statements by terms such as “anticipate,” “believe,” “could,” “estimate,” “expects,” “intend,” “may,” “plan,” “potential,” “predict,” “project,” “should,” “will,” “would” or the negative of those terms, and similar expressions that convey uncertainty of future events or outcomes. These forwardlooking statements reflect our beliefs and views with respect to future events and are based on estimates and assumptions as of the date of this Annual Report on Form 10K and are subject to risks and uncertainties. We discuss many of these risks in greater detail in the section entitled “Risk Factors” included in Part I, Item 1A and elsewhere in this Report. Moreover, we operate in a very competitive and rapidly changing environment. New risks emerge from time to time. It is not possible to predict all risks, nor can we assess the impact of all factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forwardlooking statements we may make. Given these uncertainties, you should not place undue reliance on these forwardlooking statements. We qualify all of the forwardlooking statements in this Annual Report on Form 10K by these cautionary statements. Except as required by law, we assume no obligation to update these forwardlooking statements publicly, or to update the reasons actual results could differ materially from those anticipated in any forwardlooking statements, whether as a result of new information, future events or otherwise. Overview We are a clinical stage biotechnology company developing AK002, our wholly owned monoclonal antibody, for the treatment of various eosinophil and mast cell related diseases. AK002 select [/INST] Negative. </s>
2,019
7,939
1,564,824
Allakos Inc.
2020-02-25
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 financial statements and the other financial information appearing elsewhere in this Annual Report on Form 10-K. These statements generally relate to future events or to our future financial performance and involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. The following discussion and analysis contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Our actual results and the timing of events may differ materially from those discussed in our forward-looking statements as a result of various factors, including those discussed below and those discussed in the section entitled “Risk Factors” included in this Annual Report on Form 10-K. If we do update one or more forward-looking statements, no inference should be drawn that we will make additional updates with respect to those or other forward-looking statements. Additional information concerning these and other risks and uncertainties is contained in our other periodic filings with the SEC. Forward-looking statements include, but are not limited to, statements about: • the impact that the adoption of new accounting pronouncements will have on our financial statements; • the ability of our clinical trials to demonstrate safety and efficacy of our product candidates, and other positive results; • the timing and focus of our future clinical trials, and the reporting of data from those trials; • our plans relating to commercializing antolimab (AK002), if approved, including the geographic areas of focus and sales strategy; • the size of the market opportunity for antolimab (AK002) in each of the diseases we are targeting; • the number of diseases represented in the patient population enrolled in our clinical trials, and our ability to evaluate response to treatment of antolimab (AK002) in diseases other than the primary indication in our clinical trials; • our estimates of the number of patients in the United States who suffer from the diseases we are targeting and the number of patients that will enroll in our clinical trials; • the beneficial characteristics, safety, efficacy and therapeutic effects of antolimab (AK002); • the timing or likelihood of regulatory filings and approvals, including our expectation to seek special designations, such as orphan drug designation, for antolimab (AK002) or our other product candidates for various diseases; • our ability to obtain and maintain regulatory approval of antolimab (AK002) or our other product candidates; • our plans relating to the further development of antolimab (AK002) and our other product candidates; • existing regulations and regulatory developments in the United States and other jurisdictions; • our plans and ability to obtain or protect intellectual property rights, including extensions of existing patent terms where available; • our continued reliance on third-parties to conduct additional clinical trials of antolimab (AK002) and our other product candidates, and for the manufacture of our product candidates for preclinical studies and clinical trials; • the need to hire additional personnel and our ability to attract and retain such personnel; • the accuracy of our estimates regarding expenses, future revenue, capital requirements and needs for additional financing; • our financial performance; • the sufficiency of our existing cash, cash equivalents and marketable securities to fund our future operating expenses and capital expenditure requirements; and • our anticipated use of the proceeds from our initial public offering and the concurrent private placement in July 2018 and subsequent follow-on offering in August 2019. These forward-looking statements are subject to a number of risks, uncertainties, and assumptions, including, but not limited to, those described in “Risk Factors.” In some cases, you can identify these statements by terms such as “anticipate,” “believe,” “could,” “estimate,” “expects,” “intend,” “may,” “plan,” “potential,” “predict,” “project,” “should,” “will,” “would” or the negative of those terms, and similar expressions that convey uncertainty of future events or outcomes. These forward-looking statements reflect our beliefs and views with respect to future events and are based on estimates and assumptions as of the date of this Annual Report on Form 10-K and are subject to risks and uncertainties. We discuss many of these risks in greater detail in the section entitled “Risk Factors” included in Part I, Item 1A and elsewhere in this Report. Moreover, we operate in a very competitive and rapidly changing environment. New risks emerge from time to time. It is not possible to predict all risks, nor can we assess the impact of all factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements we may make. Given these uncertainties, you should not place undue reliance on these forward-looking statements. We qualify all of the forward-looking statements in this Annual Report on Form 10-K by these cautionary statements. Except as required by law, we assume no obligation to update these forward-looking statements publicly, or to update the reasons actual results could differ materially from those anticipated in any forward-looking statements, whether as a result of new information, future events or otherwise. Our discussion and analysis below are focused on our financial results and liquidity and capital resources for the years ended December 31, 2019 and 2018, including year-over-year comparisons of our financial performance and condition for these years. Discussion and analysis of the year ended December 31, 2017 specifically, as well as the year-over-year comparison of our financial performance and condition for the years ended December 31, 2018 and 2017, are located in Part II, Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2018, filed with the SEC on March 14, 2019. Overview We are a clinical stage biotechnology company developing antolimab (AK002), our wholly owned monoclonal antibody, for the treatment of various mast cell and eosinophil related diseases. Antolimab (AK002) selectively targets both mast cells and eosinophils, two types of white blood cells that are widely distributed in the body and play a central role in the inflammatory response. Inappropriately activated mast cells and eosinophils have been identified as key drivers in a number of severe diseases affecting the gastrointestinal tract, eyes, skin, lungs and other organs. As such, antolimab (AK002) has the potential to treat a large number of severe diseases. Antolimab (AK002) completed a double-blind, randomized, placebo-controlled Phase 2 study in patients with eosinophilic gastritis (“EG”) and/or eosinophilic gastroenteritis (“EGE”; the “ENIGMA study”). The ENIGMA study met all prespecified primary and secondary endpoints when compared to placebo. Additionally, patients in the ENIGMA study with co-morbid eosinophilic esophagitis (“EoE”) showed histological and symptom improvement when treated with antolimab (AK002) compared to placebo. Based on these results from the ENIGMA study, we plan to initiate a Phase 3 study in patients with EG and/or EGE and a Phase 2/3 study in patients with EoE. Antolimab (AK002) also showed promising activity in clinical studies in chronic urticaria (“CU”), indolent systemic mastocytosis (“ISM”), and severe allergic conjunctivitis (“SAC”). In addition, improvements were also observed in atopic comorbidities such as asthma, atopic dermatitis, and allergic rhinitis. The activity observed in these studies suggests that antolimab (AK002) could provide significant benefit to patients suffering from these diseases and highlights the potential of antolimab (AK002) to broadly inhibit mast cells and deplete eosinophils in different disease settings. Despite the knowledge that mast cells and eosinophils drive many pathological conditions, there are no approved therapies that selectively target both mast cells and eosinophils. Antolimab (AK002) binds to Siglec-8, an inhibitory receptor found on mast cells and eosinophils, which represents a novel way to selectively deplete or inhibit these important immune cells and thereby potentially resolve inflammation. We believe antolimab (AK002) is the only Siglec-8 targeting antibody currently in clinical development and may have advantages over current treatment options available to patients for the diseases we are pursuing. Since our inception in 2012, we have devoted substantially all of our resources and efforts towards the research and development of our product candidates. Our lead product candidate, antolimab (AK002), a monoclonal antibody targeting Siglec-8, entered clinical trials in 2016. In addition to activities conducted internally at our facilities, we have utilized significant financial resources to engage contractors, consultants and other third parties to conduct various preclinical and clinical development activities on our behalf. To date, we have not had any products approved for sale and have not generated any revenue nor been profitable. Further, we do not expect to generate revenue from product sales until such time, if ever, that we are able to successfully complete the development and obtain marketing approval for one of our product candidates. We will continue to require additional capital to develop our product candidates and fund operations for the foreseeable future. We have incurred significant operating losses to date and expect to incur significant operating losses for the foreseeable future. Our net losses were $85.4 million and $43.5 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had an accumulated deficit of $189.5 million. Prior to completing our IPO in July 2018 and subsequent follow-on offering in August 2019, our operations had been historically financed primarily through the private placements of convertible debt instruments and convertible preferred stock. These private placements provided gross proceeds of $146.9 million. As of December 31, 2019, we had cash, cash equivalents and marketable securities of $495.9 million, which we believe will be sufficient to fund our planned operations for at least the next 12 months from the issuance of our financial statements. July 2018 Initial Public Offering On July 23, 2018, we completed an IPO, selling 8,203,332 shares of common stock at $18.00 per share (the “July 2018 IPO”). Proceeds from our July 2018 IPO, net of underwriting discounts and commissions, were $137.3 million. Concurrently with our July 2018 IPO, we completed a private placement of 250,000 shares of common stock at $18.00 per share to an existing stockholder. Proceeds from this private placement were $4.5 million. In connection with the completion of the July 2018 IPO, all then outstanding shares of convertible preferred stock converted into 30,971,627 shares of common stock. August 2019 Follow-On Offering On August 9, 2019, we closed an underwritten public offering (the “August 2019 Offering”) under our shelf registration statement on Form S-3 (File No. 333-233018) pursuant to which we sold an aggregate of 5,227,272 shares of our common stock at a public offering price of $77.00 per share. We received aggregate net proceeds of $377.5 million, after deducting the underwriting discounts and commissions and offering expenses. Components of Operating Results Revenue We have not generated any revenue from product sales or otherwise, and do not expect to generate any revenue for at least the next several years. Operating Expenses We classify operating expenses into two categories: (i) research and development and (ii) general and administrative. Research and Development Expenses Research and development expenses represent the following costs incurred by us for the discovery, development and manufacturing of our product candidates: • consultant and personnel-related costs including salaries, benefits, travel and stock-based compensation expense; • costs incurred under service agreements with contract research organizations (“CROs”) that conduct nonclinical and clinical research activities on our behalf; • costs incurred under service agreements with contract development and manufacturing organizations (“CDMOs”) for the manufacture and fill finish of our preclinical and clinical materials; • costs related to in-house research and development activities conducted at our facilities including laboratory supplies, non-capital laboratory equipment and depreciation of capital laboratory equipment and leasehold improvements to laboratories; • costs incurred under exclusive and non-exclusive license agreements with third-parties; and • allocated facility and other costs including the rent and maintenance of our facilities, insurance premiums, depreciation of shared-use leasehold improvements and general office supplies. The successful development of our product candidates is highly uncertain. Accordingly, it is difficult to estimate the nature, timing and extent of costs necessary to complete the remainder of the development of our product candidates. We are also unable to predict when, if ever, we will be able to generate revenue from our product candidates. This is due to the numerous risks and uncertainties associated with developing drugs, including the uncertainty surrounding: • demonstrating sufficient safety and tolerability profiles of product candidates; • successful enrollment and completion of clinical trials; • requisite clearance and approvals from applicable regulatory authorities; • establishing and maintaining commercial manufacturing capabilities with CDMOs; • obtaining and maintaining protection of intellectual property; and • commercializing product candidates, if and when approved, alone or in collaboration with third-parties. A change pertaining to any of these variables would significantly impact the timing and extent of costs incurred with respect to the development and commercialization of our product candidates. External costs incurred from CROs and CDMOs have comprised a significant portion of our research and development expenses since inception. We track CRO and CDMO costs on a program-by-program basis following the advancement of a product candidate into clinical development. Consulting and personnel-related costs, laboratory supplies and non-capital equipment utilized in the conduct of in-house research, in-licensing fees and general overhead, are not tracked on a program-by-program basis, nor are they allocated, as they commonly benefit multiple projects, including those still in our pipeline. The following table summarizes our research and development expenses for the periods indicated (in thousands): General and Administrative Expenses General and administrative expenses consist of fees paid to consultants, salaries, benefits and other personnel-related costs, including stock-based compensation, for our personnel in executive, finance, accounting and other administrative functions, legal costs, fees paid for accounting and tax services and facility costs not otherwise included in research and development expenses. Legal costs include general corporate and patent legal fees and related costs. We anticipate that our general and administrative expenses will increase in the future to support our continued research and development activities including costs related to personnel, outside consultants, attorneys and accountants, among others. Additionally, we expect to incur incremental costs associated with continuing to operate as a public company, including expenses related to maintaining compliance with the rules and regulations of the SEC, and those of any national securities exchange on which our securities are traded, additional insurance premiums, investor relations activities and other ancillary administrative and professional services. Interest Income (Expense), Net Interest income, net primarily consists of interest and investment income earned on our cash, cash equivalents and marketable securities included on the balance sheets. Other Income (Expense), Net Other expense, net, primarily consists of amounts realized from gains and losses related to fluctuations in foreign currencies. In-Licensing Agreements We have entered into a number of exclusive and nonexclusive, royalty bearing license agreements with third-parties for certain intellectual property. Under the terms of the license agreements described below, we are obligated to pay milestone payments upon the achievement of specified clinical, regulatory and commercial milestones. Actual amounts due under the license agreements vary depending on factors including, but not limited to, the number of product candidates we develop and our ability to successfully develop and commercialize our product candidates covered under the respective agreements. In addition to milestone payments, we are also subject to future royalty payments based on sales of our product candidates covered under the agreements, as well as certain minimum annual royalty and commercial reservation fees. Because the achievement of milestones and the timing and extent of future royalties is not probable, these contingent amounts have not been included on our balance sheets or as part of Contractual Obligations and Commitments discussion below. We did not incur any milestone expense for the year ended December 31, 2019. We recognized $0.3 million of milestone expense for the year ended December 31, 2018. Milestone payments are not creditable against royalties. As of December 31, 2019, we have not incurred any royalty liabilities related to our license agreements, as product sales have not yet commenced. Exclusive License Agreement with The Johns Hopkins University In December 2013, we entered into a license agreement with JHU for a worldwide exclusive license to develop, use, manufacture and commercialize covered product candidates including antolimab (AK002), which was amended in September 2016. Under the terms of the agreement, we have made upfront and milestone payments of $0.3 million through December 31, 2019 and we may be required to make aggregate additional milestone payments of up to $4.0 million. We also issued 88,887 shares of common stock as consideration under the JHU license agreement. In addition to milestone payments, we are also subject to single-digit royalties to JHU based on future net sales of each licensed therapeutic product candidate by us and our affiliates and sublicensees, with up to a low six-digit dollar minimum annual royalty payment. Non-exclusive License Agreement with BioWa Inc. and Lonza Sales AG In October 2013, we entered into a tripartite agreement with BioWa and Lonza for the non-exclusive worldwide license to develop and commercialize product candidates including antolimab (AK002) that are manufactured using a technology jointly developed and owned by BioWa and Lonza. Under the terms of the agreement, we have made milestone payments of $0.4 million through December 31, 2019 and we may be required to make aggregate additional milestone payments of up to $41.0 million. In addition to milestone payments, we are also subject to minimum annual commercial license fees of $40,000 per year to BioWa until such time as BioWa receives royalty payments, as well as low single-digit royalties to BioWa and to Lonza. Royalties are based on future net sales by us and our affiliates and sublicensees and vary dependent on Lonza’s participation as sole manufacturer for commercial production. Critical Accounting Policies and Use of 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 generally accepted accounting principles in the United States (“U.S. GAAP”). The preparation of our 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. We believe that the accounting policies discussed below are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving management’s judgments and estimates. Accrued Contract Research and Development Expense As part of our preparation of the financial statements, we are required to estimate our accrued expenses as of each balance sheet date. This process involves reviewing open contracts and purchase orders, as well as working with internal personnel to identify the existence and extent of services that have been performed on our behalf which have not yet been invoiced. 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, recording adjustments, if necessary. Estimates underlying accrued contract research and development expense primarily relate to our evaluation of the timing and extent of services performed by CROs and CDMOs that conduct various research and development activities on our behalf. As the financial terms included within service agreements with such CROs and CDMOs vary from contract to contract and often include uneven payment flows, our evaluation focuses on the level of effort and resources expended. Accordingly, the calculation of accrued contract research and development expense requires us to analyze a significant amount of inputs and data from multiple internal and external sources, including information from communications with clinical operations and technical operations personnel. 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 higher or lower in any particular period. To date, there have been no material differences between our estimates of such expenses and the amounts actually incurred for the periods reported. Stock-Based Compensation We account for stock-based compensation expense resulting from stock-based awards granted to employees and nonemployees in accordance with ASC 718, Compensation-Stock Compensation, (“ASC 718”). Per ASC 718, we measure the fair value of stock-based awards on the date of grant and recognize the associated compensation expense, net of impact from estimated forfeitures, over the requisite service period on a straight-line basis. The vesting period of the stock-based award has historically served as the requisite service period for the respective grants to our employees, nonemployee directors and consultants. At each subsequent reporting date, we are required to evaluate whether the achievement of any associated vesting conditions is probable and whether or not any such events have occurred that would have resulted in the acceleration of vesting. Determining the amount of stock-based compensation expense to be recorded requires us to develop estimates of the fair value of stock options as of the date of grant. We estimate the fair value of each stock-based award using the Black-Scholes option-pricing model. The Black-Scholes option-pricing model uses highly subjective inputs such as the fair value of our common stock, as well as other assumptions including the expected volatility of our common stock, the expected term of the respective stock-based award, the risk-free interest rate for a period that approximates the expected term of the stock-based award being valued and the expected dividend yield on our common stock over the expected term. Expected volatility. As we do not have sufficient trading history for our common stock, we have based our computation of expected volatility on the historical volatility of a representative group of public life science companies with similar characteristics to us, including company age and stage of product development. The historical volatility data is calculated based on a period of time commensurate with the expected term of the stock-based award being valued. We will continue to utilize this approach until a sufficient amount of historical information regarding the volatility of our own stock price becomes available or until other relevant circumstances change, such as our assessment that our identified entities are no longer appropriate to use as representative companies. In the latter case, more suitable, similar entities with publicly available stock prices will be incorporated in the calculation. Expected term. In order to estimate the expected term of a stock-based award, we use the simplified method prescribed by SEC Staff Accounting Bulletin No. 107, Share-Based Payment, as we do not have sufficient historical exercise data to provide a reasonable basis upon which to estimate the expected term. Under this approach, the expected term is presumed to be the average of the contractual term (ten years) and the vesting term (generally four years) of the stock-based award. We have not historically experienced, nor do we expect there to be substantially different exercise or post-vesting termination behavior among our employees and directors. Risk-free interest rate. The risk-free interest rate is based on publicly available yields of U.S. Treasury instruments with maturities consistent with the expected term of the stock-based award. Expected dividend yield. The expected dividend yield is assumed to be zero as we have never paid dividends and have no current plans to pay any dividends on our common stock. Income Taxes We account for income taxes under the asset and liability method. Current income tax expense or benefit represents the amount of income taxes we expect to pay or have refunded in the current year. Our deferred income tax assets and liabilities are determined based on differences between financial statement reporting and tax basis accounting of assets and liabilities and net operating loss and credit carryforwards, which we measure using the enacted tax rates and laws that will be in effect when such items are expected to reverse. We reduce deferred income tax assets, as necessary, by applying a valuation allowance to the extent that we determined it is more likely than not that some or all of our tax benefits will not be realized. We account for uncertain tax positions in accordance with ASC 740-10, Accounting for Uncertainty in Income Taxes. We assess all material positions reflected in our income tax returns, including all significant uncertain positions, for all tax years that are subject to assessment or challenge by relevant taxing authorities. Upon determining the sustainability of our positions, we measure the largest amount of benefit possessing greater than fifty percent likelihood of being realized upon ultimate settlement. We reassess such positions at each balance sheet date to determine whether any factors underlying the sustainability assertion have changed and whether or not the amount of the recognized tax benefit is still appropriate. As of December 31, 2019, our gross deferred tax assets were $61.5 million. Due to our lack of earnings history and uncertainties surrounding our ability to generate future taxable income, we have offset the total net deferred tax assets with a full valuation allowance. The deferred tax assets were primarily comprised of federal and state tax net operating losses, (“NOLs”), which may be limited by certain rules governing changes in ownership, as defined in Section 382 of the Internal Revenue Code of 1986, as amended. Similar rules may apply under state tax laws. Our ability to use our remaining NOLs may be further limited if we experience future ownership changes. The recognition and measurement of tax benefits requires significant judgment, especially in assessing uncertain tax positions. Judgments concerning the recognition and measurement of our tax benefits, as well as limitations surrounding their realizability, might change as new information becomes available. Recent Accounting Pronouncements See Note 2 to our financial statements for recently issued accounting pronouncements, including the respective effective dates of adoption and effects on our results of operations and financial condition. Results of Operations The following table summarizes our results of operations for the periods indicated (in thousands): Comparison of the Years Ended December 31, 2019 and 2018 Research and Development Expenses Research and development expenses were $61.9 million for the year ended December 31, 2019 compared to $33.3 million for the year ended December 31, 2018, an increase of $28.6 million. The period-over-period increase in research and development expenses includes $17.9 million of incremental antolimab (AK002) contract research and development costs, primarily attributable to $15.9 million of CDMO services and $2.0 million of CRO services. Increased hiring of R&D personnel during fiscal year 2019 contributed to an additional $9.8 million of consulting and personnel-related costs and an additional $1.3 million increase of other unallocated research and development costs related to the conduct of in-house research. Period-over-period increases were offset by a decrease of $1.1 million related to reduced spend on historical product candidates that are no longer in development and a $0.3 million license fee that was recognized during the first quarter of 2018. General and Administrative Expenses General and administrative expenses were $29.6 million for the year ended December 31, 2019 compared to $12.4 million for the year ended December 31, 2018, an increase of $17.2 million. The period-over-period increase in general and administrative expenses was primarily attributable to an additional $12.1 million of personnel-related costs resulting from our increased hiring of G&A personnel, as well as $2.3 million of incremental expense incurred from outside professional service providers for legal, information technology, and investor relations activities associated with becoming a publicly traded company in July 2018. Finally, we incurred incremental facilities and other administrative costs of $1.8 million, which includes general business insurance premiums and other such costs not otherwise included in research and development expenses. Interest Income (Expense), Net Interest income, net, was $6.2 million for the year ended December 31, 2019 compared to $2.4 million for the year ended December 31, 2018, an increase of $3.8 million. The year-over-year increase is directly attributable to increased interest income earned on capital raised by our July 2018 IPO and our August 2019 Offering. Other Expense, Net There were no significant period-over-period changes in other expense, net, for the years ended December 31, 2019 and 2018. Benefit from Income Taxes There was no benefit from income taxes during the years ended December 31, 2019 and 2018. Liquidity and Capital Resources Sources of Liquidity We are a clinical stage biotechnology company with a limited operating history. As a result of our significant research and development expenditures, we have generated net losses since our inception. Prior to completing our July 2018 IPO and August 2019 Offering, we historically financed our operations primarily through the private placement of convertible preferred stock. These private placements provided gross proceeds of $146.9 million. We also had a debt facility with SVB, for an aggregate of $5.0 million, which was fully repaid and terminated during 2017. In connection with our July 2018 IPO, we sold 8,203,332 shares of common stock at a price of $18.00 per share. Proceeds from the July 2018 IPO, net of underwriting discounts and commissions, were $137.3 million. Concurrently with our July 2018 IPO, we completed a private placement of 250,000 shares of common stock at $18.00 per share to an existing stockholder. Proceeds from this private placement were $4.5 million. We closed the August 2019 Offering under our shelf registration statement on Form S-3 (File No. 333-233018) pursuant to which we sold an aggregate of 5,227,272 shares of our common stock at a public offering price of $77.00 per share. We received aggregate net proceeds of $377.5 million, after deducting the underwriting discounts and commissions and offering expenses. As of December 31, 2019, we had cash, cash equivalents and marketable securities of $495.9 million. Based on our existing business plan, we believe that our current cash, cash equivalents and marketable securities will be sufficient to fund our anticipated level of operations through at least the next 12 months from the issuance of our financial statements. Summary Cash Flows The following table summarizes the primary sources and uses of our cash, cash equivalents, and restricted cash for the periods indicated (in thousands): Comparison of the Years Ended December 31, 2019 and 2018 Cash Used in Operating Activities Net cash used in operating activities was $63.0 million for the year ended December 31, 2019, which was primarily attributable to our net loss of $85.4 million adjusted for net noncash charges of $14.9 million and net changes in operating assets and liabilities of $7.5 million. Noncash charges included $15.8 million in stock-based compensation expense, $1.5 million in depreciation and amortization expense and $0.3 million in amortization of right-of-use asset, partially offset by $2.7 million in net amortization of premiums and discounts on marketable securities. Net cash used in operating activities was $38.5 million for the year ended December 31, 2018, which was primarily attributable to our net loss of $43.5 million adjusted for net noncash charges of $3.4 million and net changes in operating assets and liabilities of $1.6 million. Noncash charges included $4.6 million in stock-based compensation expense and $0.2 million in depreciation and amortization expense, partially offset by $1.3 million in net amortization of premiums and discounts on marketable securities and $0.1 million accretion of tenant improvement allowances. Cash Used in Investing Activities Net cash used in investing activities was $312.0 million for the year ended December 31, 2019, which consisted of $541.7 million for the purchases of marketable securities and $0.8 million for the purchases of property and equipment, partially offset by $231.0 million for maturities of marketable securities. Net cash used in investing activities was $151.0 million for the year ended December 31, 2018, which consisted of $236.6 million for the purchases of marketable securities and $6.9 million for the purchases of property and equipment, partially offset by $92.5 million for maturities of marketable securities. Cash Provided by Financing Activities Net cash provided by financing activities was $381.2 million for the year ended December 31, 2019, which consisted primarily of $377.5 million in net proceeds from the issuance of common stock, $2.4 million in proceeds received from employees for the exercise of stock options and $1.2 million in proceeds from the issuance of common stock under the 2018 ESPP. Net cash provided by financing activities was $138.8 million for the year ended December 31, 2018, which consisted primarily of $138.4 million in proceeds from the issuance of common stock, $0.3 million in proceeds received from employees for the exercise of stock options and $0.1 million in proceeds from the repayment of recourse promissory notes. Funding Requirements We will continue to require additional capital to develop our product candidates and fund operations for the foreseeable future. We may seek to raise funding through private or public equity or debt financings, or other sources such as strategic collaborations. Adequate additional funding may not be available to us on acceptable terms or at all. Our failure to raise capital as and when needed could have a negative impact on our financial condition and our ability to pursue our business strategies. The timing and amount of our capital expenditures will depend on many factors, including: • the number and scope of clinical indications and clinical trials we decide to pursue; • the scope and costs of commercial manufacturing activities; • the extent to which we acquire or in-license other product candidates and technologies, if any; • the cost, timing and outcome of regulatory review of our product candidates; • the cost and timing of establishing sales and marketing capabilities for product candidates receiving marketing approval, if any; • the costs of preparing, filing and prosecuting patent applications, maintaining and enforcing our intellectual property rights and defending intellectual property-related claims; • our efforts to enhance operational systems and our ability to attract, hire and retain qualified personnel, including personnel to support the development of our product candidates; and • the costs associated with being a public company. If we are unable to raise additional funds when needed, we may be required to delay, reduce or terminate some or all of our development and commercialization efforts. We may also be required to sell or license to others rights to our product candidates in certain territories or indications that we would prefer to develop and commercialize ourselves. The issuance of additional equity securities may cause our stockholders to experience dilution. Future equity or debt financings may contain terms that are not favorable to us or our stockholders including debt instruments imposing covenants that restrict our operations and limit our ability to incur liens, issue additional debt, pay dividends, repurchase our common stock, make certain investments or engage in certain merger, consolidation, licensing or asset sale transactions. Contractual Obligations and Commitments The following table outlines our contractual obligations and commitments at December 31, 2019 (in thousands): (1) Operating lease obligations represent future minimum lease payments due under our two lease agreements. (2) Purchase obligations represent noncancelable minimum service fees due to counterparties under various master service agreements. In addition to the amounts included in the table above, we enter into contracts in the normal course of business with CROs and other counterparties assisting with our preclinical studies and clinical trials. Such contracts are generally cancellable, with varying provisions regarding termination. In the event of a contract being terminated, we would only be obligated for services received as of the effective date of the termination, along with cancellation fees, as applicable. Off-Balance Sheet Arrangements Since our inception, we have not entered into any off-balance sheet arrangements as defined in the rules and regulations of the SEC.
-0.016976
-0.01694
0
<s>[INST] Forwardlooking statements include, but are not limited to, statements about: the impact that the adoption of new accounting pronouncements will have on our financial statements; the ability of our clinical trials to demonstrate safety and efficacy of our product candidates, and other positive results; the timing and focus of our future clinical trials, and the reporting of data from those trials; our plans relating to commercializing antolimab (AK002), if approved, including the geographic areas of focus and sales strategy; the size of the market opportunity for antolimab (AK002) in each of the diseases we are targeting; the number of diseases represented in the patient population enrolled in our clinical trials, and our ability to evaluate response to treatment of antolimab (AK002) in diseases other than the primary indication in our clinical trials; our estimates of the number of patients in the United States who suffer from the diseases we are targeting and the number of patients that will enroll in our clinical trials; the beneficial characteristics, safety, efficacy and therapeutic effects of antolimab (AK002); the timing or likelihood of regulatory filings and approvals, including our expectation to seek special designations, such as orphan drug designation, for antolimab (AK002) or our other product candidates for various diseases; our ability to obtain and maintain regulatory approval of antolimab (AK002) or our other product candidates; our plans relating to the further development of antolimab (AK002) and our other product candidates; existing regulations and regulatory developments in the United States and other jurisdictions; our plans and ability to obtain or protect intellectual property rights, including extensions of existing patent terms where available; our continued reliance on thirdparties to conduct additional clinical trials of antolimab (AK002) and our other product candidates, and for the manufacture of our product candidates for preclinical studies and clinical trials; the need to hire additional personnel and our ability to attract and retain such personnel; the accuracy of our estimates regarding expenses, future revenue, capital requirements and needs for additional financing; our financial performance; the sufficiency of our existing cash, cash equivalents and marketable securities to fund our future operating expenses and capital expenditure requirements; and our anticipated use of the proceeds from our initial public offering and the concurrent private placement in July 2018 and subsequent followon offering in August 2019. These forwardlooking statements are subject to a number of risks, uncertainties, and assumptions, including, but not limited to, those described in “Risk Factors.” In some cases, you can identify these statements by terms such as “anticipate,” “believe,” “could,” “estimate,” “expects,” “intend,” “may,” “plan,” “potential,” “predict,” “project,” “should,” “will,” “would” or the negative of those terms, and similar expressions that convey uncertainty of future events or outcomes. These forwardlooking statements reflect our beliefs and views with respect to future events and are based on estimates and assumptions as of the date of this Annual Report on Form 10K and are subject to risks and uncertainties. We discuss many of these risks in greater detail in the section entitled “Risk Factors” included in Part I, Item 1A and elsewhere in this Report. Moreover, we operate in a very competitive and rapidly changing environment. New risks emerge from time to time. It is not possible to predict all risks, nor can we assess the impact of all factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forwardlooking statements we may make. Given these uncertainties, you should not place undue reliance on these forwardlooking statements. We qualify all of the forwardlooking statements in this Annual Report on Form 10K by these cautionary statements. Except as required by law, we assume no obligation to update these forwardlooking statements publicly, or to update the reasons actual results could differ materially from those anticipated in any forwardlooking statements, whether as a result of new information, future events or otherwise. Our discussion and analysis below are focused on our financial results and liquidity and capital resources for the years ended December 31 [/INST] Negative. </s>
2,020
5,997
1,664,106
LogicBio Therapeutics, 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 of our financial condition and results of operations should be read in conjunction with our financial statements and related notes appearing elsewhere in this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10-K, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties. As a result of many factors, including those factors set forth in the “Risk Factors” section of this Annual Report on Form 10-K, our actual results could differ materially from the results described in, or implied by, these forward-looking statements. Overview We are a genome editing company focused on developing medicines to durably treat rare diseases in patients with significant unmet medical need using GeneRide, our proprietary technology platform. Our GeneRide technology is designed to precisely integrate corrective genes into a patient’s genome to provide a stable therapeutic effect. Because GeneRide is designed to have this durable therapeutic effect, we are initially targeting rare liver disorders in pediatric patients where it is critical to provide treatment early in a patient’s life before irreversible disease pathology can occur. We have demonstrated proof of concept of our therapeutic platform in animal models for a number of diseases and are focusing on development of our lead product candidate, LB-001, for the treatment of Methylmalonic Acidemia, or MMA, a life-threatening disease that presents at birth. Based on our GeneRide technology, we are developing our lead product candidate, LB-001, to treat MMA. We plan to advance LB-001 to an IND filing by the end of 2019 and into a Phase 1/2 clinical trial in pediatric MMA patients in 2020. We believe that achieving clinical proof of concept in an inherited liver disease such as MMA will validate our platform technology, including its potential application to other organs and diseases. In addition to MMA, we have demonstrated proof of concept of our platform in hemophilia B, alpha-1-antitrypsin deficiency, or A1ATD, and Crigler-Najjar syndrome animal disease models. We expect to select future product candidates from these genetic diseases or others addressed by targeting the liver initially, and later by targeting the CNS and muscle. Since our inception in 2014, we have devoted all of our efforts to business planning, research and development, developing and protecting our intellectual property, raising capital, recruiting management and technical staff. We do not have any products approved for sale and have not generated any revenue. As of December 31, 2018, we have raised approximately $72.3 million in net proceeds through our initial public offering, or IPO, in October 2018 and approximately $33.1 million in net proceeds from the sale of our convertible preferred stock in 2016 and 2017. We have incurred significant operating losses since our inception. Our ability to generate product revenue sufficient to achieve profitability will depend on the successful development and commercialization of one or more of our product candidates. Our net losses were $17.6 million and $5.8 million for the years ended December 31, 2018 and 2017, respectively. As of December 31, 2018, we had an accumulated deficit of $27.2 million. We expect to continue to incur significant expenses and increasing operating losses for the foreseeable future in connection with our ongoing activities. Furthermore, we now incur additional costs associated with operating as a public company that we did not previously incur or had previously incurred at lower rates as a private company, including significant legal, accounting, investor relations and other expenses. Initial Public Offering On October 23, 2018, we completed our IPO, in which we issued and sold 8,050,000 shares of common stock, including 1,050,000 shares sold pursuant to the full exercise of the underwriters’ option to purchase additional shares, at a public offering price of $10.00 per share. The aggregate net proceeds to us from the IPO were approximately $72.3 million after deducting underwriting discounts and commissions and offering expenses. The shares began trading on The Nasdaq Global Market on October 19, 2018. Upon completion of the IPO, all of our outstanding shares of convertible preferred stock, converted into 11,789,775 shares of our common stock. Components of Results of Operations Revenue Since inception through December 31, 2018, we have not generated any revenue. We do not expect to generate any revenue from the sale of products in the near future. If our development efforts for LB-001, or other product candidates that we may develop in the future, are successful and result in regulatory approval or collaboration or license agreements with third parties, we may generate revenue in the future from a combination of product sales or payments from collaboration or license agreements. Operating Expenses Research and Development Expenses Research and development expenses consist primarily of costs incurred for our research activities, including our discovery efforts and the development of our product candidates, and include: • salaries, benefits and other related costs, including stock-based compensation expense, for personnel engaged in research and development functions; • license maintenance fees and milestone fees incurred in connection with various license agreements; • the costs of laboratory supplies and acquiring, developing and manufacturing preclinical study and, eventually, clinical trial materials; • expenses incurred under agreements with contract research organizations, or CROs, contract manufacturing organizations, or CMOs, as well as academic institutions and consultants that conduct our preclinical studies and other scientific development services; • facility-related expenses, which include direct depreciation costs and allocated expenses for rent and maintenance of facilities and other operating costs; • costs of outside consultants, including their fees, stock-based compensation and related travel expenses; and • costs related to compliance with regulatory requirements. We expense research and development costs as incurred. Costs for external development activities are recognized based on an evaluation of the progress to completion of specific tasks using information provided to us by our vendors. Payments for these activities are based on the terms of the individual agreements, which may differ from the pattern of costs incurred, and are reflected in our financial statements as prepaid or accrued research and development expenses. Research and development activities are central to our business model. We expect that our research and development expenses will continue to increase for the foreseeable future as we initiate clinical trials for our product candidate LB-001 and continue to discover and develop additional product candidates. If any of our product candidates enter into later stages of clinical development, they will 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. General and Administrative Expenses General and administrative expenses consist primarily of salaries and other related costs, including stock-based compensation, for personnel in our executive, finance, corporate and business development and administrative functions. General and administrative expenses also include professional fees for legal, patent, accounting, auditing, tax and consulting services, travel expenses, and facility-related expenses, which include direct depreciation costs and allocated expenses for rent and maintenance of facilities and other operating costs. We expect that our general and administrative expenses will increase in the future as we increase our general and administrative headcount to support our continued research and development and potential commercialization of our product candidates. We also expect to incur increased expenses associated with being a public company, including costs of accounting, audit, legal, regulatory and tax compliance services, director and officer insurance costs; and investor and public relations costs. Other Income (Expense), Net Interest income (expense), net consists primarily of interest on our cash and cash equivalents. Other (expense) income, net consists primarily of foreign exchange gains and losses. Results of Operations Year Ended December 31, 2018 and 2017 The following table summarizes our results of operations for the year ended December 31, 2018 and 2017: Research and Development Expenses The following table summarizes our research and development expenses for the years ended December 31, 2018 and 2017: Research and development expenses for the year ended December 31, 2018 were $11.1 million, compared to $3.6 million for year ended December 31, 2017. The increase of approximately $7.5 million was primarily due to an increase of approximately $3.4 million related to external development and manufacturing expenses for our lead product candidate LB-001, $3.1 million in other research and development expenses as we increased our overall research and development activities, and $1.0 million in personnel-related costs related to an increase in headcount. Personnel-related costs for the year ended December 31, 2018 included stock-based compensation expense of $0.3 million compared to $0.4 million for the year ended December 31, 2017. General and Administrative Expenses General and administrative expenses were $6.9 million for the year ended December 31, 2018, compared to $2.3 million for the year ended December 31, 2017. The increase of approximately $4.6 million was primarily due to legal and professional fees and personnel-related costs, including salaries, stock-based compensation and bonuses. The increase in professional fees was primarily due to the increase in legal, auditing and consulting services provided. The increase in personnel-related costs was primarily due to an increase in headcount of executive level employees. Stock-based compensation expense included in general and administrative expenses was $0.8 million and $0.1 million for the years ended December 31, 2018 and 2017, respectively. Other Income, Net Other income, net was $0.4 million for the year ended December 31, 2018, compared to other income, net of $0.1 million for the year ended December 31, 2017. The change was primarily related to interest earned on our money market accounts. Liquidity and Capital Resources Overview Since our inception and through December 31, 2018, we have not generated any revenue and have incurred significant losses and negative cash flows from our operations. Cash Flows The following table summarized our cash flows for each of the years ended December 31, 2018 and 2017: Operating Activities During the year ended December 31, 2018, operating activities used $15.3 million of cash, primarily from our net loss of $17.6 million and net cash provided by changes in our operating assets and liabilities of $1.0 million, non-cash charges of $1.3 million, which were primarily related to stock-based compensation expense and loss on disposal of property and equipment. Changes in net cash in our operating assets and liabilities for the year ended December 31, 2018 consisted primarily of a $0.2 million increase to prepaid expenses and other current assets, a $0.9 million increase in accrued expenses and other liabilities and a $0.2 million decrease to other non-current assets. The increase in accrued expenses was primarily due to the increase in accrued professional services mainly related to the IPO. During the year ended December 31, 2017, operating activities used $5.8 million of cash, primarily from our net loss of $5.8 million and net cash used by changes in our operating assets and liabilities of $0.5 million, partially offset by non-cash charges of $0.5 million, primarily related to stock-based compensation expense. Net cash used by changes in our operating assets and liabilities for the year ended December 31, 2017 consisted primarily of a $1.0 million increase in prepaid expenses and other current assets and a $0.2 million increase in other non-current assets, which were partially offset by an increase of $0.8 million in accounts payable. The increases in prepaid expenses and other current assets and other non-current assets were primarily due to an increase in prepayments related to our research agreements. The increase in accounts payable was primarily due to an increase in spending related to LB-001. Investing Activities During the year ended December 31, 2018, net cash used in investing activities was $0.6 million, primarily from the purchase of property and equipment. During the year ended December 31, 2017, net cash used in investing activities was $36,000 for the purchase of property and equipment. Financing Activities During the year ended December 31, 2018, net cash provided by financing activities was $72.3 million, primarily from the issuance of common stock related to the IPO. During the year ended December 31, 2017, net cash provided by financing activities was $28.7 million, primarily from net proceeds from the sale of the first tranche of Series B preferred stock in June 2017. Funding Requirements We expect our expenses to increase substantially in connection with our ongoing activities, particularly as we advance the preclinical activities and clinical trials of our product candidates. We expect that our expenses will increase substantially if and as we: • continue our current research programs and our preclinical development of any product candidates from our current research programs; • initiate clinical trials for LB-001 and any other product candidates we identify and develop; • seek to identify, assess, acquire and/or develop additional research programs and additional product candidates; • seek marketing approvals for any product candidate that successfully complete clinical trials; • develop, optimize, scale and validate a manufacturing process and analytical methods for any product candidates we may develop; • establish and build out internal process and analytical development capabilities and research and preclinical grade production; • obtain market acceptance of any product candidates we may develop as viable treatment options; • address competing technological and market developments; • maintain, expand and protect our intellectual property portfolio and provide reimbursement of third-party expenses related to our patent portfolio; • further develop our GeneRide technology platform; • hire additional technical, quality, regulatory, clinical, scientific and commercial personnel; add operational, financial and management information systems and personnel, including personnel to support our process and product development, manufacturing and planned future commercialization efforts; • make royalty, milestone or other payments under current and any future in-license agreements; • establish and maintain supply chain and manufacturing relationships with third parties that can provide adequate products and services, in both amount, timing and quality, to support clinical development and the market demand for any product candidate for which we obtain regulatory and marketing approval; • leasing and building new facilities, including offices and labs, to support organizational growth; • validate and build-out a commercial-scale current Good Manufacturing Practices, or cGMP, manufacturing facility; and • establish a sales, marketing and distribution infrastructure to commercialize any product candidates for which we may obtain marketing approval. Because of the numerous risks and uncertainties associated with the development of LB-001 and other product candidates and programs, and because the extent to which we may enter into collaborations with third parties for development of our product candidates is unknown, we are unable to estimate the timing and amounts of increased capital outlays and operating expenses associated with completing the research and development of our product candidates. Our future funding requirements, both near and long-term, will depend on many factors, including: • the initiation, scope, progress, timing, costs and results of drug discovery, preclinical development, laboratory testing, and planned clinical trials for LB-001 and any other product candidates; • the outcome, timing and cost of meeting regulatory requirements established by the U.S. Food and Drug Administration, or FDA, and other comparable foreign regulatory authorities, including resolving any potential clinical holds that may be imposed on us; • 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; • the achievement of milestones or occurrence of other developments that trigger payments under any of our current agreements or other agreements we may enter into; • the extent to which we are obligated to reimburse, or entitled to reimbursement of, clinical trial costs under future collaboration agreements, if any; • the effect of competing technological and market developments; • the cost and timing of completion of clinical or commercial-scale manufacturing activities; • the extent to which we in-license or acquire other products and technologies; • our ability to establish and maintain collaborations on favorable terms, if at all; • the cost of establishing sales, marketing and distribution capabilities for LB-001 and any other product candidates in regions where we choose to commercialize our product candidates, if approved; and • the initiation, progress, timing and results of our commercialization of LB-001 and any other product candidates, if approved, for commercial sale. A change in the outcome of any of these variables with respect to the development of a product candidate could mean a significant change in the costs and timing associated with the development of that product candidate. For example, if the FDA or another regulatory authority were to require us to conduct clinical trials beyond those that we anticipate will be required for the completion of clinical development of a product candidate, or if we experience significant trial delays due to patient enrollment or other reasons, we would be required to expend significant additional financial resources and time on the completion of clinical development. We may never succeed in obtaining regulatory approval for any of our product candidates. Until such time, if ever, that we can generate product revenue sufficient to achieve profitability, we expect to finance our cash needs through offerings of securities, private equity financing, debt financings, collaborations, government contracts or other strategic transactions. The terms of financing may adversely affect the holdings or the rights of our stockholders. If we are unable to obtain funding, we may be required to delay, limit, reduce or terminate some or all of our research and product development, product portfolio expansion or future commercialization efforts. We will also continue to incur costs as a public company that we did not previously incur or have previously incurred at lower rates, including increased fees payable to the non-employee members of our board of directors, increased personnel costs, increased director and officer insurance premiums, audit and legal fees, investor relations fees and expenses for compliance with public company reporting requirements under the Securities Exchange Act of 1934, as amended, or the Exchange Act, and rules implemented by the SEC and Nasdaq. Contractual Obligations and Commitments The following table summarizes our contractual obligations as of December 31, 2018: (1) Represents license and research fees under our collaboration and research agreements. These amounts do not include any potential contingent payments, including those due upon the achievement by us of specified clinical, regulatory and commercial events, as applicable, or patent prosecution, royalty payments or license and research fees we may be required to make under license agreements we have entered into with various entities, including Stanford, the University of Texas and other research institutions. We have excluded these potential payments in the contractual obligations table because the timing and likelihood of these contingent payments are not currently known and would be difficult to predict or estimate. We enter into contracts in the normal course of business with CROs, CMOs and other third parties for clinical trials and preclinical research studies and testing. Manufacturing commitments in the preceding table 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 preceding table are limited to the non-cancelable portion of the agreement terms or the minimum cancellation fee. We may incur potential contingent payments upon our achievement of clinical, regulatory and commercial milestones, as applicable, or royalty payments that we may be required to make under license agreements we have entered into with various entities pursuant to which we have in-licensed certain intellectual property. Due to the uncertainty of the achievement and timing of the events requiring payment under these agreements, the amounts to be paid by us are not fixed or determinable at this time and are excluded from the table above. Critical Accounting Policies and Significant Judgments and Estimates Our management’s discussion and analysis of financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States. The preparation of our consolidated financial statements and related disclosures requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, costs and expenses and the disclosure of contingent assets and liabilities in our financial statements. We base our estimates on historical experience, known trends and events and various other factors that we believe are 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. We evaluate our estimates and assumptions on an ongoing basis. Our actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in greater detail in Note 2 to our consolidated financial statements appearing at the end of 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 Expenses As part of the process of preparing our consolidated financial statements, we are required to estimate our accrued research and development expenses. We make estimates of our accrued expenses as of each balance sheet date in the consolidated financial statements based on facts and circumstances known to us at that time. 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 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 the estimate, we adjust the accrual or the amount of prepaid expenses 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 may result in reporting amounts that are too high or too low in any particular period. To date, there have not been any material adjustments to our prior estimates of accrued research and development expenses. Stock-Based Compensation We account for stock-based compensation transactions using a grant-date fair-value-based method under FASB Codification Topic 718, Compensation-Stock Compensation. We account for all stock-based awards granted to employees and non-employees based on their fair value on the date of the grant and recognize compensation expense of those awards, over the requisite service period, which is generally the vesting period of the respective award. We apply the straight-line method of expense recognition to all awards with only service-based vesting conditions. We have also issued restricted stock with performance-based vesting conditions and recorded the expense for these awards when we concluded that it was probable that the performance condition would be achieved. Stock-based compensation is classified in the accompanying statements of operations based on the function to which the related services are provided. We recognize stock-based compensation expense for the portion of awards that have vested. Forfeitures are accounted for as they occur. We estimate the fair value of each stock option grant on the date of 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. Emerging Growth Company Status The Jumpstart Our Business Startups Act of 2012 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. Off-Balance Sheet Arrangements We have not entered into any off-balance sheet arrangements and do not have any holdings in variable interest entities. Recently Issued Accounting Pronouncements Refer to Note 2 in the accompanying notes to our consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K for a discussion of recent accounting pronouncements.
0.011551
0.011658
0
<s>[INST] Overview We are a genome editing company focused on developing medicines to durably treat rare diseases in patients with significant unmet medical need using GeneRide, our proprietary technology platform. Our GeneRide technology is designed to precisely integrate corrective genes into a patient’s genome to provide a stable therapeutic effect. Because GeneRide is designed to have this durable therapeutic effect, we are initially targeting rare liver disorders in pediatric patients where it is critical to provide treatment early in a patient’s life before irreversible disease pathology can occur. We have demonstrated proof of concept of our therapeutic platform in animal models for a number of diseases and are focusing on development of our lead product candidate, LB001, for the treatment of Methylmalonic Acidemia, or MMA, a lifethreatening disease that presents at birth. Based on our GeneRide technology, we are developing our lead product candidate, LB001, to treat MMA. We plan to advance LB001 to an IND filing by the end of 2019 and into a Phase 1/2 clinical trial in pediatric MMA patients in 2020. We believe that achieving clinical proof of concept in an inherited liver disease such as MMA will validate our platform technology, including its potential application to other organs and diseases. In addition to MMA, we have demonstrated proof of concept of our platform in hemophilia B, alpha1antitrypsin deficiency, or A1ATD, and CriglerNajjar syndrome animal disease models. We expect to select future product candidates from these genetic diseases or others addressed by targeting the liver initially, and later by targeting the CNS and muscle. Since our inception in 2014, we have devoted all of our efforts to business planning, research and development, developing and protecting our intellectual property, raising capital, recruiting management and technical staff. We do not have any products approved for sale and have not generated any revenue. As of December 31, 2018, we have raised approximately $72.3 million in net proceeds through our initial public offering, or IPO, in October 2018 and approximately $33.1 million in net proceeds from the sale of our convertible preferred stock in 2016 and 2017. We have incurred significant operating losses since our inception. Our ability to generate product revenue sufficient to achieve profitability will depend on the successful development and commercialization of one or more of our product candidates. Our net losses were $17.6 million and $5.8 million for the years ended December 31, 2018 and 2017, respectively. As of December 31, 2018, we had an accumulated deficit of $27.2 million. We expect to continue to incur significant expenses and increasing operating losses for the foreseeable future in connection with our ongoing activities. Furthermore, we now incur additional costs associated with operating as a public company that we did not previously incur or had previously incurred at lower rates as a private company, including significant legal, accounting, investor relations and other expenses. Initial Public Offering On October 23, 2018, we completed our IPO, in which we issued and sold 8,050,000 shares of common stock, including 1,050,000 shares sold pursuant to the full exercise of the underwriters’ option to purchase additional shares, at a public offering price of $10.00 per share. The aggregate net proceeds to us from the IPO were approximately $72.3 million after deducting underwriting discounts and commissions and offering expenses. The shares began trading on The Nasdaq Global Market on October 19, 2018. Upon completion of the IPO, all of our outstanding shares of convertible preferred stock, converted into 11,789,775 shares of our common stock. Components of Results of Operations Revenue Since inception through December 31, 2018, we have not generated any revenue. We do not expect to generate any revenue from the sale of products in the near future. If our development efforts for LB001, or other product candidates that we may develop in the future [/INST] Positive. </s>
2,019
4,070
1,664,106
LogicBio Therapeutics, 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 of our financial condition and results of operations should be read in conjunction with our financial statements and related notes appearing elsewhere in this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10-K, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties. As a result of many factors, including those factors set forth in the “Risk Factors” section of this Annual Report on Form 10-K, our actual results could differ materially from the results described in, or implied by, these forward-looking statements. Overview We are a genome editing company focused on developing medicines to durably treat rare diseases in patients with significant unmet medical need using GeneRide, our proprietary technology platform. Our GeneRide technology is designed to precisely integrate corrective genes into a patient’s genome to provide a stable therapeutic effect. Because GeneRide is designed to have this durable therapeutic effect, we are initially targeting rare liver disorders in pediatric patients where it is critical to provide treatment early in a patient’s life before irreversible disease pathology can occur. We have demonstrated proof of concept of our therapeutic platform in animal models for a number of diseases and are focusing on development of our lead product candidate, LB-001, for the treatment of Methylmalonic Acidemia, or MMA, a life-threatening disease that presents at birth. Based on our GeneRide technology, we are developing our lead product candidate, LB-001, to treat MMA. In January 2020, we announced the submission of an IND to support the initiation of a Phase 1/2 clinical trial in pediatric patients with MMA, which the FDA has placed on clinical hold. Subsequently, we received a letter from the FDA specifying its questions related to the clinical hold. The clinical hold was based on questions that were clinical and nonclinical in nature, including questions related to the studies conducted for our IND filing, but did not relate to chemistry, manufacturing, and controls. We expect to have interactions with the FDA regarding their questions through mid-2020, after which we plan to provide guidance on the anticipated timing for the initiation of the Phase 1/2 clinical trial for LB-001. We believe that achieving clinical proof of concept in an inherited liver disease such as MMA will validate our platform technology, including its potential application to other organs and diseases. In January 2020, we announced a research collaboration with Takeda Pharmaceutical Company Limited to further develop LB-301 in Crigler-Najjar syndrome, or CN, the second indication to be pursued using the GeneRide platform. In addition to MMA and CN, we have demonstrated proof of concept of our platform in hemophilia B and alpha-1-antitrypsin deficiency, or A1ATD, animal disease models. We expect to select future product candidates from these genetic diseases or others addressed by targeting the liver initially, and later by targeting the central nervous system, or CNS, and muscle. Since our inception in 2014, we have devoted all of our efforts to business planning, research and development, developing and protecting our intellectual property, raising capital, recruiting management and technical staff. We do not have any products approved for sale and have not generated any revenue. As of December 31, 2019, we have raised approximately $9.8 million in net proceeds through the loan and security agreement in July 2019, approximately $72.3 million in net proceeds through our initial public offering, or IPO, in October 2018 and approximately $33.1 million in net proceeds from the sale of our convertible preferred stock in 2016 and 2017. We have incurred significant operating losses since our inception. Our ability to generate product revenue sufficient to achieve profitability will depend on the successful development and commercialization of one or more of our product candidates. Our net losses were $40.1 million and $17.6 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had an accumulated deficit of $67.4 million. We expect to continue to incur significant expenses and increasing operating losses for the foreseeable future in connection with our ongoing activities. Furthermore, we now incur additional costs associated with operating as a public company that we did not previously incur or had previously incurred at lower rates as a private company, including significant legal, accounting, investor relations and other expenses. Initial Public Offering On October 23, 2018, we completed our IPO, in which we issued and sold 8,050,000 shares of common stock, including 1,050,000 shares sold pursuant to the full exercise of the underwriters’ option to purchase additional shares, at a public offering price of $10.00 per share. The aggregate net proceeds to us from the IPO were approximately $72.3 million after deducting underwriting discounts and commissions and offering expenses. The shares began trading on The Nasdaq Global Market on October 19, 2018. Upon completion of the IPO, all of our outstanding shares of convertible preferred stock converted into 11,789,775 shares of our common stock. Components of Results of Operations Revenue Since inception through December 31, 2019, we have not generated any revenue. We do not expect to generate any revenue from the sale of products in the near future. If our development efforts for LB-001, or other product candidates that we may develop in the future, are successful and result in regulatory approval or collaboration or license agreements with third parties, we may generate revenue in the future from a combination of product sales or payments from collaboration or license agreements. Operating Expenses Research and Development Expenses Research and development expenses consist primarily of costs incurred for our research activities, including our discovery efforts and the development of our product candidates, and include: • salaries, benefits and other related costs, including stock-based compensation expense, for personnel engaged in research and development functions; • license maintenance fees and milestone fees incurred in connection with various license agreements; • the costs of laboratory supplies and acquiring, developing and manufacturing preclinical study and, eventually, clinical trial materials; • expenses incurred under agreements with contract research organizations, or CROs, contract manufacturing organizations, or CMOs, as well as academic institutions and consultants that conduct our preclinical studies and other scientific development services; • facility-related expenses, which include direct depreciation costs and allocated expenses for rent and maintenance of facilities and other operating costs; • costs of outside consultants, including their fees, stock-based compensation and related travel expenses; and • costs related to compliance with regulatory requirements. We expense research and development costs as incurred. Costs for external development activities are recognized based on an evaluation of the progress to completion of specific tasks. Payments for these activities are based on the terms of the individual agreements, which may differ from the pattern of costs incurred, and are reflected in our financial statements as prepaid or accrued research and development expenses. Research and development activities are central to our business model. We expect that our research and development expenses will continue to increase for the foreseeable future as we initiate clinical trials for our product candidate LB-001 and continue to discover and develop additional product candidates. If any of our product candidates enter into later stages of clinical development, they will 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. General and Administrative Expenses General and administrative expenses consist primarily of salaries and other related costs, including stock-based compensation, for personnel in our executive, finance, corporate and business development and administrative functions. General and administrative expenses also include professional fees for legal, patent, accounting, auditing, tax and consulting services, travel expenses, and facility-related expenses, which include direct depreciation costs and allocated expenses for rent and maintenance of facilities and other operating costs. We expect that our general and administrative expenses will increase in the future as we increase our general and administrative headcount to support our continued research and development and potential commercialization of our product candidates. We also expect to incur increased expenses associated with being a public company, including costs of accounting, audit, legal, regulatory and tax compliance services, director and officer insurance costs, and investor and public relations costs. Other Income (Expense), Net Interest income consists primarily of interest on our cash and cash equivalents and investments. Interest expense consists of interest expense related to the aggregate $10.0 million principal amount of the Term A Loan borrowing under the loan and security agreement in July 2019. A portion of the interest expense on the Term A Loan is non-cash expense relating to the accretion of the debt discount and amortization of issuance costs. In the year ended December 31, 2019, we recorded $0.5 million in interest expense, of which $0.4 million relates to cash interest paid and the remainder to the accretion of the debt discount and amortization of issuance costs. Other expense, net consists primarily of foreign exchange losses. Results of Operations Years Ended December 31, 2019 and 2018 The following table summarizes our results of operations for the years ended December 31, 2019 and 2018: Research and Development Expenses The following table summarizes our research and development expenses for the years ended December 31, 2019 and 2018: Research and development expenses for the year ended December 31, 2019 were $30.7 million, compared to $11.1 million for year ended December 31, 2018. The increase of approximately $19.6 million was primarily due to an increase of approximately $14.1 million related to external development and manufacturing expenses for our lead product candidate LB-001, $1.9 million in other research and development expenses as we increased our overall research and development activities, and $3.6 million in personnel-related costs related to an increase in headcount. Personnel-related costs for the year ended December 31, 2019 included stock-based compensation expense of $0.8 million compared to $0.3 million for the year ended December 31, 2018. General and Administrative Expenses General and administrative expenses were $10.4 million for the year ended December 31, 2019, compared to $6.9 million for the year ended December 31, 2018. The increase of approximately $3.5 million was primarily due to increased legal and professional fees and personnel-related costs, including salaries, stock-based compensation and bonuses. The increase in professional fees was primarily due to the increase in legal, auditing and consulting services provided. The increase in personnel-related costs was primarily due to an increase in headcount. Stock-based compensation expense included in general and administrative expenses was $1.0 million and $0.8 million for the years ended December 31, 2019 and 2018, respectively. Other Income, Net Other income, net was $0.9 million for the year ended December 31, 2019, compared to other income, net of $0.4 million for the year ended December 31, 2018. The change was primarily related to the increase in interest income from higher cash equivalents and investments, partially offset by interest expense related to the loan and security agreement. Results of Operations Comparison for 2018 and 2017 For a discussion of our results of operations comparison for the years ended December 31, 2018 and 2017, refer to our Annual Report on Form 10-K for the year ended December 31, 2018, filed with the SEC on April 1, 2019. Liquidity and Capital Resources Overview Since our inception and through December 31, 2019, we have not generated any revenue and have incurred significant losses and negative cash flows from our operations. As of December 31, 2019, we had cash and cash equivalents of $33.1 million and short-term investments of $17.5 million, which we believe will be able to fund our operating expenses and capital expenditure requirements into the first quarter of 2021. Cash Flows The following table summarized our cash flows for each of the years ended December 31, 2019 and 2018: Operating Activities During the year ended December 31, 2019, net cash used in operating activities was approximately $38.8 million, primarily related to our net loss adjusted for non-cash charges and changes in the components of working capital. The $23.5 million increase in cash used in operating activities during the year ended December 31, 2019 compared to the year ended December 31, 2018, was primarily driven by an increase in our net loss due to an increase in both our research and development and general and administrative expenses. Investing Activities During the year ended December 31, 2019, net cash used in investing activities increased approximately $17.9 million, primarily related to net short-term investments activity of $17.1 million and a $0.8 million increase in the purchases of property and equipment as compared to the year ended December 31, 2018. Financing Activities During the year ended December 31, 2019, net cash provided by financing activities was $10.1 million, primarily related to net proceeds of $9.8 million under the July 2019 loan and security agreement as well as $0.2 million related to the exercise of stock options. During the year ended December 31, 2018, net cash provided by financing activities was $72.3 million, primarily from the issuance of common stock related to the IPO. Funding Requirements We expect our expenses to increase in connection with our ongoing activities, particularly as we advance the preclinical activities and clinical trials of our product candidates and any future product candidates. We expect that our expenses will increase substantially if and as we: • continue our current research programs and our preclinical development of any product candidates from our current research programs; • initiate clinical trials for LB-001 and any other product candidates we identify and develop; • seek to identify, assess, acquire and/or develop additional research programs and additional product candidates; • seek marketing approvals for any product candidate that successfully complete clinical trials; • develop, optimize, scale and validate a manufacturing process and analytical methods for any product candidates we may develop; • establish and build out internal process and analytical development capabilities and preclinical and clinical grade production; • obtain market acceptance of any product candidates we may develop as viable treatment options; • address competing technological and market developments; • maintain, expand and protect our intellectual property portfolio and provide reimbursement of third-party expenses related to our patent portfolio; • further develop our GeneRide technology platform; • hire additional technical, quality, regulatory, clinical, scientific and commercial personnel and add operational, financial and management information systems and personnel, including personnel to support our process and product development, manufacturing and planned future commercialization efforts; • make royalty, milestone or other payments under current and any future in-license agreements; • establish and maintain supply chain and manufacturing relationships with third parties that can provide adequate products and services, in both amount, timing and quality, to support clinical development and the market demand for any product candidate for which we obtain regulatory and marketing approval; • lease and build new facilities, including offices and labs, to support organizational growth; • validate and build-out a commercial-scale current Good Manufacturing Practices, or cGMP, manufacturing facility; and • establish a sales, marketing and distribution infrastructure to commercialize any product candidates for which we may obtain marketing approval. We are unable to estimate the timing and amounts of increased capital outlays and operating expenses associated with completing the research and development of our product candidates because of the numerous risks and uncertainties associated with the development of LB-001 and any other product candidates and programs we may develop and because the extent to which we may enter into collaborations with third parties for development of LB-001 and any other product candidates we may develop is unknown. For example, in January 2020, we announced the submission of an IND to support the initiation of a Phase 1/2 clinical trial in pediatric patients with MMA, which the FDA has placed on clinical hold pending the resolution of certain clinical and nonclinical questions. Our future funding requirements, both near and long-term, will depend on many factors, including: • the initiation, scope, progress, timing, costs and results of drug discovery, preclinical development, laboratory testing, and planned clinical trials for LB-001 and any other product candidates; • the outcome, timing and cost of meeting regulatory requirements established by the U.S. Food and Drug Administration, or FDA, and other comparable foreign regulatory authorities, including resolving any potential clinical holds that may be imposed on us; • 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; • the achievement of milestones or occurrence of other developments that trigger payments under any of our current agreements or other agreements we may enter into; • the extent to which we are obligated to reimburse, or entitled to reimbursement of, clinical trial and other research and development costs under future collaboration agreements, if any; • the effect of competing technological and market developments; • the cost and timing of completion of clinical or commercial-scale manufacturing activities; • the extent to which we in-license or acquire other products and technologies; • our ability to establish and maintain collaborations on favorable terms, if at all; • the cost of establishing sales, marketing and distribution capabilities for LB-001 and any other product candidates in regions where we choose to commercialize our product candidates, if approved; and • the initiation, progress, timing and results of our commercialization of LB-001 and any other product candidates, if approved, for commercial sale. A change in the outcome of any of these variables with respect to the development of a product candidate could mean a significant change in the costs and timing associated with the research and development of that product candidate. For example, if the clinical hold on the IND for LB-001 causes significant delays in the progress of our MMA program, the FDA or another regulatory authority were to require us to conduct preclinical studies or clinical trials beyond those that we anticipate will be required, or if we experience significant trial delays due to patient enrollment or other reasons, we would be required to expend significant additional financial resources and time on preclinical and clinical research and development activities. Any significant delays in our programs may also require us to reevaluate our corporate strategy, resulting in the expenditure of significant resources and time. We may never succeed in obtaining regulatory approval for our product candidates or any future product candidates. Until such time, if ever, that we can generate product revenue sufficient to achieve profitability, we expect to finance our cash needs through offerings of securities, private equity financing, debt financings, collaborations, government contracts or other strategic transactions. The terms of financing may adversely affect the holdings or the rights of our stockholders. If we are unable to obtain funding, we may be required to delay, limit, reduce or terminate some or all of our research and product development, product portfolio expansion or future commercialization efforts. We will also continue to incur costs as a public company that we did not previously incur or have previously incurred at lower rates, including increased fees payable to the non-employee members of our board of directors, increased personnel costs, increased director and officer insurance premiums, audit and legal fees, investor relations fees and expenses for compliance with public company reporting requirements under the Securities Exchange Act of 1934, as amended, or the Exchange Act, and rules implemented by the SEC and the Nasdaq Global Market. Contractual Obligations and Commitments: We are a smaller reporting company, as defined in Rule 12b-2 under the Securities Exchange Act of 1934, as amended, for this reporting period and are not required to provide the information required under this item. Critical Accounting Policies and Significant Judgments and Estimates Our management’s discussion and analysis of financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States. The preparation of our consolidated financial statements and related disclosures requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, costs and expenses and the disclosure of contingent assets and liabilities in our financial statements. We base our estimates on historical experience, known trends and events and various other factors that we believe are 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. We evaluate our estimates and assumptions on an ongoing basis. Our actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in greater detail in Note 2 to our consolidated financial statements appearing at the end of 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 Expenses As part of the process of preparing our consolidated financial statements, we are required to estimate our accrued research and development expenses. We make estimates of our accrued expenses as of each balance sheet date in the consolidated financial statements based on facts and circumstances known to us at that time. 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 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 the estimate, we adjust the accrual or the amount of prepaid expenses 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 may result in reporting amounts that are too high or too low in any particular period. To date, there have not been any material adjustments to our prior estimates of accrued research and development expenses. Stock-Based Compensation We account for stock-based compensation transactions using a grant-date fair-value-based method under FASB Codification Topic 718, Compensation-Stock Compensation. We account for all stock-based awards granted to employees and non-employees based on their fair value on the date of the grant and recognize compensation expense of those awards, over the requisite service period, which is generally the vesting period of the respective award. We apply the straight-line method of expense recognition to all awards with only service-based vesting conditions. We have also issued restricted stock with performance-based vesting conditions and recorded the expense for these awards when we concluded that it was probable that the performance condition would be achieved. Stock-based compensation is classified in the accompanying statements of operations based on the function to which the related services are provided. We recognize stock-based compensation expense for the portion of awards that have vested. Forfeitures are accounted for as they occur. We estimate the fair value of each stock option grant on the date of 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. Emerging Growth Company Status The Jumpstart Our Business Startups Act of 2012 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. Off-Balance Sheet Arrangements We have not entered into any off-balance sheet arrangements and do not have any holdings in variable interest entities. Recently Issued Accounting Pronouncements Refer to Note 2 in the accompanying notes to our consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K for a discussion of recent accounting pronouncements.
0.262974
0.263068
0
<s>[INST] The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our financial statements and related notes appearing elsewhere in this Annual Report on Form 10K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10K, including information with respect to our plans and strategy for our business, includes forwardlooking statements that involve risks and uncertainties. As a result of many factors, including those factors set forth in the “Risk Factors” section of this Annual Report on Form 10K, our actual results could differ materially from the results described in, or implied by, these forwardlooking statements. Overview We are a genome editing company focused on developing medicines to durably treat rare diseases in patients with significant unmet medical need using GeneRide, our proprietary technology platform. Our GeneRide technology is designed to precisely integrate corrective genes into a patient’s genome to provide a stable therapeutic effect. Because GeneRide is designed to have this durable therapeutic effect, we are initially targeting rare liver disorders in pediatric patients where it is critical to provide treatment early in a patient’s life before irreversible disease pathology can occur. We have demonstrated proof of concept of our therapeutic platform in animal models for a number of diseases and are focusing on development of our lead product candidate, LB001, for the treatment of Methylmalonic Acidemia, or MMA, a lifethreatening disease that presents at birth. Based on our GeneRide technology, we are developing our lead product candidate, LB001, to treat MMA. In January 2020, we announced the submission of an IND to support the initiation of a Phase 1/2 clinical trial in pediatric patients with MMA, which the FDA has placed on clinical hold. Subsequently, we received a letter from the FDA specifying its questions related to the clinical hold. The clinical hold was based on questions that were clinical and nonclinical in nature, including questions related to the studies conducted for our IND filing, but did not relate to chemistry, manufacturing, and controls. We expect to have interactions with the FDA regarding their questions through mid2020, after which we plan to provide guidance on the anticipated timing for the initiation of the Phase 1/2 clinical trial for LB001. We believe that achieving clinical proof of concept in an inherited liver disease such as MMA will validate our platform technology, including its potential application to other organs and diseases. In January 2020, we announced a research collaboration with Takeda Pharmaceutical Company Limited to further develop LB301 in CriglerNajjar syndrome, or CN, the second indication to be pursued using the GeneRide platform. In addition to MMA and CN, we have demonstrated proof of concept of our platform in hemophilia B and alpha1antitrypsin deficiency, or A1ATD, animal disease models. We expect to select future product candidates from these genetic diseases or others addressed by targeting the liver initially, and later by targeting the central nervous system, or CNS, and muscle. Since our inception in 2014, we have devoted all of our efforts to business planning, research and development, developing and protecting our intellectual property, raising capital, recruiting management and technical staff. We do not have any products approved for sale and have not generated any revenue. As of December 31, 2019, we have raised approximately $9.8 million in net proceeds through the loan and security agreement in July 2019, approximately $72.3 million in net proceeds through our initial public offering, or IPO, in October 2018 and approximately $33.1 million in net proceeds from the sale of our convertible preferred stock in 2016 and 2017. We have incurred significant operating losses since our inception. Our ability to generate product revenue sufficient to achieve profitability will depend on the successful development and commercialization of one or more of our product candidates. Our net losses were $40.1 million and $17.6 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had an accumulated defic [/INST] Positive. </s>
2,020
4,065
1,720,116
Red Violet, Inc.
2019-03-07
2018-12-31
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. You should read the following discussion in conjunction with our consolidated financial statements and related notes included in this Annual Report on Form 10-K (“2018 Form 10-K”). This 2018 Form 10-K contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 (“PSLRA”), Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), about our expectations, beliefs, or intentions regarding our business, financial condition, results of operations, strategies, or prospects. You can identify forward-looking statements by the fact that these statements do not relate strictly to historical or current matters. Rather, forward-looking statements relate to anticipated or expected events, activities, trends, or results as of the date they are made. Because forward-looking statements relate to matters that have not yet occurred, these statements are inherently subject to risks and uncertainties that could cause our actual results to differ materially from any future results expressed or implied by the forward-looking statements. Many factors could cause our actual activities or results to differ materially from the activities and results anticipated in forward-looking statements. These factors include those contained in Part I, “Item 1A. Risk Factors” of this 2018 Form 10-K. We do not undertake any obligation to update forward-looking statements, except as required by law. We intend that all forward-looking statements be subject to the safe harbor provisions of PSLRA. These forward-looking statements are only predictions and reflect our views as of the date they are made with respect to future events and financial performance. Overview Red Violet, Inc. (“we,” “us,” “our,” “red violet,” or the “Company”), a Delaware corporation, is a software and services company specializing in big data analysis, providing cloud-based, mission-critical solutions to enterprises in a variety of industries. red violet’s mission is to transform data into intelligence utilizing our proprietary technology platform to solve complex problems for our clients. Harnessing the power of data fusion and powerful analytics, we transform data into intelligence, in a fast and efficient manner, so our clients can spend their time on what matters most -- running their organizations with confidence. Through our intelligent platform, CORETM, we uncover the relevance of disparate data points utilizing our analytical capabilities to provide real-time and insightful views of people, businesses, assets and their interrelationships. We empower clients across markets and industries to better execute all aspects of their business, from managing risk, identifying fraud and abuse, and ensuring legislative compliance, to debt recovery. We provide unique and compelling solutions essential to the daily workflow of organizations within both the public and private sectors. Our cloud-based data fusion platform, combined with our massive database consisting of public-records, proprietary and publicly-available data, as well as a unique repository of self-reported information on millions of consumers, enables the delivery of differentiated products and solutions used for a variety of essential functions. These essential functions include identification and authentication, and investigation and validation. Leveraging leading-edge technology, proprietary algorithms, and massive datasets, and through intuitive and powerful analytical applications, we provide solutions to organizations within the risk management industry. CORE is our next generation data fusion platform, providing mission-critical information about individuals, businesses and assets to a variety of markets and industries. Through machine learning and advanced analytics, we use the power of data fusion to ingest and analyze data at a massive scale. The derived information from the data fusion process ultimately serves to generate unique solutions for banking and financial services companies, insurance companies, healthcare companies, law enforcement and government, the collection industry, law firms, retail, telecommunications companies, corporate security and investigative firms. Built in a secure payment card industry (“PCI”) compliant environment, our cloud-based next generation technology delivers greater than four 9s of service uptime. By leveraging our proprietary infrastructure design within the cloud, we currently operate in six datacenters spread geographically across the U.S. and are able to dynamically and seamlessly scale as needed. Using our intelligent framework, and leveraging a microservices architecture where appropriate, we reduce operational cost and complexity, thus delivering superior performance at greatly reduced costs compared to traditional datacenter architectures. Since the release of our CORE platform in May 2016, we have added billions of data records and continue to add over a billion records per month on average. Our average query response time for a comprehensive profile is less than 250 milliseconds versus competitive platforms that measure comprehensive profile response times in seconds. On March 26, 2018, Fluent, Inc. (“Fluent”), a Delaware corporation, completed a spin-off (the “Spin-off”) of its risk management business from its digital marketing business by way of a distribution of all the shares of common stock of Fluent’s wholly-owned subsidiary, red violet, to Fluent’s stockholders of record as of March 19, 2018 (the “Record Date”) and certain warrant holders. The distribution occurred by way of a pro rata stock distribution to such common stock and warrant holders, each of whom received one share of red violet’s common stock for every 7.5 shares of Fluent’s common stock held on the Record Date or to which they were entitled to under their warrants, which resulted in a distribution of a total of 10,266,613 shares of red violet common stock. Upon the Spin-off, red violet owns Fluent subsidiaries which previously operated Fluent’s risk management business. As a result of the Spin-off, red violet is an independent public company and red violet’s common stock began regular-way trading on The NASDAQ Capital Market under the symbol “RDVT” on March 27, 2018. Although the Spin-off was completed on March 26, 2018, we have reflected the Spin-off in the financial statements included in this Form 10-K as if it occurred on March 31, 2018 as we have determined that the impact is not material to the consolidated financial statements. The financial statements present the consolidated results of operations, financial condition, and cash flows of red violet and its subsidiaries. For periods prior to the Spin-off, these financial statements were prepared on a consolidated and combined basis because certain of the entities were under common control. All intercompany accounts and transactions have been eliminated between the consolidated and combined entities. From the inception of our risk management business in September 2014 through December 2016, the majority of our operations were dedicated to the early-stage development of our business model, including the development of our proprietary, cloud-based technology platform, CORE, and the buildout of our initial-phase suite of products, powered by CORE, to serve a variety of industries within risk management. Beginning in January 2017, with our technology platform production ready and hardened, our initial suite of products released into the marketplace, and a multi-year product roadmap defined, we transformed from a development organization to a sales-driven organization with sales increasing from a $5.8 million annual run-rate for the month ended January 31, 2017 to a $18.6 million annual run-rate for the month ended December 31, 2018. In order for us to continue to develop new products, grow our existing business and expand into additional markets, we must generate and sustain sufficient operating profits and cash flow in future periods. This will require us to generate additional sales from current products and new products currently under development. We are building out our sales organization to drive current products and to introduce new products into the market place. We will incur increased compensation expenses relating to our sales and marketing, executive and administrative, and infrastructure-related personnel as we increase headcount in the next 12 months. Industry Trends and Uncertainties Operating results are affected by the following factors that impact the big data and analytics sector in the United States: • The macroeconomic conditions, including the availability of affordable credit and capital, interest rates, inflation, employment levels and consumer confidence, influence our revenue. Macroeconomic conditions also have a direct impact on overall technology, marketing and advertising expenditures in the U.S. As marketing budgets are often more discretionary in nature, they are easier to reduce in the short term as compared to other corporate expenses. Future widespread economic slowdowns in any of the industries or markets our clients serve could reduce the technology and marketing expenditures of our clients and prospective customers. • Our revenue is also significantly influenced by industry trends, including the demand for business analytics services in the industries we serve. Companies are increasingly relying on business analytics and big-data technologies to help process data in a cost-efficient manner. As customers have gained the ability to rapidly aggregate data generated by their own activities, they are increasingly expecting access to real-time data and analytics from their service providers as well as solutions that fully integrate into their workflows. The increasing number and complexity of regulations centered around data and provision of information services makes operations for businesses in the big data and analytic sector more challenging. • The enactment of new or amended legislation or industry regulations pertaining to consumer or private sector privacy issues could have a material adverse impact on information and marketing services. Legislation or industry regulations regarding consumer or private sector privacy issues could place restrictions upon the collection, sharing and use of information that is currently legally available, which could materially increase our cost of collecting and maintaining some data. These types of legislation or industry regulations could also prohibit us from collecting or disseminating certain types of data, which could adversely affect our ability to meet our clients’ requirements and our profitability and cash flow targets. Company Specific Trends and Uncertainties Our operating results are also directly affected by company-specific factors, including the following: • Some of our competitors have substantially greater financial, technical, sales and marketing resources, better name recognition and a larger customer base. Even if we introduce advanced products that meet evolving customer requirements in a timely manner, there can be no assurance that our new products will gain market acceptance. • Certain companies in the big data and analytics sector have expanded their product lines or technologies in recent years as a result of acquisitions. Further, more companies have developed products which conform to existing and emerging industry standards and have sought to compete on the basis of price. We anticipate increased competition from large data and analytics vendors. Increased competition in the big data and analytics sector could result in significant price competition, reduced profit margins or loss of market share, any of which could have a material adverse effect on our business, operating results and financial condition. There can be no assurance that we will be able to compete successfully in the future with current or new competitors. Critical Accounting Policies and Estimates Management’s discussion and analysis of 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 (“US GAAP”). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to the allowance for doubtful accounts, useful lives of property and equipment and intangible assets, recoverability of the carrying amounts of goodwill and intangible assets, share-based compensation and income tax provision. We base our estimates 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. We believe the following critical accounting policies govern our more significant judgments and estimates used in the preparation of our consolidated financial statements. Revenue recognition On January 1, 2018, we adopted Accounting Standards Update (“ASU”) No. 2014-09, “Revenue from Contracts with Customers (Topic 606)”, using the modified retrospective method applied to all contracts that were not completed contracts at the date of initial application. There was no impact on the opening accumulated deficit as of January 1, 2018 due to the adoption of Topic 606. Revenue is generally recognized on (a) a transactional basis determined by the customers’ usage, (b) a monthly fee or (c) a combination of both. Revenue pursuant to transactions determined by the customers’ usage is recognized when the transaction is complete, and either party may terminate the transactional agreement at any time. Revenue pursuant to contracts containing a monthly fee is recognized ratably over the contract period, which is generally 12 months, and the contract shall automatically renew for additional, successive 12-month terms unless written notice of intent not to renew is provided by one party to the other at least 30 days or 60 days prior to the expiration of the then current term. For the year ended December 31, 2018, 58% of total revenue was attributable to customers with pricing contracts versus 42% attributable to transactional customers. For the year ended December 31, 2017, 36% of total revenue was attributable to customers with pricing contracts versus 64% attributable to transactional customers. Pricing contracts are generally annual contracts or longer, with auto renewal. We market our services primarily through our own sales force. We also market our services through indirect channels such as resellers, who sell directly to businesses and consumers, which account for a small portion of revenue. Revenue is recognized when control of goods or services is transferred to our customers, in an amount that reflects the consideration we expect to be entitled to in exchange for those goods or services. Our performance obligation is to provide on demand solutions to our customers by leveraging our proprietary technology and applying machine learning and advanced analytics to our massive data repository. The pricing for the customer contracts is based on usage, a monthly fee, or a combination of both. Available within Topic 606, we have applied the portfolio approach practical expedient in accounting for customer revenue as one collective group, rather than individual contracts. Based on our historical knowledge of the contracts contained in this portfolio and the similar nature and characteristics of the customers, we have concluded the financial statement effects are not materially different than if accounting for revenue on a contract by contract basis. Revenue is recognized over a period of time since the performance obligation is delivered in a series. Our customers simultaneously receive and consume the benefits provided by the Company’s performance as and when provided. Furthermore, we have elected the “right to invoice” practical expedient, available within Topic 606, as our measure of progress, since we have a right to payment from a customer in an amount that corresponds directly with the value of our performance completed-to-date. The Company's revenue arrangements do not contain significant financing components. If a customer pays consideration before we transfer services to the customer, those amounts are classified as deferred revenue. In relation to the deferred revenue balance as of December 31, 2017, all was recognized into revenue during the year ended December 31, 2018. As of December 31, 2018, approximately $0.9 million of revenue is expected to be recognized in the future for outstanding performance obligations, primarily related to pricing contracts that have a term of more than 12 months. Approximately $0.6 million of revenue will be recognized in 2019 and the remainder in 2020. The actual timing of recognition may vary due to factors outside of the Company’s control. The Company excludes variable consideration related entirely to wholly unsatisfied performance obligations and contracts and recognizes such variable consideration based upon the right to invoice the customer. Sales commissions are incurred and recorded on an ongoing basis over the term of the customer relationship. These costs are recorded in sales and marketing expenses. In addition, we elected the practical expedient to not disclose the value of unsatisfied performance obligations for (i) contracts with an original expected length of one year or less and (ii) contracts for which we recognize revenue at the amount to which we have the right to invoice for services performed. Allowances for doubtful accounts We maintain allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. Management determines whether an allowance needs to be provided for an amount due from a customer depending on the aging of the individual receivable balance, recent payment history, contractual terms and other qualitative factors such as status of business relationship with the customer. Historically, our estimates for doubtful accounts have not differed materially from actual results. The amount of the allowance for doubtful accounts was $0.1 million and $0.2 million as of December 31, 2018 and 2017, respectively. Income taxes We account for income taxes in accordance with ASC 740, “Income Taxes,” which requires the use of the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred tax assets and liabilities are computed based upon the difference between the financial statement and income tax basis of assets and liabilities using the enacted tax rate applicable when the related asset or liability is expected to be realized or settled. Deferred income tax expenses or benefits are based on the changes in the asset or liability each period. If available evidence suggests that it is more likely than not that some portion or all of the deferred tax assets will not be realized, a valuation allowance is required to reduce the deferred tax assets to the amount that is more likely than not to be realized. As of December 31, 2018, we have a valuation allowance of $2.3 million. Future changes in such valuation allowance are included in the provision for deferred income taxes in the period of change. On December 22, 2017, the Tax Cuts and Jobs Act of 2017 (the “Act”) was enacted, resulting in significant modifications to existing law, including lowering the U.S. corporate statutory income tax rate to 21%, among other changes. As a full valuation allowance was provided as of December 31, 2018 and 2017, the Act does not have any material net impact on our consolidated financial statements, however, certain income tax disclosures, including the re-measurement of deferred tax assets and liabilities and related valuation allowance, and the effective income tax rate reconciliation, are affected. ASC 740 clarifies the accounting for uncertain tax positions. This interpretation requires that an entity recognizes in the consolidated financial statements the impact of a tax position, if that position is more likely than not of being sustained upon examination, based on the technical merits of the position. Recognized income tax positions are measured at the largest amount that is greater than 50% likely of being realized. Changes in recognition or measurement are reflected in the period in which the change in judgment occurs. The Company’s accounting policy is to accrue interest and penalties related to uncertain tax positions, if and when required, as interest expense and a component of other expenses, respectively, in the consolidated statements of operations. Intangible assets other than goodwill Our intangible assets are initially recorded at the capitalized actual costs incurred, their acquisition cost, or fair value if acquired as part of a business combination, and amortized on a straight-line basis over their respective estimated useful lives, which are the periods over which the assets are expected to contribute directly or indirectly to the future cash flows of the Company. The Company’s intangible assets represent software developed for internal use. Intangible assets have estimated useful lives of 5-10 years. In accordance with ASC 350-40, “Software - internal use software,” we capitalize eligible costs, including salaries and staff benefits, share-based compensation expense, traveling expenses incurred by relevant employees, and other relevant costs of developing internal-use software that are incurred in the application development stage when developing or obtaining software for internal use. Once the software developed for internal use is ready for its intended use, it is amortized on a straight-line basis over its useful life. Goodwill In accordance with ASC 350, “Intangibles - Goodwill and Other,” goodwill is tested at least annually for impairment, or when events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable, by assessing qualitative factors or performing a quantitative analysis in determining whether it is more likely than not that its fair value exceeds the carrying value. A quantitative step one assessment involves determining the fair value of each reporting unit using market participant assumptions. In January 2017, the FASB issued Accounting Standards Update No. 2017-04 (“ASU 2017-04”), “Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment,” which eliminates step two from the goodwill impairment test. Under ASU 2017-04, an entity should recognize an impairment charge for the amount by which the carrying amount of a reporting unit exceeds its fair value up to the amount of goodwill allocated to that reporting unit. The Company early adopted ASU 2017-04 in the fourth quarter of 2017. On October 1, 2018, we performed a qualitative assessment on the reporting unit and, based on this assessment, no events have occurred to indicate that it is more likely than not that the fair value of the reporting unit is less than its carry amount. On October 1, 2017, we performed a quantitative assessment on the reporting unit and the result of our assessment indicated that the estimated fair value of the reporting unit exceeded its carrying value. We concluded that goodwill was not impaired as of December 31, 2018 and 2017. For purposes of reviewing impairment and the recoverability of goodwill, we must make various assumptions regarding estimated future cash flows and other factors in determining the fair values of the reporting unit, including market multiples, discount rates, etc. Impairment of long-lived assets Finite-lived intangible assets are amortized over their respective useful lives and, along with other long-lived assets, are evaluated for impairment periodically whenever events or changes in circumstances indicate that their related carrying amounts may not be recoverable in accordance with ASC 360-10-15, “Impairment or Disposal of Long-Lived Assets.” In evaluating long-lived assets for recoverability, including finite-lived intangibles and property and equipment, the Company uses its best estimate of future cash flows expected to result from the use of the asset and eventual disposition in accordance with ASC 360-10-15. To the extent that estimated future undiscounted cash inflows attributable to the asset, less estimated future undiscounted cash outflows, are less than the carrying amount, an impairment loss is recognized in an amount equal to the difference between the carrying value of such asset and its fair value. Assets to be disposed of and for which there is a committed plan of disposal, whether through sale or abandonment, are reported at the lower of carrying value or fair value less costs to sell. Asset recoverability is an area involving management judgment, requiring assessment as to whether the carrying value of assets can be supported by the undiscounted future cash flows. In calculating the future cash flows, certain assumptions are required to be made in respect of highly uncertain matters such as revenue growth rates, gross margin percentages and terminal growth rates. We concluded there was no impairment as of December 31, 2018 and 2017. Share-based compensation We account for share-based compensation to employees in accordance with ASC 718, “Compensation-Stock Compensation.” Under ASC 718, we measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award and generally recognizes the costs on a straight-line basis over the period the employee is required to provide service in exchange for the award, which generally is the vesting period. For awards with performance conditions, we begin recording share-based compensation when achieving the performance criteria is probable. The fair value of restricted stock units (“RSUs”) is determined based on the number of shares granted and the quoted price of our common stock. The estimated number of stock awards that will ultimately vest requires judgment, and to the extent actual results or updated estimates differ from our current estimates, such amount will be recorded as a cumulative adjustment in the period estimates are revised. Changes in our estimates and assumptions may cause us to realize material changes in share-based compensation expense in the future. We have issued share-based awards with performance-based vesting criteria. Achievement of the milestones must be probable before we begin recording share-based compensation expense. At each reporting date, we review the likelihood that these awards will vest and if the vesting is deemed probable, we begin to recognize compensation expense at that time. In the period that achievement of the performance-based criteria is deemed probable, US GAAP requires the immediate recognition of all previously unrecognized compensation since the original grant date. As a result, compensation expense recorded in the period that achievement is deemed probable could include a substantial amount of previously unrecorded compensation expense related to the prior periods. If ultimately performance goals are not met, for any share-based awards where vesting was previously deemed probable, previously recognized compensation cost will be reversed. During the second quarter of 2018, we early adopted ASU 2018-07, “Improvements to Nonemployee Share-Based Payment Accounting,” which generally expands the scope of ASC 718, Compensation - Stock Compensation, to include share-based payment transactions for acquiring goods and services from nonemployees and to supersede the guidance in ASC 505-50, Equity-Based Payments to Non-employees, which previously included the accounting for nonemployee awards. Recently Issued Accounting Standards See Item 8 of Part II, “Financial Statements and Supplementary Data - Note 2. Summary of significant accounting policies - (s) Recently issued accounting standards.” Fourth Quarter Financial Results For the three months ended December 31, 2018, as compared to the three months ended December 31, 2017: • Total revenue increased 74% to $4.7 million. • Net loss improved by $1.1 million to $2.0 million. • Loss per share improved by $0.11 to $0.20. • Adjusted gross profit increased 186% to $2.4 million. • Adjusted gross margin increased to 51% from 31%. • Adjusted EBITDA improved by $1.1 million to negative $1.0 million. Full Year Financial Results For the year ended December 31, 2018, as compared to the year ended December 31, 2017: • Total revenue increased 90% to $16.3 million. • Net loss improved by $14.6 million to $6.9 million. • Loss per share improved by $1.42 to $0.67. • Adjusted gross profit increased 407% to $7.7 million. • Adjusted gross margin increased to 47% from 18%. • Adjusted EBITDA improved by $4.0 million to negative $4.3 million. Use and Reconciliation of Non-GAAP Financial Measures Management evaluates the financial performance of our business on a variety of key indicators, including non-GAAP metrics of adjusted EBITDA, adjusted gross profit and adjusted gross margin. Adjusted EBITDA is a financial measure equal to net loss, the most directly comparable financial measure based on US GAAP, excluding interest income, net, depreciation and amortization, share-based compensation expense, litigation costs, insurance proceeds in relation to settled litigation, transition service income, and write-off of long-lived assets and others, as noted in the tables below. We define adjusted gross profit as revenue less cost of revenue (exclusive of depreciation and amortization), and adjusted gross margin as adjusted gross profit as a percentage of revenue. We present adjusted EBITDA, adjusted gross profit and adjusted gross margin as supplemental measures of our operating performance because we believe they provide useful information to our investors as they eliminate the impact of certain items that we do not consider indicative of our cash operations and ongoing operating performance. In addition, we use them as an integral part of our internal reporting to measure the performance of our business, evaluate the performance of our senior management and measure the operating strength of our business. Adjusted EBITDA, adjusted gross profit and adjusted gross margin are measures frequently used by securities analysts, investors and other interested parties in their evaluation of the operating performance of companies similar to ours and are indicators of the operational strength of our business. Adjusted EBITDA eliminates the uneven effect of considerable amounts of non-cash depreciation and amortization, share-based compensation expense and the impact of other items. Adjusted gross profit and adjusted gross margin are calculated by using cost of revenue (exclusive of depreciation and amortization). Adjusted EBITDA, adjusted gross profit and adjusted gross margin are not intended to be performance measures that should be regarded as an alternative to, or more meaningful than, either loss before income taxes or net loss as indicators of operating performance or to cash flows from operating activities as a measure of liquidity. The way we measure adjusted EBITDA, adjusted gross profit and adjusted gross margin may not be comparable to similarly titled measures presented by other companies, and may not be identical to corresponding measures used in our various agreements. Results of Operations Year ended December 31, 2018 compared to year ended December 31, 2017 Revenue. Revenue increased $7.7 million or 90% to $16.3 million for the year ended December 31, 2018 from $8.6 million for the year ended December 31, 2017. This increase was driven by strong growth in volume from onboarding of new customers and usage from existing customers. Our core billable customer base grew from 2,703 customers for the month ended December 31, 2017 to 3,627 customers for the month ended December 31, 2018. Cost of revenue (exclusive of depreciation and amortization). Cost of revenue increased $1.5 million or 22% to $8.6 million for the year ended December 31, 2018 from $7.1 million for the year ended December 31, 2017. Our cost of revenue primarily includes data acquisition costs. Data acquisition costs consist primarily of the costs to acquire data either on a transactional basis or through flat-fee data licensing agreements, including unlimited usage agreements. We continue to expand our relationships with our key data suppliers, including our largest data supplier which accounted for approximately 46% of our total data acquisition costs for the year ended December 31, 2018 compared to approximately 43% for the year ended December 31, 2017. Other cost of revenue items include expenses related to third-party infrastructure fees. As the construct of our data costs is a flat-fee, unlimited usage model, the cost of revenue as a percentage of revenue decreased to 53% for the year ended December 31, 2018 from 82% for the year ended December 31, 2017. We expect that cost of revenue as a percentage of revenue will continue to decrease over the coming years as our revenue increases. Historically, at scale, the industry business model’s cost of revenue will trend between 15% and 30% as a percentage of revenue. Sales and marketing expenses. Sales and marketing expenses increased $0.4 million or 8% to $4.8 million for the year ended December 31, 2018 from $4.4 million for the year ended December 31, 2017. The increase resulted from increased headcount as we continue to invest in the expansion of our sales organization. Sales and marketing expenses consist of salaries and benefits, advertising and marketing, traveling expenses, and share-based compensation expense, incurred by our sales team. General and administrative expenses. General and administrative expenses decreased $9.1 million or 52% to $8.4 million for the year ended December 31, 2018 from $17.5 million for the year ended December 31, 2017. The decrease resulted from decreases in litigation costs and share-based compensation expense, which were partially offset by increases in employee salaries and benefits and other professional fees. For the years ended December 31, 2018 and 2017, our general and administrative expenses consisted primarily of litigation costs of $0.4 million and $9.2 million, share-based compensation expense of $0.6 million and $2.6 million, employee salaries and benefits of $3.3 million and $2.8 million, and other professional fees of $1.8 million and $1.0 million, respectively. Depreciation and amortization. Depreciation and amortization expenses increased $0.9 million or 75% to $2.0 million for the year ended December 31, 2018 from $1.1 million for the year ended December 31, 2017. The increase in depreciation and amortization for the year ended December 31, 2018 resulted primarily from the amortization of software developed for internal use that became ready for its intended use after December 31, 2017. Other income, net. For the year ended December 31, 2018, other income, net consisted primarily of transition service income of $0.2 million and the insurance proceeds of $0.4 million in relation to previously settled litigation. Loss before income taxes. We had a loss before income taxes of $6.9 million for the year ended December 31, 2018 as compared to $21.5 million for the year ended December 31, 2017. The decrease in loss before income taxes resulted from the increase in revenue, decrease in our cost of revenue as a percentage of revenue, decreases in litigation costs and share-based compensation expense, which were partially offset by increases in salaries and benefits, other professional fees and depreciation and amortization. Income taxes. Income tax expense of $0 was recognized for the years ended December 31, 2018 and 2017. A full valuation allowance on the deferred tax assets was recognized as of December 31, 2018 and 2017. On December 22, 2017, the Act was enacted, with the statutory federal income tax rate lowered to 21% among other changes, effective on January 1, 2018. As a full valuation allowance was provided as of December 31, 2018 and 2017, the Act does not have a material net impact on our consolidated financial statements. See Note 9, “Income Taxes,” included in “Notes to Consolidated Financial Statements,” for details. Net loss. A net loss of $6.9 million was recognized for the year ended December 31, 2018 as compared to $21.5 million for the year ended December 31, 2017, as a result of the foregoing. Effect of Inflation The rates of inflation experienced in recent years have had no material impact on our financial statements. We attempt to recover increased costs by increasing prices for our services, to the extent permitted by contracts and competition. Liquidity and Capital Resources Cash flows used in operating activities. For the year ended December 31, 2018, net cash used in operating activities was $8.1 million, primarily the result of the net loss of $6.9 million, adjusted for certain non-cash items totaling $3.4 million, consisting of share-based compensation expense, depreciation and amortization, write-off of long-lived assets, provision for bad debts and allocation of expenses from Fluent, Inc. In addition, the net working capital increased $4.6 million, primarily the result of the decrease in accounts payable and accrued expenses and other current liabilities and the increase in accounts receivable following the increase in revenue. For the year ended December 31, 2017, net cash used in operating activities was $10.4 million, primarily the result of the net loss of $21.5 million, adjusted for certain non-cash items of an aggregate of $7.9 million, and the cash provided by net working capital of $3.2 million. Cash flows used in investing activities. Net cash used in investing activities for the years ended December 31, 2018 and 2017 was $6.0 million and $6.5 million, respectively, primarily as a result of capitalized costs included in intangible assets of $5.9 million and $6.0 million for the corresponding periods. Cash flows provided by financing activities. Net cash provided by financing activities for the years ended December 31, 2018 and 2017 was $23.9 million (inclusive of the $20.0 million cash contribution by Fluent to red violet upon the Spin-off) and $16.7 million, respectively, as a result of capital contributed by Fluent during the corresponding periods. As of December 31, 2018, we had material commitments under certain data licensing agreements of $21.8 million. We anticipate funding our operations using available cash and cash flow generated from operations within the next twelve months. We reported net loss of $6.9 million for the year ended December 31, 2018 as compared to $21.5 million for the year ended December 31, 2017. As of December 31, 2018, we had a total shareholders’ equity balance of $36.3 million. As of December 31, 2018, we had cash and cash equivalents of approximately $10.0 million. Prior to the Spin-off, we funded our operations via intercompany transfers from Fluent on an as needed basis. Based on projections of growth in revenue and operating results in the coming year, and the available cash and cash equivalents held by us, we believe that we will have sufficient cash resources to finance our operations and expected capital expenditures for the next twelve months. Subject to revenue growth, we may have to raise capital through the issuance of additional equity and/or debt, which, if we are able to obtain, could have the effect of diluting stockholders. Any equity or debt financings, if available at all, may be on terms which are not favorable to us. If our operations do not generate positive cash flow in the upcoming year, or if we are not able to obtain additional equity or debt financing on terms and conditions acceptable to us, if at all, we may be unable to implement our business plan, or even continue our operations. Off-Balance Sheet Arrangements We do not have any outstanding off-balance sheet guarantees, interest rate swap transactions or foreign currency forward contracts. In addition, we do not engage in trading activities involving non-exchange traded contracts. In our ongoing business, we do not enter into transactions involving, or otherwise form relationships with, unconsolidated entities or financial partnerships that are established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. FORWARD-LOOKING STATEMENTS This 2018 Form 10-K contains certain “forward-looking statements” within the meaning of the PSLRA, Section 27A of the Securities Act, and Section 21E of the Exchange Act. Such forward-looking statements contain information about our expectations, beliefs or intentions regarding our product development and commercialization efforts, business, financial condition, results of operations, strategies or prospects. You can identify forward-looking statements by the fact that these statements do not relate strictly to historical or current matters. Rather, forward-looking statements relate to anticipated or expected events, activities, trends or results as of the date they are made. Because forward-looking statements relate to matters that have not yet occurred, these statements are inherently subject to risks and uncertainties that could cause our actual results to differ materially from any future results expressed or implied by the forward-looking statements. Many factors could cause our actual activities or results to differ materially from the activities and results anticipated in forward-looking statements. These factors include the following: • We have a history of losses and negative cash flow from operations which makes our future results uncertain. • Our products and services are highly technical and if they contain undetected errors, our business could be adversely affected and we may have to defend lawsuits or pay damages in connection with any alleged or actual failure of our products and services. • Because our networks and information technology systems are critical to our success, if unauthorized persons access our systems or our systems otherwise cease to function properly, our operations could be adversely affected and we could lose revenue or proprietary information, all of which could materially adversely affect our business. • We must adequately protect our intellectual property in order to prevent loss of valuable proprietary information. • We depend, in part, on strategic alliances, joint ventures and acquisitions to grow our business. If we are unable to make strategic acquisitions and develop and maintain these strategic alliances and joint ventures, our growth may be adversely affected. • If we consummate any future acquisitions, we will be subject to the risks inherent in identifying, acquiring and operating a newly acquired business. • Our business is subject to various governmental regulations, laws and orders, compliance with which may cause us to incur significant expenses or reduce the availability or effectiveness of our solutions, and the failure to comply with which could subject us to civil or criminal penalties or other liabilities. • The outcome of litigation, inquiries, investigations, examinations or other legal proceedings in which we are involved, in which we may become involved, or in which our customers or competitors are involved could subject us to significant monetary damages or restrictions on our ability to do business. • Our relationships with key customers may be materially diminished or terminated. • If we lose the services of key personnel, it could adversely affect our business. • If we fail to respond to rapid technological changes in the big data and analytics sector, we may lose customers and/or our products and/or services may become obsolete. • Our revenue is concentrated in the U.S. market across a broad range of industries. When these industries or the broader financial markets experience a downturn, demand for our services and revenue may be adversely affected. • We could lose our access to data sources which could prevent us from providing our services. • Data security and integrity are critically important to our business, and breaches of security, unauthorized access to or disclosure of confidential information, disruption, including distributed denial of service (“DDoS”) attacks or the perception that confidential information is not secure, could result in a material loss of business, substantial legal liability or significant harm to our reputation. • We face intense competition from both start-up and established companies that may have significant advantages over us and our products. • There may be further consolidation in our end-customer markets, which may adversely affect our revenue. • To the extent the availability of free or relatively inexpensive consumer and/or business information increases, the demand for some of our services may decrease. • If our newer products do not achieve market acceptance, revenue growth may suffer. • Our products and services can have long sales and implementation cycles, which may result in substantial expenses before realizing any associated revenue. • If we fail to maintain and improve our systems, our technology, and our interfaces with data sources and customers, demand for our services could be adversely affected. • If our outside service providers and key vendors are not able to or do not fulfill their service obligations, our operations could be disrupted and our operating results could be harmed. • Consolidation in the big data and analytics sector may limit market acceptance of our products and services. • We may incur substantial expenses defending against claims of infringement. • Our stock price has been and may continue to be volatile, and the value of an investment in our common stock may decline. • Future issuances of shares of our common stock in connection with acquisitions or pursuant to our stock incentive plan could have a dilutive effect on your investment. • The concentration of our stock ownership may limit individual stockholder ability to influence corporate matters. • We are an “emerging growth company,” and we cannot be certain if the reduced reporting requirements available to emerging growth companies will make our shares of common stock less attractive to investors. • We expect that we may need additional capital in the future; however, such capital may not be available to us on reasonable terms, if at all, when or as we require additional funding. If we issue additional shares of our common stock or other securities that may be convertible into, or exercisable or exchangeable for, our common stock, our existing stockholders would experience further dilution.
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<s>[INST] Overview Red Violet, Inc. (“we,” “us,” “our,” “red violet,” or the “Company”), a Delaware corporation, is a software and services company specializing in big data analysis, providing cloudbased, missioncritical solutions to enterprises in a variety of industries. red violet’s mission is to transform data into intelligence utilizing our proprietary technology platform to solve complex problems for our clients. Harnessing the power of data fusion and powerful analytics, we transform data into intelligence, in a fast and efficient manner, so our clients can spend their time on what matters most running their organizations with confidence. Through our intelligent platform, CORETM, we uncover the relevance of disparate data points utilizing our analytical capabilities to provide realtime and insightful views of people, businesses, assets and their interrelationships. We empower clients across markets and industries to better execute all aspects of their business, from managing risk, identifying fraud and abuse, and ensuring legislative compliance, to debt recovery. We provide unique and compelling solutions essential to the daily workflow of organizations within both the public and private sectors. Our cloudbased data fusion platform, combined with our massive database consisting of publicrecords, proprietary and publiclyavailable data, as well as a unique repository of selfreported information on millions of consumers, enables the delivery of differentiated products and solutions used for a variety of essential functions. These essential functions include identification and authentication, and investigation and validation. Leveraging leadingedge technology, proprietary algorithms, and massive datasets, and through intuitive and powerful analytical applications, we provide solutions to organizations within the risk management industry. CORE is our next generation data fusion platform, providing missioncritical information about individuals, businesses and assets to a variety of markets and industries. Through machine learning and advanced analytics, we use the power of data fusion to ingest and analyze data at a massive scale. The derived information from the data fusion process ultimately serves to generate unique solutions for banking and financial services companies, insurance companies, healthcare companies, law enforcement and government, the collection industry, law firms, retail, telecommunications companies, corporate security and investigative firms. Built in a secure payment card industry (“PCI”) compliant environment, our cloudbased next generation technology delivers greater than four 9s of service uptime. By leveraging our proprietary infrastructure design within the cloud, we currently operate in six datacenters spread geographically across the U.S. and are able to dynamically and seamlessly scale as needed. Using our intelligent framework, and leveraging a microservices architecture where appropriate, we reduce operational cost and complexity, thus delivering superior performance at greatly reduced costs compared to traditional datacenter architectures. Since the release of our CORE platform in May 2016, we have added billions of data records and continue to add over a billion records per month on average. Our average query response time for a comprehensive profile is less than 250 milliseconds versus competitive platforms that measure comprehensive profile response times in seconds. On March 26, 2018, Fluent, Inc. (“Fluent”), a Delaware corporation, completed a spinoff (the “Spinoff”) of its risk management business from its digital marketing business by way of a distribution of all the shares of common stock of Fluent’s whollyowned subsidiary, red violet, to Fluent’s stockholders of record as of March 19, 2018 (the “Record Date”) and certain warrant holders. The distribution occurred by way of a pro rata stock distribution to such common stock and warrant holders, each of whom received one share of red violet’s common stock for every 7.5 shares of Fluent’s common stock held on the Record Date or to which they were entitled to under their warrants, which resulted in a distribution of a total of 10,266,613 shares of red violet common stock. Upon the Spinoff, red violet owns Fluent subsidiaries which previously operated Fluent’s risk management business. As a result of the Spinoff, red violet is an independent public company and red violet’s common stock began regularway trading on The NASDAQ Capital Market under the symbol “RDVT” on March 27, 2018. Although the Spinoff was completed on March 26, 2018 [/INST] Negative. </s>
2,019
7,228
1,720,116
Red Violet, 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 in conjunction with our consolidated financial statements and related notes included in this Annual Report on Form 10-K (“2019 Form 10-K”). This 2019 Form 10-K contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 (“PSLRA”), Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), about our expectations, beliefs, or intentions regarding our business, financial condition, results of operations, strategies, or prospects. You can identify forward-looking statements by the fact that these statements do not relate strictly to historical or current matters. Rather, forward-looking statements relate to anticipated or expected events, activities, trends, or results as of the date they are made. Because forward-looking statements relate to matters that have not yet occurred, these statements are inherently subject to risks and uncertainties that could cause our actual results to differ materially from any future results expressed or implied by the forward-looking statements. Many factors could cause our actual activities or results to differ materially from the activities and results anticipated in forward-looking statements. These factors include those contained in Part I, “Item 1A. Risk Factors” of this 2019 Form 10-K. We do not undertake any obligation to update forward-looking statements, except as required by law. We intend that all forward-looking statements be subject to the safe harbor provisions of PSLRA. These forward-looking statements are only predictions and reflect our views as of the date they are made with respect to future events and financial performance. Overview Red Violet, Inc. (“we,” “us,” “our,” “red violet,” or the “Company”), a Delaware corporation, is dedicated to making the world a safer place and reducing the cost of doing business. We specialize in data fusion and analytics, providing cloud-based, mission-critical solutions to enterprises with use cases including fraud detection, risk mitigation, due diligence and marketing. Through our intelligent platform, CORETM, we uncover the relevance of disparate data points utilizing our analytical capabilities to provide real-time and insightful views of people, businesses, assets and their interrelationships. Leveraging proprietary technology and applying machine learning and advanced analytical and decision-making capabilities, CORE provides compelling solutions to public and private sector organizations through intuitive, easy-to-use analytical applications. We empower clients across markets and industries to better execute all aspects of their business, from managing risk, recovering debt, identifying fraud and abuse, and ensuring legislative compliance, to identifying and acquiring customers. With a massive data repository of approximately nine petabytes of public-record, proprietary and publicly-available data, as well as self-reported consumer information and behavioral signals, we transform data into intelligence for our customers to enable better data-driven decisioning. We presently market our solutions primarily through two brands, idiCORE™, our flagship product, and FOREWARN®. idiCORE is a next-generation, investigative solution used to address a variety of organizational challenges including due diligence, risk mitigation, identity authentication and legislative compliance, by financial services companies, insurance companies, healthcare companies, law enforcement and government, collections, law firms, retail, telecommunication companies, corporate security and investigative firms. FOREWARN is an app-based solution currently tailored for the real estate industry, providing instant knowledge prior to face-to-face engagement with a consumer, helping professionals identify and mitigate risk. As of December 31, 2019 and 2018, idiCORE had 5,064 and 3,627 billable customers and FOREWARN had 30,577 and 11,397 users, respectively. We generate substantially all of our revenue from licensing our solutions. Customers access our solutions through a hosted environment using an online interface, batch processing, API and custom integrations. We recognize revenue from licensing fees (a) on a transactional basis determined by the customer’s usage, (b) via a monthly fee or (c) from a combination of both. Revenue pursuant to pricing contracts containing a monthly fee is recognized ratably over the contract period. Pricing contracts are generally annual contracts or longer, with auto renewal. Revenue from pricing contracts represented 65% and 58% of total revenue for the years ended December 31, 2019 and 2018, respectively. Our go-to-market strategy leverages (a) an inside sales team that cultivates relationships, and ultimately closes business, with their end-user markets, (b) a strategic sales team that provides a more personal, face-to-face approach for major accounts within certain industries, and (c) distributors, resellers, and strategic partners that have a significant foothold in many of the industries that we have not historically served, as well as to further penetrate those industries that we do serve. Our sales model generally begins with a free trial followed by an initial purchase on a transactional basis or minimum-committed monthly spend. As organizations derive benefits from our solutions, we are able to “land and expand” within larger organizations as additional use cases expand across departments, divisions and geographic locations and customers become increasingly reliant on our solutions in their daily workflow. On March 26, 2018, Fluent, Inc. (“Fluent”) spun off its risk management business by way of a distribution of all of the shares of common stock of its then wholly-owned subsidiary, red violet, to its stockholders as of the record date and certain warrant holders (the “Spin-off”). Upon the Spin-off, red violet owned Fluent subsidiaries that previously operated Fluent’s risk management business, and red violet became an independent public company. For periods prior to the Spin-off, these financial statements were prepared on a consolidated and combined basis because certain of the entities were under common control. In order for us to continue to develop new products, grow our existing business and expand into additional markets, we must generate and sustain sufficient operating profits and cash flow in future periods. This will require us to generate additional sales from current products and new products currently under development. We are building out our sales organization to drive current products and to introduce new products into the market place. We will incur increased compensation expenses relating to our sales and marketing, executive and administrative, product development and infrastructure-related personnel as we increase headcount in the next 12 months. Industry Trends and Uncertainties Operating results are affected by the following factors that impact the big data and analytics sector in the United States: • The macroeconomic conditions, including the availability of affordable credit and capital, interest rates, inflation, employment levels and consumer confidence, influence our revenue. Macroeconomic conditions also have a direct impact on overall technology, marketing and advertising expenditures in the U.S. As marketing budgets are often more discretionary in nature, they are easier to reduce in the short term as compared to other corporate expenses. Future widespread economic slowdowns in any of the industries or markets our clients serve could reduce the technology and marketing expenditures of our clients and prospective customers. • Our revenue is also significantly influenced by industry trends, including the demand for business analytics services in the industries we serve. Companies are increasingly relying on business analytics and big-data technologies to help process data in a cost-efficient manner. As customers have gained the ability to rapidly aggregate data generated by their own activities, they are increasingly expecting access to real-time data and analytics from their service providers as well as solutions that fully integrate into their workflows. The increasing number and complexity of regulations centered around data and provision of information services makes operations for businesses in the big data and analytic sector more challenging. • The enactment of new or amended legislation or industry regulations pertaining to consumer or private sector privacy issues could have a material adverse impact on information and marketing services. Legislation or industry regulations regarding consumer or private sector privacy issues could place restrictions upon the collection, sharing and use of information that is currently legally available, which could materially increase our cost of collecting and maintaining some data. These types of legislation or industry regulations could also prohibit us from collecting or disseminating certain types of data, which could adversely affect our ability to meet our clients’ requirements and our profitability and cash flow targets. Company Specific Trends and Uncertainties Our operating results are also directly affected by company-specific factors, including the following: • Some of our competitors have substantially greater financial, technical, sales and marketing resources, better name recognition and a larger customer base. Even if we introduce advanced products that meet evolving customer requirements in a timely manner, there can be no assurance that our new products will gain market acceptance. • Certain companies in the big data and analytics sector have expanded their product lines or technologies in recent years as a result of acquisitions. Further, more companies have developed products which conform to existing and emerging industry standards and have sought to compete on the basis of price. We anticipate increased competition from large data and analytics vendors. Increased competition in the big data and analytics sector could result in significant price competition, reduced profit margins or loss of market share, any of which could have a material adverse effect on our business, operating results and financial condition. There can be no assurance that we will be able to compete successfully in the future with current or new competitors. Critical Accounting Policies and Estimates Management’s discussion and analysis of 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 (“US GAAP”). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to the allowance for doubtful accounts, useful lives of property and equipment and intangible assets, recoverability of the carrying amounts of goodwill and intangible assets, share-based compensation and income tax provision. We base our estimates 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. We believe the following critical accounting policies govern our more significant judgments and estimates used in the preparation of our consolidated financial statements. Revenue recognition On January 1, 2018, the Company adopted ASC 606, “Revenue from Contracts with Customers,” (“Topic 606”) using the modified retrospective method applied to all contracts that were not completed contracts at the date of initial application. There was no impact on the opening accumulated deficit as of January 1, 2018 due to the adoption of Topic 606. Revenue is recognized when control of goods or services is transferred to the Company’s customers, in an amount that reflects the consideration the Company expects to be entitled to in exchange for those goods or services. The Company’s performance obligation is to provide on demand solutions to its customers by leveraging its proprietary technology and applying machine learning and advanced analytics to its massive data repository. The pricing for the customer contracts is based on usage, a monthly fee, or a combination of both. Revenue is generally recognized on (a) a transactional basis determined by the customers’ usage, (b) a monthly fee or (c) a combination of both. Revenue pursuant to transactions determined by the customers’ usage is recognized when the transaction is complete, and either party may terminate the transactional agreement at any time. Revenue pursuant to contracts containing a monthly fee is recognized ratably over the contract period, which is generally 12 months, and the contract shall automatically renew for additional, successive 12-month terms unless written notice of intent not to renew is provided by one party to the other at least 30 days or 60 days prior to the expiration of the then current term. The Company’s revenue is recorded net of applicable sales taxes billed to customers. Available within Topic 606, the Company has applied the portfolio approach practical expedient in accounting for customer revenue as one collective group, rather than individual contracts. Based on the Company’s historical knowledge of the contracts contained in this portfolio and the similar nature and characteristics of the customers, the Company has concluded the financial statement effects are not materially different than if accounting for revenue on a contract by contract basis. Revenue is recognized over a period of time since the performance obligation is delivered in a series. The Company’s customers simultaneously receive and consume the benefits provided by the Company’s performance as and when provided. Furthermore, the Company has elected the “right to invoice” practical expedient, available within Topic 606, as its measure of progress, since it has a right to payment from a customer in an amount that corresponds directly with the value of its performance completed-to-date. The Company's revenue arrangements do not contain significant financing components. For the years ended December 31, 2019 and 2018, 65% and 58% of total revenue was attributable to customers with pricing contracts, respectively, versus 35% and 42% attributable to transactional customers, respectively. Pricing contracts are generally annual contracts or longer, with auto renewal. If a customer pays consideration before the Company transfers services to the customer, those amounts are classified as deferred revenue. As of December 31, 2019 and 2018, the balance of deferred revenue was $128 and $26, respectively, all of which is expected to be realized in the next 12 months. In relation to the deferred revenue balance as of December 31, 2018, $26 was recognized into revenue during the year ended December 31, 2019. As of December 31, 2019, $2,929 of revenue is expected to be recognized in the future for performance obligations that are unsatisfied or partially unsatisfied, related to pricing contracts that have a term of more than 12 months. $1,820 of revenue will be recognized in 2020, $1,106 in 2021, and $3 in 2022. The actual timing of recognition may vary due to factors outside of the Company’s control. The Company excludes variable consideration related entirely to wholly unsatisfied performance obligations and contracts and recognizes such variable consideration based upon the right to invoice the customer. Sales commissions are incurred and recorded on an ongoing basis over the term of the customer relationship. These costs are recorded in sales and marketing expenses. In addition, the Company elected the practical expedient to not disclose the value of unsatisfied performance obligations for (i) contracts with an original expected length of one year or less and (ii) contracts for which the Company recognizes revenue at the amount to which it has the right to invoice for services performed. Allowances for doubtful accounts We maintain allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. Management determines whether an allowance needs to be provided for an amount due from a customer depending on the aging of the individual receivable balance, recent payment history, contractual terms and other qualitative factors such as status of business relationship with the customer. Historically, our estimates for doubtful accounts have not differed materially from actual results. The amount of the allowance for doubtful accounts was $0.04 million and $0.1 million as of December 31, 2019 and 2018, respectively. Income taxes We account for income taxes in accordance with ASC 740, “Income Taxes,” which requires the use of the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred tax assets and liabilities are computed based upon the difference between the financial statement and income tax basis of assets and liabilities using the enacted tax rate applicable when the related asset or liability is expected to be realized or settled. Deferred income tax expenses or benefits are based on the changes in the asset or liability each period. If available evidence suggests that it is more likely than not that some portion or all of the deferred tax assets will not be realized, a valuation allowance is required to reduce the deferred tax assets to the amount that is more likely than not to be realized. As of December 31, 2019 and 2018, we had a valuation allowance of $5.1 million and $2.3 million, respectively. Future changes in such valuation allowance are included in the provision for deferred income taxes in the period of change. ASC 740 clarifies the accounting for uncertain tax positions. This interpretation requires that an entity recognizes in the consolidated financial statements the impact of a tax position, if that position is more likely than not of being sustained upon examination, based on the technical merits of the position. Recognized income tax positions are measured at the largest amount that is greater than 50% likely of being realized. Changes in recognition or measurement are reflected in the period in which the change in judgment occurs. The Company’s accounting policy is to accrue interest and penalties related to uncertain tax positions, if and when required, as interest expense and a component of other expenses, respectively, in the consolidated statements of operations. Intangible assets other than goodwill Our intangible assets are initially recorded at the capitalized actual costs incurred, their acquisition cost, or fair value if acquired as part of a business combination, and amortized on a straight-line basis over their respective estimated useful lives, which are the periods over which the assets are expected to contribute directly or indirectly to the future cash flows of the Company. The Company’s intangible assets represent software developed for internal use. Intangible assets have estimated useful lives of 5-10 years. In accordance with ASC 350-40, “Software - internal use software,” we capitalize eligible costs, including salaries and staff benefits, share-based compensation, travel expenses incurred by relevant employees, and other relevant costs of developing internal-use software that are incurred in the application development stage when developing or obtaining software for internal use. Once the software developed for internal use is ready for its intended use, it is amortized on a straight-line basis over its useful life. Goodwill In accordance with ASC 350, “Intangibles - Goodwill and Other,” goodwill is tested at least annually for impairment, or when events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable, by assessing qualitative factors or performing a quantitative analysis in determining whether it is more likely than not that its fair value exceeds the carrying value. A quantitative assessment involves determining the fair value of each reporting unit using market participant assumptions. An entity should recognize an impairment charge for the amount by which the carrying amount of a reporting unit exceeds its fair value up to the amount of goodwill allocated to that reporting unit. On October 1, 2019 and 2018, we performed qualitative assessments on the reporting unit and, based on this assessment, no events have occurred to indicate that it is more likely than not that the fair value of the reporting unit is less than its carry amount. We concluded that goodwill was not impaired as of December 31, 2019 and 2018. For purposes of reviewing impairment and the recoverability of goodwill, we must make various assumptions regarding estimated future cash flows and other factors in determining the fair values of the reporting unit, including market multiples, discount rates, etc. Impairment of long-lived assets Finite-lived intangible assets are amortized over their respective useful lives and, along with other long-lived assets, are evaluated for impairment periodically whenever events or changes in circumstances indicate that their related carrying amounts may not be recoverable in accordance with ASC 360-10-15, “Impairment or Disposal of Long-Lived Assets.” In evaluating long-lived assets for recoverability, including finite-lived intangibles and property and equipment, the Company uses its best estimate of future cash flows expected to result from the use of the asset and eventual disposition in accordance with ASC 360-10-15. To the extent that estimated future undiscounted cash inflows attributable to the asset, less estimated future undiscounted cash outflows, are less than the carrying amount, an impairment loss is recognized in an amount equal to the difference between the carrying value of such asset and its fair value. Assets to be disposed of and for which there is a committed plan of disposal, whether through sale or abandonment, are reported at the lower of carrying value or fair value less costs to sell. Asset recoverability is an area involving management judgment, requiring assessment as to whether the carrying value of assets can be supported by the undiscounted future cash flows. In calculating the future cash flows, certain assumptions are required to be made in respect of highly uncertain matters such as revenue growth rates, gross margin percentages and terminal growth rates. We concluded there was no impairment as of December 31, 2019 and 2018. Share-based compensation We account for share-based compensation to employees in accordance with ASC 718, “Compensation-Stock Compensation.” Under ASC 718, we measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award and, for those awards subject only to service condition, recognizes the costs on a straight-line basis over the period the employee is required to provide service in exchange for the award, which generally is the vesting period. For awards with performance and service conditions, we begin recording share-based compensation when achieving the performance criteria is probable and we recognize the costs using the accelerated attribution method. The fair value of restricted stock units (“RSUs”) is determined based on the number of shares granted and the quoted price of our common stock. The estimated number of stock awards that will ultimately vest requires judgment, and to the extent actual results or updated estimates differ from our current estimates, such amount will be recorded as a cumulative adjustment in the period estimates are revised. Changes in our estimates and assumptions may cause us to realize material changes in share-based compensation expense in the future. We have issued share-based awards with performance-based vesting criteria. Achievement of the milestones must be probable before we begin recording share-based compensation expense. When the performance-based vesting criteria is considered probable, we begin to recognize compensation expense at that time. In the period that achievement of the performance-based criteria is deemed probable, US GAAP requires the immediate recognition of all previously unrecognized compensation since the original grant date. As a result, compensation expense recorded in the period that achievement is deemed probable could include a substantial amount of previously unrecorded compensation expense related to the prior periods. For any share-based awards where performance-based vesting criteria is no longer considered probable, previously recognized compensation cost would be reversed. As of December 31, 2019, we have deemed the achievement of the performance-based criteria to be probable for all share-based awards with performance-based vesting criteria. We apply ASU 2018-07, “Improvements to Nonemployee Share-Based Payment Accounting,” which generally expands the scope of ASC 718, Compensation - Stock Compensation, to include share-based payment transactions for acquiring goods and services from nonemployees and supersedes the guidance in ASC 505-50, Equity-Based Payments to Non-employees, which previously included the accounting for nonemployee awards. Recently Issued Accounting Standards See Item 8 of Part II, “Financial Statements and Supplementary Data - Note 2. Summary of significant accounting policies - (s) Recently issued accounting standards.” Fourth Quarter Financial Results For the three months ended December 31, 2019 as compared to the three months ended December 31, 2018: • Total revenue increased 92% to $9.1 million. • Net loss was $4.9 million (including share-based compensation expense of $4.6 million, which includes a one-time $2.3 million) as compared to $2.0 million (including share-based compensation expense of $0.3 million). • Adjusted EBITDA was $0.8 million as compared to a negative $1.0 million. • Gross profit increased 155% to $4.9 million. Gross margin increased to 54% from 41%. • Adjusted gross profit increased 134% to $5.6 million. Adjusted gross margin increased to 62% from 51%. Full Year Financial Results For the year ended December 31, 2019 as compared to the year ended December 31, 2018: • Total revenue increased 86% to $30.3 million. • Net loss was $11.1 million (including share-based compensation expense of $9.9 million) as compared to $6.9 million (including share-based compensation expense of $0.7 million). • Adjusted EBITDA was $1.9 million as compared to a negative $4.3 million. • Gross profit increased 159% to $15.4 million. Gross margin increased to 51% from 36%. • Adjusted gross profit increased 135% to $18.0 million. Adjusted gross margin increased to 60% from 47%. Use and Reconciliation of Non-GAAP Financial Measures Management evaluates the financial performance of our business on a variety of key indicators, including non-GAAP metrics of adjusted EBITDA, adjusted gross profit and adjusted gross margin. Adjusted EBITDA is a financial measure equal to net loss, the most directly comparable financial measure based on US GAAP, excluding interest income, net, depreciation and amortization, share-based compensation expense, litigation costs, net, sales and use tax expense, insurance proceeds in relation to settled litigation, transition service income, and write-off of long-lived assets and others, as noted in the tables below. We define adjusted gross profit as revenue less cost of revenue (exclusive of depreciation and amortization), and adjusted gross margin as adjusted gross profit as a percentage of revenue. The following is a reconciliation of gross profit, the most directly comparable GAAP financial measure, to adjusted gross profit: In order to assist readers of our consolidated financial statements in understanding the operating results that management uses to evaluate the business and for financial planning purposes, we present non-GAAP measures of adjusted EBITDA, adjusted gross profit and adjusted gross margin as supplemental measures of our operating performance. We believe they provide useful information to our investors as they eliminate the impact of certain items that we do not consider indicative of our cash operations and ongoing operating performance. In addition, we use them as an integral part of our internal reporting to measure the performance and operating strength of our business. We believe adjusted EBITDA, adjusted gross profit and adjusted gross margin are relevant and provide useful information frequently used by securities analysts, investors and other interested parties in their evaluation of the operating performance of companies similar to ours and are indicators of the operational strength of our business. We believe adjusted EBITDA eliminates the uneven effect of considerable amounts of non-cash depreciation and amortization, share-based compensation expense and the impact of other non-recurring items, providing useful comparisons versus prior periods or forecasts. Our adjusted gross profit is a measure used by management in evaluating the business’s current operating performance by excluding the impact of prior historical costs of assets that are expensed systematically and allocated over the estimated useful lives of the assets, which may not be indicative of the current operating activity. Our adjusted gross profit is calculated by using revenue, less cost of revenue (exclusive of depreciation and amortization). We believe adjusted gross profit provides useful information to our investors by eliminating the impact of non-cash depreciation and amortization, and specifically the amortization of software developed for internal use, providing a baseline of our core operating results that allow for analyzing trends in our underlying business consistently over multiple periods. Adjusted gross margin is calculated as adjusted gross profit as a percentage of revenue. Adjusted EBITDA, adjusted gross profit and adjusted gross margin are not intended to be performance measures that should be regarded as an alternative to, or more meaningful than, financial measures presented in accordance with GAAP. The way we measure adjusted EBITDA, adjusted gross profit and adjusted gross margin may not be comparable to similarly titled measures presented by other companies, and may not be identical to corresponding measures used in our various agreements. Results of Operations Year ended December 31, 2019 compared to year ended December 31, 2018 Revenue. Revenue increased $14.0 million or 86% to $30.3 million for the year ended December 31, 2019 from $16.3 million for the year ended December 31, 2018. This increase was driven by strong growth in volume from onboarding of new customers and usage from existing customers. Revenue from new customers increased $1.8 million or 52%, base revenue from existing customers increased $9.9 million or 94%, and growth revenue from existing customers increased $2.3 million or 100% for the year ended December 31, 2019 compared to the year ended December 31, 2018, respectively. Our idiCORE billable customer base grew from 3,627 customers as of December 31, 2018 to 5,064 customers as of December 31, 2019. Revenue from new customers represents the total monthly revenue generated from new customers in a given period. A customer is defined as a new customer during the first six months of revenue generation. Base revenue from existing customers represents the total monthly revenue generated from existing customers in a given period that does not exceed the customers' trailing six-month average revenue. A customer is defined as an existing customer six months after their initial month of revenue. Growth revenue from existing customers represents the total monthly revenue generated from existing customers in a given period in excess of the customers' trailing six-month average revenue. Cost of revenue (exclusive of depreciation and amortization). Cost of revenue increased $3.7 million or 42% to $12.3 million for the year ended December 31, 2019 from $8.6 million for the year ended December 31, 2018. Our cost of revenue primarily includes data acquisition costs. Data acquisition costs consist primarily of the costs to acquire data either on a transactional basis or through flat-fee data licensing agreements, including unlimited usage agreements. We continue to enhance the breadth and depth of our data through the addition and expansion of relationships with key data suppliers, including our largest data supplier, which accounted for approximately 40% of our total data acquisition costs for the year ended December 31, 2019 compared to approximately 46% for the year ended December 31, 2018. Other cost of revenue items include expenses related to third-party infrastructure fees. As the construct of our data costs is primarily a flat-fee, unlimited usage model, the cost of revenue as a percentage of revenue decreased to 40% for the year ended December 31, 2019 from 53% for the year ended December 31, 2018. We expect that cost of revenue as a percentage of revenue will continue to decrease over the coming years as our revenue increases. Historically, at scale, the industry business model’s cost of revenue will trend between 15% and 30% as a percentage of revenue. Sales and marketing expenses. Sales and marketing expenses increased $2.7 million or 58% to $7.5 million for the year ended December 31, 2019 from $4.8 million for the year ended December 31, 2018. Sales and marketing expenses consist of salaries and benefits, advertising and marketing, travel expenses, and share-based compensation expense, incurred by our sales team, and provision for bad debts. The increase during the year ended December 31, 2019 was primarily attributable to the $1.9 million increase in salaries and benefits, as we continue to invest in the expansion of our sales organization, and sales commissions from increased revenue. In addition, $0.6 million of the total increase was attributable to an increase in share-based compensation expense and provision for bad debts. General and administrative expenses. General and administrative expenses increased $10.4 million or 124% to $18.8 million for the year ended December 31, 2019 from $8.4 million for the year ended December 31, 2018. The increase during the year ended December 31, 2019 was primarily attributable to the $8.9 million increase in share-based compensation expense. The increase in share-based compensation expense was as a result of achieving certain performance-based milestones in the second quarter of 2019 and certain new grants issued after the second quarter of 2019, as outlined in Note 11, “Share-based compensation,” included in “Notes to Consolidated Financial Statements.” For the years ended December 31, 2019 and 2018, our general and administrative expenses consisted primarily of employee salaries and benefits of $4.7 million and $3.3 million, share-based compensation expense of $9.5 million (including a one-time $2.2 million as a result of achieving certain performance-based milestones) and $0.6 million, and professional fees of $2.6 million and $2.7 million, respectively. Depreciation and amortization. Depreciation and amortization expenses increased $0.9 million or 45% to $2.9 million for the year ended December 31, 2019 from $2.0 million for the year ended December 31, 2018. The increase in depreciation and amortization for the year ended December 31, 2019 resulted primarily from the amortization of software developed for internal use that became ready for its intended use after December 31, 2018. Other income, net. There was no other income, net, for the year ended December 31, 2019. For the year ended December 31, 2018, other income, net, consisted primarily of transition service income of $0.2 million and the insurance proceeds of $0.4 million in relation to previously settled litigation. Loss before income taxes. We had a loss before income taxes of $11.1 million for the year ended December 31, 2019 as compared to $6.9 million for the year ended December 31, 2018. The increase in loss before income taxes was primarily attributable to the increase in noncash share-based compensation expense of $9.2 million ($2.2 million of which is one-time), salaries and benefits and sales commission of $3.3 million, and depreciation and amortization of $0.9 million, which was partially offset by the increase in revenue and the decrease in our cost of revenue as a percentage of revenue. Income taxes. Income tax expense of $0 was recognized for the years ended December 31, 2019 and 2018. A full valuation allowance on the deferred tax assets was recognized as of December 31, 2019 and 2018. See Note 9, “Income Taxes,” included in “Notes to Consolidated Financial Statements,” for details. Net loss. A net loss of $11.1 million was recognized for the year ended December 31, 2019 as compared to $6.9 million for the year ended December 31, 2018, as a result of the foregoing. Effect of Inflation The rates of inflation experienced in recent years have had no material impact on our financial statements. We attempt to recover increased costs by increasing prices for our services, to the extent permitted by contracts and competition. Liquidity and Capital Resources Cash flows provided by (used in) operating activities. For the year ended December 31, 2019, net cash provided by operating activities was $1.6 million, primarily the result of the net loss of $11.1 million, adjusted for certain non-cash items (consisting of share-based compensation expense, depreciation and amortization, write-off of long-lived assets, provision for bad debts and noncash lease expenses) totaling $13.8 million, and the cash used as a result of changes in assets and liabilities of $1.1 million, primarily the result of the increase in accounts receivable, following the increase in revenue. For the year ended December 31, 2018, net cash used in operating activities was $8.1 million, primarily the result of the net loss of $6.9 million, adjusted for certain non-cash items (consisting of share-based compensation expense, depreciation and amortization, write-off of long-lived assets, provision for bad debts and allocation of expenses from Fluent, Inc.) totaling $3.4 million, and the cash used as a result of changes in assets and liabilities of $4.6 million, primarily the result of the increase in accounts receivable and the decrease in accrued expenses and other current liabilities. Cash flows used in investing activities. Net cash used in investing activities for the years ended December 31, 2019 and 2018 was $6.0 million, primarily as a result of capitalized costs included in intangible assets of $5.9 million in each of the corresponding periods. Cash flows provided by financing activities. Net cash provided by financing activities for the year ended December 31, 2019 was $6.2 million as a result of $7.4 million raised through a registered direct offering in August 2019, which was partially offset by the taxes paid related to net share settlement of vesting of restricted stock units of $1.3 million. Net cash provided by financing activities for the year ended December 31, 2018 was $23.9 million (inclusive of the $20.0 million cash contribution by Fluent to red violet upon the Spin-off) as a result of capital contributed by Fluent. As of December 31, 2019, we had material commitments under certain data licensing agreements of $14.8 million. We anticipate funding our operations using available cash and cash flow generated from operations within the next twelve months. We reported net loss of $11.1 million and $6.9 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had a total shareholders’ equity balance of $42.1 million. As of December 31, 2019, we had cash and cash equivalents of approximately $11.8 million. Based on projections of growth in revenue and operating results in the next twelve months, and the available cash and cash equivalents held by us, including the net proceeds of $7.4 million through the registered direct offering in August 2019, we believe that we will have sufficient cash resources to finance our operations and expected capital expenditures for the next twelve months. Subject to revenue growth, we may have to raise capital through the issuance of additional equity and/or debt, which, if we are able to obtain, could have the effect of diluting stockholders. Any equity or debt financings, if available at all, may be on terms which are not favorable to us. If our operations do not generate positive cash flow in the upcoming year, or if we are not able to obtain additional equity or debt financing on terms and conditions acceptable to us, if at all, we may be unable to implement our business plan, or even continue our operations. Off-Balance Sheet Arrangements We do not have any outstanding off-balance sheet guarantees, interest rate swap transactions or foreign currency forward contracts. In addition, we do not engage in trading activities involving non-exchange traded contracts. In our ongoing business, we do not enter into transactions involving, or otherwise form relationships with, unconsolidated entities or financial partnerships that are established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. FORWARD-LOOKING STATEMENTS This 2019 Form 10-K contains certain “forward-looking statements” within the meaning of the PSLRA, Section 27A of the Securities Act, and Section 21E of the Exchange Act. Such forward-looking statements contain information about our expectations, beliefs or intentions regarding our product development and commercialization efforts, business, financial condition, results of operations, strategies or prospects. You can identify forward-looking statements by the fact that these statements do not relate strictly to historical or current matters. Rather, forward-looking statements relate to anticipated or expected events, activities, trends or results as of the date they are made. Because forward-looking statements relate to matters that have not yet occurred, these statements are inherently subject to risks and uncertainties that could cause our actual results to differ materially from any future results expressed or implied by the forward-looking statements. Many factors could cause our actual activities or results to differ materially from the activities and results anticipated in forward-looking statements. These factors include the following: • We have a history of losses which makes our future results uncertain. • Our products and services are highly technical and if they contain undetected errors, our business could be adversely affected and we may have to defend lawsuits or pay damages in connection with any alleged or actual failure of our products and services. • Because our networks and information technology systems are critical to our success, if unauthorized persons access our systems or our systems otherwise cease to function properly, our operations could be adversely affected and we could lose revenue or proprietary information, all of which could materially adversely affect our business. • We must adequately protect our intellectual property in order to prevent loss of valuable proprietary information. • We depend, in part, on strategic alliances, joint ventures and acquisitions to grow our business. If we are unable to make strategic acquisitions and develop and maintain these strategic alliances and joint ventures, our growth may be adversely affected. • If we consummate any future acquisitions, we will be subject to the risks inherent in identifying, acquiring and operating a newly acquired business. • Our business is subject to various governmental regulations, laws and orders, compliance with which may cause us to incur significant expenses or reduce the availability or effectiveness of our solutions, and the failure to comply with which could subject us to civil or criminal penalties or other liabilities. • The outcome of litigation, inquiries, investigations, examinations or other legal proceedings in which we are involved, in which we may become involved, or in which our customers or competitors are involved could subject us to significant monetary damages or restrictions on our ability to do business. • Our relationships with key customers may be materially diminished or terminated. • If we lose the services of key personnel, it could adversely affect our business. • If we fail to respond to rapid technological changes in the big data and analytics sector, we may lose customers and/or our products and/or services may become obsolete. • Our revenue is concentrated in the U.S. market across a broad range of industries. When these industries or the broader financial markets experience a downturn, demand for our services and revenue may be adversely affected. • We could lose our access to data sources which could prevent us from providing our services. • Data security and integrity are critically important to our business, and breaches of security, unauthorized access to or disclosure of confidential information, disruption, including distributed denial of service (“DDoS”) attacks or the perception that confidential information is not secure, could result in a material loss of business, substantial legal liability or significant harm to our reputation. • We face intense competition from both start-up and established companies that may have significant advantages over us and our products. • There may be further consolidation in our end-customer markets, which may adversely affect our revenue. • To the extent the availability of free or relatively inexpensive consumer and/or business information increases, the demand for some of our services may decrease. • If our newer products do not achieve market acceptance, revenue growth may suffer. • Our products and services can have long sales and implementation cycles, which may result in substantial expenses before realizing any associated revenue. • If we fail to maintain and improve our systems, our technology, and our interfaces with data sources and customers, demand for our services could be adversely affected. • If our outside service providers and key vendors are not able to or do not fulfill their service obligations, our operations could be disrupted and our operating results could be harmed. • Consolidation in the big data and analytics sector may limit market acceptance of our products and services. • We may incur substantial expenses defending against claims of infringement. • Our bylaws designate the Court of Chancery of the State of Delaware as the sole and exclusive forum for certain actions, including derivative actions, which could limit a stockholder’s ability to bring a claim in a judicial forum that it finds favorable for disputes with the Company and its directors, officers, other employees, or the Company's stockholders and may discourage lawsuits with respect to such claims. • We could be negatively impacted by the recent outbreak of coronavirus (COVID-19). • Our stock price has been and may continue to be volatile, and the value of an investment in our common stock may decline. • Future issuances of shares of our common stock in connection with acquisitions or pursuant to our stock incentive plan could have a dilutive effect on your investment. • The concentration of our stock ownership may limit individual stockholder ability to influence corporate matters. • We are an “emerging growth company,” and we cannot be certain if the reduced reporting requirements available to emerging growth companies will make our shares of common stock less attractive to investors. • We expect that we may need additional capital in the future; however, such capital may not be available to us on reasonable terms, if at all, when or as we require additional funding. If we issue additional shares of our common stock or other securities that may be convertible into, or exercisable or exchangeable for, our common stock, our existing stockholders would experience further dilution.
0.021206
0.021684
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<s>[INST] Overview Red Violet, Inc. (“we,” “us,” “our,” “red violet,” or the “Company”), a Delaware corporation, is dedicated to making the world a safer place and reducing the cost of doing business. We specialize in data fusion and analytics, providing cloudbased, missioncritical solutions to enterprises with use cases including fraud detection, risk mitigation, due diligence and marketing. Through our intelligent platform, CORETM, we uncover the relevance of disparate data points utilizing our analytical capabilities to provide realtime and insightful views of people, businesses, assets and their interrelationships. Leveraging proprietary technology and applying machine learning and advanced analytical and decisionmaking capabilities, CORE provides compelling solutions to public and private sector organizations through intuitive, easytouse analytical applications. We empower clients across markets and industries to better execute all aspects of their business, from managing risk, recovering debt, identifying fraud and abuse, and ensuring legislative compliance, to identifying and acquiring customers. With a massive data repository of approximately nine petabytes of publicrecord, proprietary and publiclyavailable data, as well as selfreported consumer information and behavioral signals, we transform data into intelligence for our customers to enable better datadriven decisioning. We presently market our solutions primarily through two brands, idiCORE™, our flagship product, and FOREWARN®. idiCORE is a nextgeneration, investigative solution used to address a variety of organizational challenges including due diligence, risk mitigation, identity authentication and legislative compliance, by financial services companies, insurance companies, healthcare companies, law enforcement and government, collections, law firms, retail, telecommunication companies, corporate security and investigative firms. FOREWARN is an appbased solution currently tailored for the real estate industry, providing instant knowledge prior to facetoface engagement with a consumer, helping professionals identify and mitigate risk. As of December 31, 2019 and 2018, idiCORE had 5,064 and 3,627 billable customers and FOREWARN had 30,577 and 11,397 users, respectively. We generate substantially all of our revenue from licensing our solutions. Customers access our solutions through a hosted environment using an online interface, batch processing, API and custom integrations. We recognize revenue from licensing fees (a) on a transactional basis determined by the customer’s usage, (b) via a monthly fee or (c) from a combination of both. Revenue pursuant to pricing contracts containing a monthly fee is recognized ratably over the contract period. Pricing contracts are generally annual contracts or longer, with auto renewal. Revenue from pricing contracts represented 65% and 58% of total revenue for the years ended December 31, 2019 and 2018, respectively. Our gotomarket strategy leverages (a) an inside sales team that cultivates relationships, and ultimately closes business, with their enduser markets, (b) a strategic sales team that provides a more personal, facetoface approach for major accounts within certain industries, and (c) distributors, resellers, and strategic partners that have a significant foothold in many of the industries that we have not historically served, as well as to further penetrate those industries that we do serve. Our sales model generally begins with a free trial followed by an initial purchase on a transactional basis or minimumcommitted monthly spend. As organizations derive benefits from our solutions, we are able to “land and expand” within larger organizations as additional use cases expand across departments, divisions and geographic locations and customers become increasingly reliant on our solutions in their daily workflow. On March 26, 2018, Fluent, Inc. (“Fluent”) spun off its risk management business by way of a distribution of all of the shares of common stock of its then whollyowned subsidiary, red violet, to its stockholders as of the record date and certain warrant holders (the “Spinoff”). Upon the Spinoff, red violet owned Fluent subsidiaries that previously operated Fluent’s risk management business, and red violet became an independent public company. For periods prior to the Spinoff, these financial [/INST] Positive. </s>
2,020
7,397
1,728,951
ESSENTIAL PROPERTIES REALTY TRUST, INC.
2019-02-28
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 together with the “Selected Financial Data” and “Business” sections, as well as the consolidated financial statements and related notes in Part II, Item 8 of this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this report, including information with respect to our plans and strategies for our business, includes forward-looking statements that involve risks and uncertainties. You should read “Item 1A. Risk Factors” and the “Special Note Regarding Forward-Looking Statements” 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 these forward-looking statements. Overview We are an internally managed real estate company that acquires, owns and manages primarily single-tenant properties that are net leased on a long-term basis to middle-market companies operating service-oriented or experience-based businesses. We have a diversified portfolio that focuses on properties leased to tenants in businesses such as restaurants (including quick service and casual and family dining), car washes, automotive services, medical services, convenience stores, entertainment, early childhood education and health and fitness. We acquire and lease freestanding, single-tenant commercial real estate facilities where a tenant services its customers and conducts activities that are essential to the generation of the tenant’s sales and profits. We were organized on January 12, 2018 as a Maryland corporation and intend to qualify to be taxed as a REIT beginning with our taxable year ended December 31, 2018. On June 25, 2018, we completed our IPO of 32,500,000 shares of our common stock, $0.01 par value per share, at an initial public offering price of $14.00 per share, pursuant to a registration statement on Form S-11 (File No. 333-225215), filed with the SEC under the Securities Act. On July 24, 2018, we issued an additional 2,772,191 shares of common stock at the IPO price of $14.00 per share pursuant to the partial exercise of an option granted to the underwriters of our IPO. Net proceeds from the IPO and the issuance of shares to underwriters, after deducting underwriting discounts and commissions and other expenses, were $458.7 million. Our common stock is listed on the NYSE under the ticker symbol “EPRT”. Prior to the completion of the IPO, we engaged in a number of formation transactions designed to facilitate the completion of the IPO (the “Formation Transactions”). Among other things, on June 20, 2018, EPRT LLC converted from a Delaware limited liability company into a Delaware limited partnership, changed its name to Essential Properties, L.P. (the “Operating Partnership”) and became the subsidiary through which we hold substantially all of our assets and conduct our operations. Prior to the completion of the Formation Transactions, EPRT LLC was a wholly owned subsidiary of EPRT Holdings (together with EPRT LLC, the “Predecessor”), and EPRT Holdings received 17,913,592 units of limited partnership interest in the Operating Partnership (“OP Units”) in connection with EPRT LLC’s conversion into a Delaware limited partnership. Essential Properties OP G.P., LLC, our wholly owned subsidiary, became the sole general partner of the Operating Partnership in connection with the completion of our IPO. Concurrent with the completion of the IPO, we received an additional $125.0 million investment from an affiliate of Eldridge in the Concurrent Private Placement of 7,785,611 shares of our common stock and 1,142,960 OP Units. We contributed the net proceeds from the issuance of the 43,057,802 shares of common stock in our IPO (inclusive of the shares issued pursuant to the partial exercise by the underwriters of their option to purchase additional shares) and the Concurrent Private Placement of common stock to Eldridge to the Operating Partnership in exchange for a like number of OP Units. We generally lease each of our properties to a single tenant on a triple-net, long-term basis, and we generate our cash from operations primarily through the monthly lease payments, or base rent, we receive from the tenants that occupy our properties. As of December 31, 2018, we had a portfolio of real estate investments at 677 properties (inclusive of one undeveloped land parcel and 12 properties which secure our investments in mortgage loans receivable) that was diversified by tenant, industry and geography, had annualized base rent of $106.8 million and was 100.0% occupied. Substantially all of our leases provide for periodic contractual rent escalations. As of December 31, 2018, leases contributing 97.1% of our annualized base rent provided for increases in future annual base rent, generally ranging from 1% to 4% annually, with a weighted average annual escalation equal to 1.5% of base rent. As of December 31, 2018, leases contributing 91.9% of annualized base rent were triple-net, which means that our tenant is responsible for all operating expenses, such as maintenance, insurance, utility and tax expense, related to the leased property (including any increases in those costs that may occur as a result of inflation). Our remaining leases were “double net,” where the tenant is responsible for certain expenses, such as taxes and insurance, but we retain responsibility for other expenses, generally related to maintenance and structural component replacement that may be required on such leased properties in the future. Also, we incur property-level expenses associated with our vacant properties and we occasionally incur nominal property-level expenses that are not paid by our tenants, such as the costs of periodically making site inspections of our properties. Since our properties are predominantly single-tenant properties, which are generally subject to long-term leases, it is not necessary for us to perform any significant ongoing leasing activities on our properties. As of December 31, 2018, the weighted average remaining term of our leases was 14.2 years (based on annualized base rent), excluding renewal options that have not been exercised, with 3.1% of our annualized base rent attributable to leases expiring prior to January 1, 2023. Renewal options are exercisable at the option of our tenants upon expiration of their base lease term. Our leases providing for tenant renewal options generally provide for periodic contractual rent escalations during any renewed term that are similar to those applicable during the initial term of the lease. As of December 31, 2018, 67.4% of our annualized base rent was attributable to master leases, where we have acquired multiple properties from a seller and leased them back to the seller under a master lease. Since properties are generally leased under a master lease on an “all or none” basis, the structure prevents a tenant from “cherry picking” locations, where it unilaterally gives up underperforming properties while maintaining its leasehold interest in well-performing properties. Consistent with our intent to elect to qualify as a REIT for federal income tax purposes commencing with our taxable year ended December 31, 2018, we believe that we were organized and operated in a manner that will allow us to qualify as a REIT, and we intend to continue operating in such a manner. Liquidity and Capital Resources We seek to acquire real estate with a combination of debt and equity capital and with cash from operations that will not otherwise be distributed to our stockholders. Prior to the IPO, equity capital needed for our real estate investments had been provided to us by Eldridge, our primary institutional capital provider. Subsequent to the IPO, we added public equity capital to our initial private institutional equity capital to facilitate our growth. Additionally, we used the net proceeds from the IPO and the Concurrent Private Placement to repay promissory notes issued to an affiliate of Eldridge, which had been our primary source of short-term debt capital prior to the IPO. Historically, upon accumulating a sufficiently large and diverse pool of real estate, we generally refinanced this debt through the issuance of long-term, fixed-rate debt through our Master Trust Funding Program, as further described below. In June 2018, we entered into the Revolving Credit Facility, which is available to fund our short-term debt capital requirements, as further described below. Over time, we may access additional long-term debt capital with future debt issuances through our Master Trust Funding Program. Additionally, future sources of debt capital may include term borrowings from insurance companies, banks and other sources, single-asset mortgage financing and CMBS borrowings, and may offer us the opportunity to lower our cost of funding and further diversify our sources of debt capital. Over time, we may choose to issue preferred equity as a part of our overall funding strategy. As our outstanding debt matures, we may refinance it as it comes due or choose to repay it using cash and cash equivalents or borrowings under the Revolving Credit Facility. Management believes that the cash generated by our operations, together with our cash and cash equivalents at December 31, 2018, the Revolving Credit Facility, and our access to long-term debt capital, will be sufficient to fund our operations for the foreseeable future and allow us to acquire the real estate for which we currently have made commitments. By seeking to match the expected cash inflows from our long-term leases with the expected cash outflows for our long-term, fixed-rate debt, we seek to “lock in,” for as long as is economically feasible, the expected positive difference between our scheduled cash inflows on the leases and the cash outflows on our debt obligations. In this way, we seek to reduce the risk that increases in interest rates would adversely impact our results of operations. Although we are not required to maintain a particular leverage ratio and may not be able to do so, we generally intend to target, over time, a level of net debt (which includes recourse and non-recourse borrowings and any outstanding preferred stock less unrestricted cash and cash held for the benefit of lenders) that is less than six times our annualized adjusted EBITDAre. As we grow our real estate portfolio, we intend to manage our long-term debt maturities to reduce the risk that a significant amount of our debt will mature in any single year in the future. As of December 31, 2018, our nearest significant debt maturity was $272.3 million of notes issued under the Master Trust Funding Program, which mature in November 2046 but require monthly principal and interest payments through October 2021, with a balloon principal payment of $259.5 million due in November 2021. Under the Revolving Credit Facility, we had, as of December 31, 2018, outstanding borrowings of $34.0 million and $266.0 million of unused borrowing capacity. As of December 31, 2018, we had $1.3 billion of net investments in our investment portfolio, consisting of investments in 677 properties (inclusive of one undeveloped land parcel and 12 properties which secure our investments in mortgage loans receivable), with annualized base rent of $106.8 million. Substantially all of our cash from operations is generated by our investment portfolio. Our short-term liquidity requirements consist primarily of funds necessary to pay for our operating expenses, including principal and interest payments on our outstanding indebtedness, and the general and administrative expenses of servicing our portfolio and operating our business. Since our occupancy level is high and substantially all of our leases are triple-net, our tenants are generally responsible for the maintenance, insurance and property taxes associated with the properties they lease from us. When a property becomes vacant through a tenant default or expiration of the lease term with no tenant renewal, we incur the property costs not paid by the tenant, as well as those property costs accruing during the time it takes to locate a substitute tenant. As of December 31, 2018, excluding one undeveloped land parcel, all of our property locations were occupied and subject to a lease. We expect to incur some property costs from time to time in periods during which properties that become vacant are being marketed for lease. In addition, we may recognize an expense for certain property costs, such as real estate taxes billed in arrears, if we believe the tenant is likely to vacate the property before making payment on those obligations. The amount of such property costs can vary quarter to quarter based on the timing of property vacancies and the level of underperforming properties; however, we do not anticipate that such costs will be significant to our operations. From time to time, we may also sell properties that no longer meet our long-term investment objectives. Our short-term liquidity requirements also include the funding needs associated with seven of our properties where we have agreed to provide construction financing or reimburse the tenant for certain development, construction and renovation costs in exchange for contractually specified interest or rent that generally increases in proportion with our funding. As of December 31, 2018, we had agreed to finance or reimburse development, construction or renovation costs in an aggregate amount of $34.4 million and, as of the same date, we had funded $14.9 million of this commitment. We expect to fund the balance of such commitment by December 31, 2019. Additionally, as of February 22, 2019, we were under contract to acquire 20 properties with an aggregate purchase price of $40.1 million, subject to completion of our due diligence procedures and customary closing conditions. We expect to meet our short-term liquidity requirements, including our investment in potential future acquisitions, primarily from cash and cash equivalents, net cash from operating activities and borrowings under the Revolving Credit Facility. Our long-term liquidity requirements consist primarily of funds necessary to acquire additional properties and repay indebtedness. We expect to meet our long-term liquidity requirements through various sources of capital, including borrowings under the Revolving Credit Facility, net cash from operating activities, future financings, working capital, proceeds from select sales of our properties and other secured and unsecured borrowings (including potential issuances under the Master Trust Funding Program). However, at any point in time, there may be a number of factors that could have a material and adverse effect on our ability to access these capital sources, including unfavorable conditions in the overall equity and credit markets, our degree of leverage, our unencumbered asset base, borrowing restrictions imposed by our lenders, general market conditions for REITs, our operating performance, liquidity and market perceptions about us. The success of our business strategy will depend, to a significant degree, on our ability to access these various capital sources. An additional liquidity need is funding the distributions that are one of the requirements for qualification for taxation as a REIT. During the year ended December 31, 2018, our board of directors declared total cash distributions of $0.434 per share of common stock. Holders of OP Units are entitled to distributions equivalent to those paid by the Company to common stockholders. During the year ended December 31, 2018, we paid $14.1 million of distributions to common stockholders and OP Unit holders, and as of December 31, 2018, we recorded $13.2 million of distributions payable to common stockholders and OP Unit holders. To qualify for taxation as a REIT, we must make distributions to our stockholders aggregating annually at least 90% of our REIT taxable income, determined without regard to the dividends paid deduction and excluding any net capital gain. As a result of this requirement, we cannot rely on retained earnings to fund our business needs to the same extent as other entities that are not REITs. If we do not have sufficient funds available to us from our operations to fund our business needs, we will need to find alternative ways to fund those needs. Such alternatives may include, among other things, selling properties (whether or not the sales price is optimal or otherwise meets our strategic long-term objectives), incurring additional indebtedness or issuing equity securities in public or private transactions. The availability and attractiveness of the terms of these potential sources of financing cannot be assured. Description of Certain Debt Master Trust Funding Program SCF RC Funding I LLC, SCF RC Funding II LLC and SCF RC Funding III LLC (collectively, the “Master Trust Issuers”), all of which are indirect wholly owned subsidiaries of the Operating Partnership, have issued net-lease mortgage notes payable (the “Notes”) with an aggregate outstanding principal balance of $515.1 million as of December 31, 2018. The Notes are secured by all assets owned by the Master Trust Issuers. We provide property management services with respect to the mortgaged properties and service the related leases pursuant to an amended and restated property management and servicing agreement, dated as of July 11, 2017, among the Master Trust Issuers, the Operating Partnership (as property manager and as special servicer), Midland Loan Services, a division of PNC Bank, National Association (as back-up manager) and Citibank, N.A. (as indenture trustee). Beginning in 2016, two series of Notes, each comprised of two classes, were issued under the program: (1) Notes originally issued by SCF RC Funding I LLC and SCF RC Funding II LLC (the “Series 2016-1 Notes”), with an aggregate outstanding principal balance of $272.3 million as of December 31, 2018 and (2) Notes originally issued by SCF RC Funding I LLC, SCF RC Funding II LLC and SCF RC Funding III LLC (the “Series 2017-1 Notes”), with an aggregate outstanding principal balance of $242.8 million as of December 31, 2018. The Notes are the joint obligations of all Master Trust Issuers. Notes issued under our Master Trust Funding Program are secured by a lien on all of the property owned by the Master Trust Issuers and the related leases. A substantial portion of our real estate investment portfolio serves as collateral for borrowings outstanding under our Master Trust Funding Program. As of December 31, 2018, we had pledged 347 properties, with a net investment amount of $609.2 million, under the Master Trust Funding Program. The agreement governing our Master Trust Funding Program permits substitution of real estate collateral from time to time, subject to certain conditions. Absent a plan to issue additional long-term debt through the Master Trust Funding Program, we are not required to add assets to, or substitute collateral in, the existing collateral pool. We can voluntarily elect to substitute assets in the collateral pool, subject to meeting prescribed conditions that are designed to protect the collateral pool by requiring the substitute assets to be of equal or greater measure in attributes such as: the asset’s fair value, monthly rent payments, remaining lease term and weighted average coverage ratios. In addition, we can sell underperforming assets and reinvest the proceeds in new properties. Any substitutions and sales are subject to an overall limitation of 35% of the collateral pool which is typically reset at each new issuance unless the substitution or sale is credit- or risk-based, in which case there are no limitations. A significant portion of our cash flows are generated by the special purpose entities comprising our Master Trust Funding Program. For the year ended December 31, 2018, excess cash flow from the Master Trust Funding Program, after payment of debt service and servicing and trustee expenses, totaled $18.3 million on cash collections of $50.9 million, which represents a debt service coverage ratio (as defined in the program documents) of 1.53 to 1. If at any time the monthly debt service coverage ratio (as defined in the program documents) generated by the collateral pool is less than or equal to 1.25 to 1, excess cash flow from the Master Trust Funding Program entities will be deposited into a reserve account to be used for payments to be made on the Notes, to the extent there is a shortfall; if at any time the three month average debt service coverage ratio generated by the collateral pool is less than or equal to 1.15 to 1, excess cash flow from the Master Trust Funding Program entities will be applied to an early amortization of the Notes. If cash generated by our properties held in the Master Trust Funding Program is required to be held in a reserve account or applied to an early amortization of the Notes, it would reduce the amount of cash available to us and could limit or eliminate our ability to make distributions to our common stockholders. The Notes require monthly payments of principal and interest. The payment of principal and interest on any Class B Notes is subordinate to the payment of principal and interest on any Class A Notes. The Series 2016-1 Notes mature in November 2046 and have a weighted average annual interest rate of 4.51% as of December 31, 2018. However, the anticipated repayment date for the Series 2016-1 Notes is November 2021, and if the notes are not repaid in full on or before such anticipated repayment date, additional interest will begin to accrue on the notes. The Series 2017-1 Notes mature in June 2047 and have a weighted average interest rate of 4.17% as of December 31, 2018. However, the anticipated repayment date for the Series 2017-1 Notes is June 2024, and if the notes are not repaid in full on or before such anticipated repayment date, additional interest will begin to accrue on the notes. The Series 2016-1 Notes may be voluntarily prepaid, in whole or in part, at any time on or after the date that is 24 months prior to the anticipated repayment date in November 2021 without the payment of a make whole amount. Voluntary prepayments may be made before 24 months prior to the anticipated repayment date but will be subject to the payment of a make whole amount. The Series 2017-1 Notes may be voluntarily prepaid, in whole or in part, at any time on or after the date that is 31 months prior to the anticipated repayment date in June 2024 without the payment of a make whole amount. Voluntary prepayments may be made before 31 months prior to the anticipated repayment date but will be subject to the payment of a make whole amount. An event of default will occur if, among other things, the Master Trust Issuers fail to pay interest or principal on the Notes when due, materially default in compliance with the material covenants contained in the documents evidencing the Notes or the mortgages on the mortgaged property collateral or if a bankruptcy or other insolvency event occurs. Under the master trust indenture, we have a number of Master Trust Issuer covenants, including requirements to pay any taxes and other charges levied or imposed upon the Master Trust Issuers and to comply with specified insurance requirements. We are also required to ensure that all uses and operations on or of our properties comply in all material respects with all applicable environmental laws. As of December 31, 2018, we were in material compliance with all such covenants. As of December 31, 2018, scheduled principal repayments on the Notes issued under the Master Trust Funding Program for 2019 are $8.0 million. We expect to meet these repayment requirements primarily through our net cash from operating activities. Revolving Credit Facility On June 25, 2018, we entered into the Revolving Credit Facility with a group of lenders, which provides senior unsecured revolving credit in the maximum aggregate initial original principal amount of up to $300.0 million. Barclays Bank PLC, Citigroup Global Markets Inc. and Goldman Sachs Bank USA were the joint lead arrangers of the facility, with Barclays Bank PLC acting as administrative agent. Under the Revolving Credit Facility, as of December 31, 2018, we had $34.0 million of outstanding borrowings and $266.0 million of unused borrowing capacity. The Revolving Credit Facility has a term of four years from the original closing date with an extension option of up to 12-months exercisable by us, subject to certain conditions, and initially bears interest at an annual rate of (i) applicable LIBOR plus an applicable margin between 1.45% and 2.15%; or (ii) the base rate (which rate is equal to the greatest of the prime rate, the federal funds effective rate plus 0.5% or LIBOR plus 1.0%) plus an applicable margin of between 0.45% and 1.15%. The applicable LIBOR is the rate with a term equivalent to the interest period applicable to the relevant borrowing. The applicable margin is initially a spread set according to a leverage-based pricing grid. At our election, on and after receipt of an investment grade corporate credit rating from S&P or Moody’s, the applicable margin will be a spread set according to our corporate credit ratings by S&P and/or Moody’s. The Revolving Credit Facility is freely prepayable at any time and will be mandatorily prepayable if borrowings exceed the borrowing base or the facility limit. We may re-borrow amounts paid down, subject to customary borrowing conditions. We are required to pay revolving credit commitment fees throughout the term of the Revolving Credit Facility based upon our usage of the Revolving Credit Facility, at a rate which depends on our usage of the Revolving Credit Facility during the period before we receive an investment grade corporate credit rating from S&P or Moody’s, and which rate shall be based on the corporate credit rating from S&P and/or Moody’s after the time, if applicable, we receive such a rating. However, there can be no assurance that we will receive an investment grade corporate rating from S&P and/or Moody’s. The Revolving Credit Facility provides an accordion feature to increase, subject to certain conditions, the maximum availability of the facility by up to an additional $200.0 million. The Operating Partnership is the borrower under the Revolving Credit Facility, and we and each of the subsidiaries of the Operating Partnership that owns a direct or indirect interest in an eligible real property asset are guarantors under the Revolving Credit Facility. We are subject to financial covenants under the Revolving Credit Facility, including maintaining: a limitation on total consolidated leverage of not more than 60% of the total value of certain of our assets (including unencumbered cash and cash equivalents, the value of real property assets, mortgage notes receivable and up to $10 million of construction or redevelopment costs) (“Total Consolidated Assets”) with a step up on two non-consecutive occasions to 65%, at our election, for two consecutive quarters each following a material acquisition; a consolidated fixed charge coverage ratio of at least 1.50x; a consolidated tangible net worth of at least 75% of our tangible net worth at the date of the facility plus 75% of future net equity proceeds; a consolidated secured leverage ratio of not more than 50% of our Total Consolidated Assets; a secured recourse debt ratio of not more than 10% of our Total Consolidated Assets; an unencumbered leverage ratio of not more than 60% of our consolidated unencumbered real property and mortgage notes receivable with a step up on two non-consecutive occasions to 65%, at our election, for two consecutive quarters each following a material acquisition; and an unencumbered interest coverage ratio of at least 1.75x. The Revolving Credit Facility restricts our ability to pay distributions to our stockholders under certain circumstances. In particular, we are generally limited to paying cash distributions with respect to any period of four fiscal quarters in an amount not to exceed the greater of (i) 95% of adjusted funds from operations (as defined in the credit agreement), or (ii) the amount required for us to maintain our status as a REIT, and such cash distributions may be further limited during events of default. The Revolving Credit Facility contains certain covenants that, subject to exceptions, limits or restricts, among other things, our incurrence of indebtedness and liens, disposition of assets, transactions with affiliates, mergers and fundamental changes, modification of organizational documents, changes to fiscal periods, making of investments, negative pledge clauses and lines of business and REIT qualification. Cash Flows The following discussion of changes in cash flows includes the results of the Company and the Predecessor collectively for the periods presented. Comparison of the years ended December 31, 2018 and 2017 and the period from March 30, 2016 (commencement of operations) to December 31, 2016 As of December 31, 2018, we had $4.2 million of cash and cash equivalents and $12.0 million of restricted cash as compared to $7.3 million and $12.2 million, respectively, as of December 31, 2017 and $1.8 million and $10.1 million, respectively, as of December 31, 2016. Cash Flows for the year ended December 31, 2018 During the year ended December 31, 2018, net cash provided by operating activities was $45.9 million. Our cash flows from operating activities are primarily dependent upon the occupancy level of our portfolio, the rental rates specified in our leases, the collectability of rent and the level of our operating expenses and other general and administrative costs. Cash inflows related to a net income adjusted for non-cash items of $48.3 million (net income of $20.6 million adjusted for non-cash items, including depreciation and amortization of tangible and intangible real estate assets, amortization of deferred financing costs, provision for impairment of real estate, gains on dispositions of investments, net, straight-line rent receivable, equity-based compensation and allowance for doubtful accounts, of $27.7 million). These cash inflows were partially offset by a decrease of $1.6 million in accrued liabilities and other payables and an increase of $0.8 million in prepaid expenses and other assets. Net cash used in investing activities during the year ended December 31, 2018 was $461.9 million. Our net cash used in investing activities is generally used to fund property acquisitions, the development of our construction in progress, investments in loans receivable and, to a limited extent, capital expenditures, offset by cash provided from the disposition of real estate and principal collections on our direct financing receivables. The cash used in investing activities included $488.4 million to acquire investments in real estate, $15.3 million to fund construction in progress, $14.9 million of investments in loans receivable, $1.7 million for capital expenditures subsequent to acquisition, $0.5 million paid to tenants as lease incentives and an increase of $1.7 million in deposits on prospective real estate investments. These cash outflows were partially offset by $60.4 million of proceeds from sales of investments, net of disposition costs, and $0.1 million of principal collections on our direct financing lease receivables. Net cash provided by financing activities of $412.8 million during the year ended December 31, 2018 related to cash inflows of $464.2 million from the issuance of common stock in the IPO (inclusive of the shares issued pursuant to the partial exercise by the underwriters of their option to purchase additional shares), $109.0 million from the Concurrent Private Placement of common stock, $16.0 million from the Concurrent Private Placement of OP Units, $154.0 million from the issuance of notes payable to related parties, $34.0 million of borrowings under the Revolving Credit Facility and $50.0 million of capital contributions to the Predecessor. These cash inflows were partially offset by the payment of $5.5 million of IPO costs, $384.0 million of payments of principal on notes payable to related parties, $7.8 million of repayments of secured borrowing principal, payment of $3.1 million of deferred financing costs related to the Revolving Credit Facility and the payment of $14.1 million in dividends. Cash Flows for the year ended December 31, 2017 During the year ended December 31, 2017, net cash provided by operating activities was $22.5 million. Cash inflows related to a net income adjusted for non-cash items of $20.7 million (net income of $6.3 million adjusted for non-cash items, including depreciation and amortization of tangible and intangible real estate assets, amortization of deferred financing costs, provision for impairment of real estate, gains on dispositions of investments, net, straight-line rent receivable, equity-based compensation and allowance for doubtful accounts of $14.4 million) and a $4.1 million increase in accrued liabilities and other payables. These cash inflows were partially offset by a net increase in prepaid expenses and other assets of $2.3 million. Net cash used in investing activities during the year ended December 31, 2017 was $464.4 million. The cash used in investing activities included $509.8 million to acquire investments in real estate, $7.7 million to fund construction in progress, $0.3 million paid to tenants as lease incentives, $0.3 million paid for deposits on prospective real estate investments and approximately $48,000 for capital expenditures. These cash outflows were partially offset by $53.6 million of proceeds from sales of investments, net of disposition costs, and $0.1 million of principal collections on our direct financing lease receivables. Net cash provided by financing activities of $449.4 million during the year ended December 31, 2017 related to cash inflows of $543.0 million from the issuance of notes payable to related parties, $248.1 million of proceeds from secured borrowings under our Master Trust Funding Program and $83.7 million of capital contributions to the Predecessor. These cash inflows were partially offset by $313.0 million of payments of principal on notes payable to related parties, $101.2 million of equity distributions by the Predecessor, $5.6 million of repayments of secured borrowing principal and $5.6 million of deferred financing costs. Cash Flows for the period from March 30, 2016 (commencement of operations) to December 31, 2016 During the period from March 30, 2016 (commencement of operations) to December 31, 2016, net cash provided by operating activities was $10.5 million. Cash inflows related to a net income adjusted for non-cash items of $8.6 million (net income of $3.8 million adjusted for non-cash items, including depreciation and amortization of tangible and intangible real estate assets, provision for impairment of real estate, gains on dispositions of investments, net, and straight-line rent receivable of $4.8 million) and a $2.4 million increase in accrued liabilities and other payables. These cash inflows were partially offset by a net increase in prepaid expenses and other assets of $0.5 million. Net cash used in investing activities during the period from March 30, 2016 (commencement of operations) to December 31, 2016 was $279.1 million. The cash used in investing activities included $288.9 million to acquire investments in real estate, $3.7 million to acquire investments in direct financing receivables, $2.0 million paid to tenants as lease incentives, $1.0 million to fund construction in progress and $0.1 million paid for deposits on prospective real estate investments. These cash outflows were partially offset by $16.5 million of proceeds from sales of investments, net of disposition costs, and approximately $37,000 of principal collections on our direct financing lease receivables. Net cash provided by financing activities of $280.5 million during the period from March 30, 2016 (commencement of operations) to December 31, 2016 related to cash inflows of $288.6 million of capital contributions to the Predecessor and $7.5 million of proceeds from secured borrowings under our Master Trust Funding Program. These cash inflows were partially offset by $7.7 million of deferred financing costs, $7.5 million of equity distributions by the Predecessor and $0.3 million of repayments of secured borrowing principal. Off-Balance Sheet Arrangements We had no off-balance sheet arrangements as of December 31, 2018. Contractual Obligations The following table provides information with respect to our commitments as of December 31, 2018. (1) Includes interest payments on outstanding indebtedness issued under the Master Trust Funding Program through the anticipated repayment dates. (2) As of December 31, 2018, balances on the Revolving Credit Facility bear interest at an annual rate of prime rate plus a leverage-based credit spread of 0.45%. We also pay a facility fee on the total unused commitment amount of 0.15%. Subsequent to December 31, 2018, balances on the Revolving Credit Facility bear interest at an annual rate of applicable LIBOR plus an applicable margin between 1.45% and 2.15%. (3) Includes obligations to reimburse certain of our tenants for construction costs that they incur in connection with construction at our properties in exchange for contractually specified rent that generally increases proportionally with our funding. (4) Includes $1.5 million of rental payments due under ground lease arrangements where our tenants are directly responsible for payment. Additionally, we may enter into commitments to purchase goods and services in connection with the operation of our business. These commitments generally have terms of one-year or less and reflect expenditure levels comparable to our historical expenditures. We intend to elect to qualify as a REIT for federal income tax purposes commencing with our taxable year ended December 31, 2018; accordingly, we generally will not be subject to federal income tax, provided we distribute all of our REIT taxable income, determined without regard to the dividends paid deduction, to our stockholders. Critical Accounting Policies and Estimates Our accounting policies are determined in accordance with accounting principles generally accepted in the United States (“GAAP”). The preparation of our financial statements requires us to make estimates and assumptions that are subjective in nature and, as a result, our actual results could differ materially from our estimates. Estimates and assumptions include, among other things, subjective judgments regarding the fair values and useful lives of our properties for depreciation and lease classification purposes, the collectability of receivables and asset impairment analysis. Set forth below are the more critical accounting policies that require management judgment and estimates in the preparation of our consolidated financial statements. Real Estate Investments Investments in real estate are carried at cost less accumulated depreciation and impairment losses, if any. The cost of investments in real estate reflects their purchase price or development cost. We evaluate each acquisition transaction to determine whether the acquired asset meets the definition of a business. Under Accounting Standards Update (“ASU”) 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business, an acquisition does not qualify as a business when there is no substantive process acquired or substantially all of the fair value is concentrated in a single identifiable asset or group of similar identifiable assets or the acquisition does not include a substantive process in the form of an acquired workforce or an acquired contract that cannot be replaced without significant cost, effort or delay. Transaction costs related to acquisitions that are asset acquisitions are capitalized as part of the cost basis of the acquired assets, while transaction costs for acquisitions that are deemed to be acquisitions of a business are expensed as incurred. Improvements and replacements are capitalized when they extend the useful life or improve the productive capacity of the asset. Costs of repairs and maintenance are expensed as incurred. We allocate the purchase price of acquired properties accounted for as asset acquisitions to tangible and identifiable intangible assets or liabilities based on their relative fair values. Tangible assets may include land, site improvements and buildings. Intangible assets may include the value of in-place leases and above- and below-market leases and other identifiable intangible assets or liabilities based on lease or property specific characteristics. We incur various costs in the leasing and development of our properties. Amounts paid to tenants that incentivize them to extend or otherwise amend an existing lease or to sign a new lease agreement are capitalized to lease incentive on our consolidated balance sheets. Tenant improvements are capitalized to building and improvements within our consolidated balance sheets. Costs incurred which are directly related to properties under development, which include pre-construction costs essential to the development of the property, development costs, construction costs, interest costs and real estate taxes and insurance, are capitalized during the period of development as construction in progress. After the determination is made to capitalize a cost, it is allocated to the specific component of a project that benefited. Determination of when a development project commences and capitalization begins, and when a development project has reached substantial completion and is available for occupancy and capitalization must cease, involves a degree of judgment. We do not engage in speculative real estate development. We do, however, opportunistically agree to reimburse certain of our tenants for development costs at our properties in exchange for contractually specified rent that generally increases proportionally with our funding. The fair value of the tangible assets of an acquired property with an in-place operating lease is determined by valuing the property as if it were vacant, and the “as-if-vacant” value is then allocated to the tangible assets based on the fair value of the tangible assets. The fair value of in-place leases is determined by considering estimates of carrying costs during the expected lease-up periods, current market conditions, as well as costs to execute similar leases based on the specific characteristics of each tenant’s lease. We estimate the cost to execute leases with terms similar to the remaining lease terms of the in-place leases, including leasing commissions, legal and other related expenses. Factors we consider in this analysis include an estimate of the carrying costs during the expected lease-up periods considering current market conditions and costs to execute similar leases. In estimating carrying costs, we include real estate taxes, insurance and other operating expenses, and estimates of lost rentals at market rates during the expected lease-up periods, which primarily range from six to 12 months. The fair value of above- or below-market leases is recorded based on the net present value (using a discount rate that reflects the risks associated with the leases acquired) of the difference between the contractual amount to be paid pursuant to the in-place lease and our estimate of the fair market lease rate for the corresponding in-place lease, measured over the remaining non-cancelable term of the lease including any below-market fixed rate renewal options for below-market leases. In making estimates of fair values for purposes of allocating purchase price, we utilize a number of sources, including real estate valuations prepared by independent valuation firms. We also consider information and other factors including market conditions, the industry that the tenant operates in, characteristics of the real estate, e.g., location, size, demographics, value and comparative rental rates, tenant credit profile and the importance of the location of the real estate to the operations of the tenant’s business. Additionally, we consider information obtained about each property as a result of our pre-acquisition due diligence, marketing and leasing activities in estimating the fair value of the tangible and intangible assets acquired. We use the information obtained as a result of our pre-acquisition due diligence as part of our consideration of the accounting standard governing asset retirement obligations and, when necessary, will record an asset retirement obligation as part of the purchase price allocation. Real estate investments that are intended to be sold are designated as “held for sale” on the consolidated balance sheets at the lesser of carrying amount or fair value less estimated selling costs when they meet specific criteria to be presented as held for sale. Real estate investments are no longer depreciated when they are classified as held for sale. If the disposal, or intended disposal, of certain real estate investments represents a strategic shift that has had or will have a major effect on our operations and financial results, the operations of such real estate investments would be presented as discontinued operations in the consolidated statements of operations and comprehensive income for all applicable periods. Depreciation and Amortization Depreciation is computed using the straight-line method over the estimated useful lives of up to 40 years for buildings and 15 years for site improvements. Lease incentives are amortized on a straight-line basis as a reduction of rental income over the remaining non-cancellable terms of the respective leases. If a tenant terminates its lease, the unamortized portion of the lease incentive is charged to rental revenue. Construction in progress is not depreciated until the development has reached substantial completion. Tenant improvements are depreciated over the non-cancellable term of the related lease or their estimated useful life, whichever is shorter. Capitalized above-market lease values are amortized on a straight-line basis as a reduction of rental revenue over the remaining non-cancellable terms of the respective leases. Capitalized below-market lease values are accreted on a straight-line basis as an increase to rental revenue over the remaining non-cancellable terms of the respective leases including any below-market fixed rate renewal option periods. Capitalized above-market ground lease values are accreted as a reduction of property expenses over the remaining terms of the respective leases. Capitalized below-market ground lease values are amortized as an increase to property expenses over the remaining terms of the respective leases and any expected below-market renewal option periods where renewal is considered probable. The value of in-place leases, exclusive of the value of above-market and below-market lease intangibles, is amortized to depreciation and amortization expense on a straight-line basis over the remaining periods of the respective leases. If a tenant terminates its lease, the unamortized portion of each intangible, including in-place lease values, is charged to depreciation and amortization expense, while above- and below-market lease adjustments are recorded within rental revenue in the consolidated statement of operations and comprehensive income. Loans Receivable We hold our loans receivable for long-term investment. Loans receivable are carried at amortized cost, including related unamortized discounts or premiums, if any. We recognize interest income on loans receivable using the effective-interest method applied on a loan-by-loan basis. Direct costs associated with originating loans are offset against any related fees received and the balance, along with any premium or discount, is deferred and amortized as an adjustment to interest income over the term of the related loan receivable using the effective-interest method. We periodically evaluate the collectability of our loans receivable, including accrued interest, by analyzing the underlying property-level economics and trends, collateral value and quality and other relevant factors in determining the adequacy of our allowance for loan losses. A loan is determined to be impaired when, in management’s judgment based on current information and events, it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. Specific allowances for loan losses are provided for impaired loans on an individual loan basis in the amount by which the carrying value exceeds the estimated fair value of the underlying collateral less disposition costs. Direct Financing Lease Receivables Certain of our real estate investment transactions are accounted for as direct financing leases. We record the direct financing lease receivables at their net investment, determined as the aggregate minimum lease payments and the estimated non-guaranteed residual value of the leased property less unearned income. The unearned income is recognized over the life of the related lease contracts so as to produce a constant rate of return on the net investment in the asset. Our investment in direct financing lease receivables is reduced over the applicable lease term to its non-guaranteed residual value by the portion of rent allocated to the direct financing lease receivables. If and when an investment in direct financing lease receivables is identified for impairment evaluation, we will apply the guidance in both the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 310, Receivables (“ASC 310”) and ASC 840, Leases (“ASC 840”). Under ASC 310, the lease receivable portion of the net investment in a direct financing lease receivable is evaluated for impairment when it becomes probable we, as the lessor, will be unable to collect all rental payments associated with our investment in the direct financing lease receivable. Under ASC 840, we review the estimated non-guaranteed residual value of a leased property at least annually. If the review results in a lower estimate than had been previously established, we determine whether the decline in estimated non-guaranteed residual value is other than temporary. If a decline is judged to be other than temporary, the accounting for the transaction is revised using the changed estimate and the resulting reduction in the net investment in direct financing lease receivables is recognized by us as a loss in the period in which the estimate is changed. Impairment of Long-Lived Assets If circumstances indicate that the carrying value of a property may not be recoverable, we review the asset for impairment. This review is based on an estimate of the future undiscounted cash flows, excluding interest charges, expected to result from the property’s use and eventual disposition. These estimates consider factors such as expected future operating income, market and other applicable trends and residual value, as well as the effects of leasing demand, competition and other factors. If impairment exists due to the inability to recover the carrying value of a property, an impairment loss is recorded to the extent that the carrying value exceeds the estimated fair value of the property for properties to be held and used. For properties held for sale, the impairment loss is the adjustment to fair value less estimated cost to dispose of the asset. Impairment assessments have a direct impact on the consolidated statements of operations and comprehensive income because recording an impairment loss results in an immediate negative adjustment to the consolidated statements of operations and comprehensive income. Allowance for Doubtful Accounts We continually review receivables related to rent and unbilled rent receivables and determine collectability by taking into consideration the tenant’s payment history, the financial condition of the tenant, business conditions in the industry in which the tenant operates and economic conditions in the area in which the property is located. If the collectability of a receivable is in doubt, the accounts receivable and straight-line rent receivable balances are reduced by an allowance for doubtful accounts on the consolidated balance sheets or a direct write-off of the receivable is recorded in the consolidated statements of operations. The provision for doubtful accounts is included in property expenses in our consolidated statements of operations and comprehensive income. If the accounts receivable balance or straight-line rent receivable balance is subsequently deemed to be uncollectible, such receivable amounts are written-off to the allowance for doubtful accounts. Revenue Recognition Our rental revenue is primarily related to rent received from tenants. Rent from tenants is recorded in accordance with the terms of each lease on a straight-line basis over the non-cancellable initial term of the lease from the later of the date of the commencement of the lease or the date of acquisition of the property subject to the lease. Rental revenue recognition begins when the tenant controls the space and continues through the term of the related lease. Because substantially all of the leases provide for rental increases at specified intervals, we record a straight-line rent receivable and recognize revenue on a straight-line basis through the expiration of the non-cancellable term of the lease. We take into account whether the collectability of rents is reasonably assured in determining the amount of straight-line rent to record. We defer rental revenue related to lease payments received from tenants in advance of their due dates. These amounts are presented within accrued liabilities and other payables on our consolidated balance sheets. Certain properties in our investment portfolio are subject to leases that provide for contingent rent based on a percentage of the tenant’s gross sales. For these leases, we recognize contingent rental revenue when the threshold upon which the contingent lease payment is based is actually reached. Gains and Losses on Dispositions of Real Estate Through December 31, 2017, gains and losses on dispositions of real estate investments were recorded in accordance with ASC 360-20, Property, Plant and Equipment-Real Estate Sales, and include realized proceeds from real estate disposed of in the ordinary course of business, less their related net book value and less any costs incurred in association with the disposition. On January 1, 2018, we adopted ASU 2017-05, “Other Income - Gains and Losses from the Derecognition of Nonfinancial Assets (Subtopic 610-20): Clarifying the Scope of Asset Derecognition Guidance and Accounting for Partial Sales of Nonfinancial Assets” (“ASU 2017-05”), using the modified retrospective transition method. As leasing is our primary activity, we determined that our sales of real estate, which are nonfinancial assets, are sold to noncustomers and fall within the scope of ASC 610-20. We recognize the full gain on the disposition of our real estate investments as we (i) have no controlling financial interest in the real estate and (ii) have no continuing interest or obligation with respect to the disposed real estate. We re-assessed and determined there were no open contracts or partial sales and, as such, the adoption of ASU 2017-05 (i) did not result in a cumulative adjustment as of January 1, 2018 and (ii) did not have any impact on our consolidated financial statements. Income Taxes We intend to elect to be taxed as a REIT under sections 856 through 860 of the Code, commencing with our taxable year ended December 31, 2018. REITs are subject to a number of organizational and operational requirements, including a requirement that 90% of ordinary “REIT taxable income” (as determined without regard to the dividends paid deduction or net capital gains) be distributed. As a REIT, we will generally not be subject to U.S. federal income tax to the extent that we meet the organizational and operational requirements and our distributions equal or exceed REIT taxable income. For the period subsequent to the effective date of our intended REIT election, we intend to meet the organizational and operational requirements and expect distributions to exceed net taxable income. Accordingly, no provision has been made for U.S. federal income taxes. Even if we qualify for taxation as a REIT, we may be subject to state and local income and franchise taxes, and to federal income and excise tax on our undistributed income. Franchise taxes and federal excise taxes on our undistributed income, if any, are included in general and administrative expenses on the accompanying consolidated statements of operations and comprehensive income. Additionally, taxable income from our non-REIT activities managed through our taxable REIT subsidiary is subject to federal, state and local taxes. From the Predecessor’s commencement of operations on March 30, 2016 through January 31, 2017, the Predecessor and its subsidiaries included in the consolidated financial statements were treated as disregarded entities for U.S. federal and state income tax purposes, and, accordingly, the Predecessor was not subject to entity-level tax. Therefore, until the Predecessor’s issuance of Class A and Class C units on January 31, 2017, the Predecessor’s net income flowed through to SCF Funding LLC, its initial sole member, for federal income tax purposes. Following the issuance of Class A and Class C units, the Predecessor’s net income flowed through to Class A and Class C unitholders for federal income tax purposes. With regard to state income taxes, the Predecessor was a taxable entity only in certain states that tax all entities, including partnerships. We analyze our tax filing positions in all of the U.S. federal, state and local tax jurisdictions where we are required to file income tax returns, as well as for all open tax years in such jurisdictions. We follow a two-step process to evaluate uncertain tax positions. Step one, recognition, occurs when an entity concludes that a tax position, based solely on its technical merits, is more-likely-than-not to be sustained upon examination. Step two, measurement, determines the amount of benefit that is more-likely-than-not to be realized upon settlement. Derecognition of a tax position that was previously recognized would occur when we subsequently determine that a tax position no longer meets the more-likely-than-not threshold of being sustained. The use of a valuation allowance as a substitute for derecognition of tax positions is prohibited. Equity-Based Compensation In 2018, we granted shares of restricted common stock to our directors, executive officers and other employees that vest over a multi-year period, subject to the recipient’s continued service. In 2017, the Predecessor granted unit-based compensation awards to certain of its employees and managers, as well as non-employees, consisting of units that vest over a multi-year period, subject to the recipient’s continued service. We account for the restricted common stock and unit-based compensation in accordance with ASC 718, Compensation - Stock Compensation, which requires that such compensation be recognized in the financial statements based on their estimated grant-date fair value. The value of such awards is recognized as compensation expense in general and administrative expenses in the accompanying consolidated statements of operations over the requisite service periods. We recognize compensation expense for equity-based compensation using the straight-line method based on the terms of the individual grant. Variable Interest Entities The FASB provides guidance for determining whether an entity is a variable interest entity (a “VIE”). VIEs are defined as entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support. A VIE is required to be consolidated by its primary beneficiary, which is the party that (i) has the power to control the activities that most significantly impact the VIE’s economic performance and (ii) has the obligation to absorb losses, or the right to receive benefits, of the VIE that could potentially be significant to the VIE. Following the completion of the Formation Transactions, we concluded that the Operating Partnership is a VIE of which we are the primary beneficiary, as we have the power to direct the activities that most significantly impact the economic performance of the Operating Partnership. Substantially all of our assets and liabilities are held by the Operating Partnership. The assets and liabilities of the Operating Partnership are consolidated and reported as assets and liabilities on our consolidated balance sheet as of December 31, 2018. We have concluded that an entity which we have provided a $5.7 million mortgage loan receivable is a VIE because the terms of the loan agreement limit the entity’s ability to absorb expected losses or the entity’s right to receive expected residual returns. However, we are not the primary beneficiary of the entity, because we do not have the power to direct the activities that most significantly impact the entity’s economic performance. As of December 31, 2018, the carrying amount of our loan receivable with this entity was $5.7 million, and our maximum exposure to loss in this entity is limited to the carrying amount of our investment. We had no liabilities associated with this investment as of December 31, 2018. Net Income per Share We compute net income per share pursuant to the guidance in the FASB ASC Topic 260, Earnings Per Share. The guidance requires the classification of our unvested restricted common stock, which contain rights to receive non-forfeitable dividends, as participating securities requiring the two-class method of computing net income per share. Diluted net income per share of common stock further considers the effect of potentially dilutive shares of common stock outstanding during the period. The OP Units held by non-controlling interests represent potentially dilutive securities as the OP Units may be redeemed for cash or, at our election, exchanged for shares of our common stock on a one-for-one basis. Recently Issued Accounting Pronouncements In May 2014, with subsequent updates in 2015, 2016 and 2017, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers” (“ASU 2014-09”), which establishes a principles-based approach for accounting for revenue from contracts with customers. The standard does not apply to revenue recognition for lease contracts or to the interest income recognized from direct financing receivables, which together represent substantially all of our revenue. Such revenues are related to lease contracts with tenants, which currently fall within the scope of ASC Topic 840 and will fall within the scope of ASC Topic 842 upon the adoption of ASU 2016-02 on January 1, 2019 (see below). Our sales of real estate are within the scope of ASU 2017-05 (see above). We adopted ASU 2014-09 on January 1, 2018 using the modified retrospective method for transition. The adoption of this new standard did not result in a cumulative effect adjustment as of January 1, 2018 and did not have any impact on our consolidated financial statements. In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842) (“ASU 2016-02”) to amend the accounting for leases. The new standard requires lessees to classify leases as either finance or operating leases based on certain criteria and record a right-of-use asset and a lease liability for all leases with a term of greater than 12 months, regardless of their classification. The new standard requires lessors to account for leases using an approach that is substantially equivalent to the previous guidance for sales-type leases, direct financing leases and operating leases. The standard also eliminates current real estate-specific provisions and changes the guidance on sale-leaseback transactions, initial direct costs, lease modifications and lease executory costs for all entities. Certain changes to the guidance pertaining to sale-leaseback transactions may impact us. For example, the inclusion of a purchase option in the lease associated with a sale-leaseback transaction will now result in the lessor accounting for such transaction as a financing arrangement. ASU 2016-02 was effective for us on January 1, 2019 and, in accordance with the provisions of ASU 2018-11, Leases (Topic 842), Targeted Improvements, was adopted by us using the modified retrospective approach as of the beginning of the period of adoption. There was no impact to retained earnings at the time of adoption and, therefore, no cumulative-effect adjustment was recorded. At the time of adoption, both lessees and lessors are permitted to make an election to apply a package of practical expedients available for implementation under the standard. We applied this package of practical expedients and, as such, at the time of adoption did not reassess the classification of existing lease contracts, whether existing or expired contracts contain a lease or whether a portion of initial direct costs for existing leases should have been expensed. The accounting applied by a lessor is largely unchanged under ASU 2016-02; however, the standard requires that lessors expense, on an as-incurred basis, certain initial direct costs that are not incremental in obtaining a lease. Under the previous standards, certain of these costs were capitalizable. Although primarily a lessor, we are also a lessee under several ground lease arrangements and under our corporate office and office equipment leases. We have completed our inventory and evaluation of these leases and have calculated a right-of-use asset and a lease liability for the present value of the minimum lease payments; the amount recognized upon adoption was less than 1% of total assets. For a portion of our ground lease arrangements, the sublessees, or our tenants, are responsible for making payment directly to the ground lessors. Prior to the new standard such amounts were presented on a net basis; however, upon adoption of ASU 2016-02 the expense related to the ground lease obligations, along with the related sublease revenues, will be presented on a gross basis in the consolidated statements of income. ASU 2016-02 also requires additional disclosures within the notes accompanying the consolidated financial statements. Substantially all of our lease contracts (under which we are the lessor) are “triple-net” leases, which means that our tenants are responsible for making payments to third parties for operating expenses such as property taxes and insurance costs associated with the properties we lease to them. Under the previous lease accounting guidance, these payments were excluded from rental revenue. In December 2018, the FASB issued ASU 2018-20 Leases (Topic 842), Narrow-Scope Improvements for Lessors. This update requires us to exclude from variable lease payments, and therefore revenue and expense, costs paid by our tenants directly to third parties (a net presentation). Costs paid by us and reimbursed by our tenants will be included in variable lease payments (a gross presentation) In June 2018, the FASB issued ASU 2018-07, Compensation - Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting (“ASU 2018-07”), which expands the scope of Topic 718 to include share-based payment transactions for acquiring goods and services from nonemployees, with the result of aligning the guidance on share-based payments to nonemployees with that for share-based payments to employees, with certain exceptions, and eliminating the need to re-value awards to nonemployees at each balance sheet date. ASU 2018-07 is effective for annual periods, and interim periods within those years, beginning after December 15, 2018, with early adoption permitted for companies who have previously adopted ASU 2017-09. We early adopted ASU 2018-07 effective July 1, 2018 for accounting for our liability-classified non-employee awards that had not vested as of that date. No adjustment to our retained earnings was required as a result of the adoption of ASU 2018-07. In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement: Changes to the Disclosure Requirements for Fair Value Measurement (“ASU 2018-13”), which changes the disclosure requirements for fair value measurements by removing, adding and modifying certain disclosures. ASU 2018-13 is effective for annual periods beginning after December 15, 2019, with early adoption permitted. We are currently evaluating the impact of adopting ASU 2018-13 on our related disclosures. Results of Operations The following discussion includes the results of the Company’s and the Predecessor’s operations collectively for the periods presented. Comparison of the years ended December 31, 2018 and 2017 Revenues: Rental revenue. Rental revenue increased by $41.6 million to $94.9 million for the year ended December 31, 2018 as compared to $53.4 million for the year ended December 31, 2017. The increase in rental revenue was primarily due to our acquisition of properties during the years ended December 31, 2018 and 2017, which provided $19.0 million and $22.2 million of additional rental revenue between the comparison periods, net of a reduction in rental revenue due to sale of properties during the comparison periods, and an increase in the net accretion of above- and below- market lease intangibles to revenue of $0.3 million between the comparison periods. Interest income on loans and direct financing receivables. Interest income on loans and direct financing receivables increased by $0.4 million for the year ended December 31, 2018 primarily due to our initial investments in loans receivable during 2018. Other revenue. Other revenue decreased by $0.2 million for the year ended December 31, 2018 as compared to year ended December 31, 2017. The decrease in other revenue was primarily due to a $0.7 million decrease in lease termination income during the year ended December 31, 2018, partially offset by having a full year of expense reimbursement income on two properties that were acquired in September 2017. Expenses: Interest. Interest expense increased by $7.6 million to $30.2 million for the year ended December 31, 2018 as compared to $22.6 million for the year ended December 31, 2017. The increase in interest expense was primarily due to $5.6 million of additional interest expense from having notes issued under our Master Trust Funding Program on July 11, 2017 outstanding during the entire year ended December 31, 2018, $0.9 million of new interest expense relating to the Revolving Credit Facility that was entered into in June 2018 and $1.1 million of additional interest expense on our notes payable to related parties due to higher average borrowing balances during the year ended December 31, 2018. General and administrative expenses. General and administrative expenses increased $5.0 million to $13.8 million for the year ended December 31, 2018 as compared to $8.8 million for the year ended December 31, 2017. This increase in general and administrative expenses was primarily due to increases in stock compensation expense of $1.6 million, directors’ fees of $0.2 million, legal and accounting fees of $1.4 million, personnel costs of $1.2 million and other costs required to support our growing real estate portfolio. Property expenses. Property expenses increased by $0.4 million to $1.9 million for the year ended December 31, 2018 as compared to $1.5 million for the year ended December 31, 2017. The increase was primarily due to having a full year of reimbursable property expense on two properties that were acquired in September 2017. Our leases are generally triple-net and provide that the tenant is responsible for the payment of all property-level expenses, such as maintenance, insurance, utility and tax expense, related to the leased property. Therefore, we are generally not responsible for operating costs related to the properties, unless a property is not subject to a triple-net lease or is vacant. Barring any significant changes in occupancy or composition of triple net leases in our portfolio between the comparison periods, we expect property expenses to remain fairly consistent. Depreciation and amortization expense. Depreciation and amortization expense relates primarily to depreciation on the properties and improvements we own and to amortization of the related lease intangibles. Depreciation and amortization expense increased by $11.9 million to $31.4 million for the year ended December 31, 2018 as compared to $19.5 million for the year ended December 31, 2017. The increase in depreciation and amortization expense during the year ended December 31, 2018 was due to the inclusion of depreciation and amortization expense for properties acquired during the years ended December 31, 2018 and 2017 which added $5.6 million and $8.0 million of additional depreciation and amortization expense during the year ended December 31, 2018. These increases were partially offset by a reduction of $1.7 million of depreciation and amortization expense on properties that we disposed during the year ended December 31, 2018. Provision for impairment of real estate. Impairment charges on real estate investments were $4.5 million and $2.4 million for the years ended December 31, 2018 and 2017, respectively. During the years ended December 31, 2018 and 2017, we recorded a provision for impairment of real estate at 20 and nine of our real estate investments. We strategically seek to identify non-performing properties that we may re-lease or dispose of in an effort to improve our returns and manage risk exposure. An increase in vacancy associated with our disposition or re-leasing strategies may trigger impairment charges when the expected future cash flows from the properties from sale or re-lease are less than their net book value. Other operating income: Gain on dispositions of real estate, net. Gain on dispositions of real estate, net decreased by $1.3 million to $5.4 million for the year ended December 31, 2018 as compared to $6.7 million for the year ended December 31, 2017. We disposed of 45 real estate properties during the year ended December 31, 2018 as compared to 47 real estate properties during the year ended December 31, 2017. Other income and expenses: Interest. Interest income increased by $0.9 million for the year ended December 31, 2018. The increase in interest income was primarily due to higher average daily cash balances in our interest-bearing bank accounts during the year ended December 31, 2018 because of the funds raised through the IPO (inclusive of the shares issued pursuant to the partial exercise by the underwriters of their option to purchase additional shares) and the Concurrent Private Placement of common stock to Eldridge. Income tax expense. Income tax expense increased by approximately $34,000 for the year ended December 31, 2018. As we are organized and operate with the intention of qualifying as a REIT, we are generally not subject to U.S. federal taxation. However, the Operating Partnership is subject to taxation in certain state and local jurisdictions that impose income taxes on a partnership. The increase in income tax expense was primarily due to the continued growth of our real estate investment portfolio and our expansion into new jurisdictions where we are subject to taxation. Net income attributable to non-controlling interests. Net income attributable to non-controlling interests represents the portion of our net income attributable to the holders of units in our Operating Partnership, which are accounted for as non-controlling interests. No such non-controlling interests existed during the year ended December 31, 2017. Comparison of the year ended December 31, 2017 and the period from March 30, 2016 (commencement of operations) to December 31, 2016 Revenues: Rental revenue. Rental revenue increased by $38.1 million to $53.4 million for the year ended December 31, 2017 as compared to $15.3 million for the period from March 30, 2016 (commencement of operations) to December 31, 2016. The increase in rental revenue was primarily due to our acquisition of 212 properties during the year ended December 31, 2017, which provided $17.6 million of additional rental revenue between the comparison periods, contractual rent escalations and the inclusion of a full year of operations from properties acquired during the period from March 30, 2016 (commencement of operations) to December 31, 2016, which contributed $20.5 million of additional rental revenue between the comparison periods. As of December 31, 2017, 98.8% of our properties were occupied. We regularly review and analyze the operational and financial condition of our tenants and the industries in which they operate in order to identify underperforming properties that we may seek to dispose of in an effort to mitigate risks in our portfolio. As of December 31, 2017, exclusive of two vacant land parcels that we own, six of our properties, representing 1.2% of our portfolio, were vacant and not generating rent, compared to 11 vacant properties, representing 3.2% of our portfolio, as of December 31, 2016. Interest income on loans and direct financing receivables. Interest income on loans and direct financing receivables increased by $0.1 million to $0.3 million for the year ended December 31, 2017, as compared to $0.2 million for the period from March 30, 2016 (commencement of operations) to December31, 2016. The increase in interest income on direct financing receivables was due to the inclusion of a full year of operations from our eight investments in direct financing receivables acquired during the period from March 30, 2016 (commencement of operations) to December 31, 2016 (net of disposition or termination of two direct financing leases during the year ended December 31, 2017). Other revenue. Other revenue increased by $0.7 million to $0.8 million for the year ended December 31, 2017, as compared to $0.1 million for the period from March 30, 2016 (commencement of operations) to December 31, 2016. The increase in other revenue was primarily due to the receipt of $0.7 million of lease termination fees from former tenants during the year ended December 31, 2017. Expenses: Interest. Interest expense increased by $21.6 million to $22.6 million for the year ended December 31, 2017 as compared to $1.0 million for the period from March 30, 2016 (commencement of operations) to December 31, 2016. The increase in interest expense was primarily due to $11.8 million of additional interest expense from having $280.8 million of notes issued under our Master Trust Funding Program in December 2016 outstanding for a full year, $8.0 million of additional interest expense on debt issued to finance acquisitions during the year ended December 31, 2017 and $1.8 million of additional non-cash interest expense from the amortization of deferred financing costs. During the year ended December 31, 2017, we issued an additional $248.1 million of notes under our Master Trust Funding Program and had net borrowings of $230.0 million through short-term notes with related parties. General and administrative. General and administrative expenses increased $4.5 million to $8.8 million for the year ended December 31, 2017 as compared to $4.3 million for the period from March 30, 2016 (commencement of operations) to December 31, 2016. This increase in general and administrative expenses was primarily due to the inclusion of a full year of operations and increased costs required to support our larger real estate investment portfolio during the year ended December 31, 2017. Property expenses. Property expenses increased by $1.0 million to $1.5 million for the year ended December 31, 2017 as compared to $0.5 million for the period from March 30, 2016 (commencement of operations) to December 31, 2016. The increase in property costs was due to the inclusion of a full year of operations and related property expenses for our vacant properties during the year ended December 31, 2017, partially offset by reduced property expenses due to a net four property decrease in our total number of vacant properties during the year ended December 31, 2017. Depreciation and amortization. Depreciation and amortization expense increased by $14.1 million to $19.5 million for the year ended December 31, 2017 as compared to $5.4 million for the period from March 30, 2016 (commencement of operations) to December 31, 2016. The increase during the year ended December 31, 2017 was due to the inclusion of a full year of operations and related depreciation and amortization expense from properties acquired during the period from March 30, 2016 (commencement of operations) to December 31, 2016, which added $8.6 million of additional depreciation and amortization expense, and $5.5 million of additional depreciation and amortization expense recorded on the 212 properties that we acquired during the year ended December 31, 2017. Provision for impairment of real estate. Impairment charges on real estate investments were $2.4 million and $1.3 million for the year ended December 31, 2017 and the period from March 30, 2016 (commencement of operations) to December 31, 2016, respectively. During the year ended December 31, 2017, we recorded a provision for impairment of real estate at nine of our real estate investments, compared to seven real estate investments during the period from March 30, 2016 (commencement of operations) to December 31, 2016. Other operating income: Gain on dispositions of real estate, net. Gain on dispositions of real estate, net increased by $5.9 million to $6.8 million for the year ended December 31, 2017 as compared to $0.9 million for the period from March 30, 2016 (commencement of operations) to December 31, 2016. The increase in gain on dispositions of real estate was primarily due to our disposition of 47 real estate properties during the year ended December 31, 2017 compared to our disposition of 17 properties during the period from March 30, 2016 (commencement of operations) to December 31, 2016. Other income and expenses: Interest. Interest income increased by approximately $46,000 for the year ended December 31, 2017 as compared to the period from March 30, 2016 (commencement of operations) to December 31, 2016. The increase in interest income was primarily due to higher average daily cash balances in our interest-bearing bank accounts during the year ended December 31, 2017. Income tax expense. Income tax expense increased by $0.1 million to $0.2 million for the year ended December 31, 2017 as compared to $0.1 million for the period from March 30, 2016 (commencement of operations) to December 31, 2016. The Predecessor was subject to taxation in certain state and local jurisdictions that impose income taxes on a partnership. The increase in income tax expense was primarily due to the continued growth of our real estate investment portfolio and our expansion into new jurisdictions where we are subject to taxation. Non-GAAP Financial Measures Our reported results are presented in accordance with GAAP. We also disclose the following non-GAAP financial measures: funds from operations (“FFO”), adjusted funds from operations (“AFFO”), earnings before interest, taxes, depreciation and amortization (“EBITDA”), EBITDA further adjusted to exclude gains (or losses) on sales of depreciable property and real estate impairment losses (“EBITDAre”), net debt, net operating income (“NOI”) and cash NOI (“Cash NOI”). We believe these non-GAAP financial measures are accepted industry measures used by analysts and investors to compare the operating performance of REITs. We compute FFO in accordance with the definition adopted by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”). NAREIT defines FFO as GAAP net income or loss adjusted to exclude extraordinary items (as defined by GAAP), net gain or loss from sales of depreciable real estate assets, impairment write-downs associated with depreciable real estate assets and real estate-related depreciation and amortization (excluding amortization of deferred financing costs and depreciation of non-real estate assets), including the pro rata share of such adjustments of unconsolidated subsidiaries. FFO is used by management, investors and analysts to facilitate meaningful comparisons of operating performance between periods and among our peers primarily because it excludes the effect of real estate depreciation and amortization and net gains on sales (which are dependent on historical costs and implicitly assume that the value of real estate diminishes predictably over time, rather than fluctuating based on existing market conditions). To derive AFFO, we modify the NAREIT computation of FFO to include other adjustments to GAAP net income related to certain items that we believe are not indicative of our core operating performance, including straight-line rental revenue, non-cash interest expense, non-cash compensation expense, amortization of market lease-related intangibles, amortization of capitalized lease incentives, capitalized interest expense, transaction costs and other non-cash charges. Such items may cause short-term fluctuations in net income but have no impact on operating cash flows or long-term operating performance. We believe that AFFO is an additional useful supplemental measure for investors to consider because it will help them to better assess our operating performance without the distortions created by non-cash and certain other revenues and expenses. FFO and AFFO do not include all items of revenue and expense included in net income, nor do they represent cash generated from operating activities, and they are not necessarily indicative of cash available to fund cash requirements; accordingly, they should not be considered alternatives to net income as a performance measure or cash flows from operations as a liquidity measure and should be considered in addition to, and not in lieu of, GAAP financial measures. FFO and AFFO may not be comparable to similarly titled measures reported by other companies. The following table reconciles net income (which is the most comparable GAAP measure) to FFO and AFFO attributable to stockholders and members and non-controlling interests: We calculate EBITDA as earnings before interest, income taxes and depreciation and amortization. In 2017, NAREIT issued a white paper recommending that companies that report EBITDA also report EBITDAre. We compute EBITDAre in accordance with the definition adopted by NAREIT. NAREIT defines EBITDAre as EBITDA (as defined above) excluding gains (or losses) from the sales of depreciable property and real estate impairment losses. We present EBITDA and EBITDAre as they are measures commonly used in our industry and we believe that these measures are useful to investors and analysts because they provide important supplemental information concerning our operating performance, exclusive of certain non-cash items and other costs. We use EBITDA and EBITDAre as measures of our operating performance and not as measures of liquidity. EBITDA and EBITDAre are not measures of financial performance under GAAP, and our EBITDA and EBITDAre may not be comparable to similarly titled measures reported by other companies. You should not consider EBITDA and EBITDAre as alternatives to net income or cash flows from operating activities determined in accordance with GAAP. The following table reconciles net income (which is the most comparable GAAP measure) to EBITDA and EBITDAre attributable to stockholders and members and non-controlling interests: We adjust EBITDAre for our most recently completed fiscal quarter based on an estimate calculated as if all acquisition and disposition activity that took place during the quarter had been made on the first day of the quarter (“Adjusted EBITDAre”). We then annualize Adjusted EBITDAre by multiplying it by four (“Annualized Adjusted EBITDAre”), which we believe provides a meaningful estimate of our current run rate for all properties owned as of the date of this report. You should not unduly rely on this measure as it is based on assumptions and estimates that may prove to be inaccurate. Our actual reported EBITDAre for future periods may be significantly less than our current Annualized Adjusted EBITDAre for a variety of reasons. The following table reconciles net income (which is the most comparable GAAP measure) to Annualized Adjusted EBITDAre attributable to stockholders and members and non-controlling interests for the three months ended December 31, 2018: (1) Adjustment assumes all acquisitions and dispositions of real estate investments made during the three months ended December 31, 2018 had occurred on October 1, 2018. We calculate our net debt as our gross debt (defined as total debt plus net deferred financing costs on our secured borrowings) less cash and cash equivalents and restricted cash deposits held for the benefit of lenders. We believe excluding cash and cash equivalents and restricted cash deposits held for the benefit of lenders from gross debt, all of which could be used to repay debt, provides an estimate of the net contractual amount of borrowed capital to be repaid, which we believe is a beneficial disclosure to investors and analysts. The following table reconciles total debt (which is the most comparable GAAP measure) to net debt: We calculate NOI as total revenues less property expenses. NOI excludes all other items of expense and income included in the financial statements in calculating net income or loss. Cash NOI further excludes non-cash items included in total revenues and property expenses, such as straight-line rental revenue, amortization of capitalized lease incentives, amortization of market-lease related intangibles and other non-cash charges. We believe NOI and Cash NOI provide useful and relevant information because they reflect only those income and expense items that are incurred at the property level and present such items on an unlevered basis. NOI and Cash NOI are not measures of financial performance under GAAP, and our NOI and Cash NOI may not be comparable to similarly titled measures reported by other companies. You should not consider our NOI and Cash NOI as alternatives to net income or cash flows from operating activities determined in accordance with GAAP. The following table reconciles net income (which is the most comparable GAAP measure) to NOI and Cash NOI attributable to stockholders and members and non-controlling interests:
-0.021944
-0.021603
0
<s>[INST] Overview We are an internally managed real estate company that acquires, owns and manages primarily singletenant properties that are net leased on a longterm basis to middlemarket companies operating serviceoriented or experiencebased businesses. We have a diversified portfolio that focuses on properties leased to tenants in businesses such as restaurants (including quick service and casual and family dining), car washes, automotive services, medical services, convenience stores, entertainment, early childhood education and health and fitness. We acquire and lease freestanding, singletenant commercial real estate facilities where a tenant services its customers and conducts activities that are essential to the generation of the tenant’s sales and profits. We were organized on January 12, 2018 as a Maryland corporation and intend to qualify to be taxed as a REIT beginning with our taxable year ended December 31, 2018. On June 25, 2018, we completed our IPO of 32,500,000 shares of our common stock, $0.01 par value per share, at an initial public offering price of $14.00 per share, pursuant to a registration statement on Form S11 (File No. 333225215), filed with the SEC under the Securities Act. On July 24, 2018, we issued an additional 2,772,191 shares of common stock at the IPO price of $14.00 per share pursuant to the partial exercise of an option granted to the underwriters of our IPO. Net proceeds from the IPO and the issuance of shares to underwriters, after deducting underwriting discounts and commissions and other expenses, were $458.7 million. Our common stock is listed on the NYSE under the ticker symbol “EPRT”. Prior to the completion of the IPO, we engaged in a number of formation transactions designed to facilitate the completion of the IPO (the “Formation Transactions”). Among other things, on June 20, 2018, EPRT LLC converted from a Delaware limited liability company into a Delaware limited partnership, changed its name to Essential Properties, L.P. (the “Operating Partnership”) and became the subsidiary through which we hold substantially all of our assets and conduct our operations. Prior to the completion of the Formation Transactions, EPRT LLC was a wholly owned subsidiary of EPRT Holdings (together with EPRT LLC, the “Predecessor”), and EPRT Holdings received 17,913,592 units of limited partnership interest in the Operating Partnership (“OP Units”) in connection with EPRT LLC’s conversion into a Delaware limited partnership. Essential Properties OP G.P., LLC, our wholly owned subsidiary, became the sole general partner of the Operating Partnership in connection with the completion of our IPO. Concurrent with the completion of the IPO, we received an additional $125.0 million investment from an affiliate of Eldridge in the Concurrent Private Placement of 7,785,611 shares of our common stock and 1,142,960 OP Units. We contributed the net proceeds from the issuance of the 43,057,802 shares of common stock in our IPO (inclusive of the shares issued pursuant to the partial exercise by the underwriters of their option to purchase additional shares) and the Concurrent Private Placement of common stock to Eldridge to the Operating Partnership in exchange for a like number of OP Units. We generally lease each of our properties to a single tenant on a triplenet, longterm basis, and we generate our cash from operations primarily through the monthly lease payments, or base rent, we receive from the tenants that occupy our properties. As of December 31, 2018, we had a portfolio of real estate investments at 677 properties (inclusive of one undeveloped land parcel and 12 properties which secure our investments in mortgage loans receivable) that was diversified by tenant, industry and geography, had annualized base rent of $10 [/INST] Negative. </s>
2,019
14,180
1,728,951
ESSENTIAL PROPERTIES REALTY TRUST, INC.
2020-03-02
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 together with our consolidated financial statements and the related notes included elsewhere in this Annual Report on Form 10-K, as well as the “Selected Financial Data” and “Business” sections of this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this report, including information with respect to our plans and strategies for our business, includes forward-looking statements that involve risks and uncertainties. You should read “Item 1A. Risk Factors” and the “Special Note Regarding Forward-Looking Statements” 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 these forward-looking statements. Overview We are an internally managed real estate company that acquires, owns and manages primarily single-tenant properties that are net leased on a long-term basis to middle-market companies operating service-oriented or experience-based businesses. We generally acquire and lease freestanding, single-tenant commercial real estate facilities where a tenant services its customers and conducts activities that are essential to the generation of the tenant’s sales and profits. We were organized on January 12, 2018 as a Maryland corporation. We have elected to be taxed as a real estate investment trust (“REIT”) for federal income tax purposes beginning with the year ended December 31, 2018, and we believe that our current organization, operations and intended distributions has allowed and will continue to allow us to continue to so qualify. On June 25, 2018, we completed the initial public offering (“IPO”) of our common stock. Our common stock is listed on the New York Stock Exchange under the ticker symbol “EPRT”. We generally lease each of our properties to a single tenant on a triple-net long-term lease basis, and we generate our cash from operations primarily through the monthly lease payments, or base rent we receive from the tenants that occupy our properties. As of December 31, 2019, we had a portfolio of 1,000 properties (inclusive of one undeveloped land parcel and ninety-one properties which secure our investments in mortgage loans receivable) that was diversified by tenant, industry, concept and geography, had annualized base rent of $151.2 million and was 100.0% occupied. Substantially all our leases provide for periodic contractual rent escalations. As of December 31, 2019, leases contributing 98.6% of our annualized base rent provided for increases in future annual base rent, generally ranging from 1% to 4%, with a weighted average annual escalation equal to 1.5% of base rent. As of December 31, 2019, leases contributing 93.5% of annualized base rent were triple-net, which means that our tenant is responsible for all operating expenses, such as maintenance, insurance, utility and tax, related to the leased property (including any increases in those costs that may occur as a result of inflation). Our remaining leases were “double net,” where the tenant is responsible for certain expenses, such as taxes and insurance, but we retain responsibility for other expenses, generally related to maintenance and structural component replacement that may be required at such leased properties. Also, we incur property-level expenses associated with our vacant properties and we occasionally incur nominal property-level expenses that are not paid by our tenants, such as the costs of periodically making site inspections of our properties. We do not currently anticipate incurring significant capital expenditures or property costs. Since our properties are predominantly single-tenant properties, which are generally subject to long-term leases, it is not necessary for us to perform any significant ongoing leasing activities on our properties. As of December 31, 2019, the weighted average remaining term of our leases was 14.6 years (based on annualized base rent), excluding renewal options that have not been exercised, with 6.8% of our annualized base rent attributable to leases expiring prior to January 1, 2025. Renewal options are exercisable at the option of our tenants upon expiration of their base lease term. Our leases providing for tenant renewal options generally provide for periodic contractual rent escalations during any renewed term that are similar to those applicable during the initial term of the lease. As of December 31, 2019, 60.3% of our annualized base rent was attributable to master leases, where we have leased multiple properties to a tenant under a master lease. Since properties are generally leased under a master lease on an “all or none” basis, the structure prevents a tenant from “cherry picking” locations, where it unilaterally gives up underperforming properties while maintaining its leasehold interest in well-performing properties. Liquidity and Capital Resources As of December 31, 2019, we had $1.9 billion of net investments in our investment portfolio, consisting of investments in 1,000 properties (inclusive of one undeveloped land parcel and 91 properties which secure our investments in mortgage loans receivable), with annualized base rent of $151.2 million. Substantially all of our cash from operations is generated by our investment portfolio. Our short-term liquidity requirements consist primarily of funds necessary to pay for our operating expenses, including principal and interest payments on our outstanding indebtedness, and the general and administrative expenses of servicing our portfolio and operating our business. Since our occupancy level is high and substantially all of our leases are triple-net, our tenants are generally responsible for the maintenance, insurance and property taxes associated with the properties they lease from us. When a property becomes vacant through a tenant default or expiration of the lease term with no tenant renewal or re-leasing, we incur the property costs not paid by the tenant, as well as those property costs accruing during the time it takes to locate a substitute tenant or to sell the property. As of December 31, 2019, none of our properties were vacant, and all were subject to a lease (excluding one undeveloped land parcel), which represents a 100.0% occupancy rate. We expect to incur some property costs from time to time in periods during which properties that become vacant are being marketed for lease or sale. In addition, we may recognize an expense for certain property costs, such as real estate taxes billed in arrears, if we believe the tenant is likely to vacate the property before making payment on those obligations. The amount of such property costs can vary quarter-to-quarter based on the timing of property vacancies and the level of underperforming properties; however, we do not expect that such costs will be significant to our operations. From time to time, we may also sell properties that no longer meet our long-term investment objectives. We intend to continue to grow through additional real estate investments. To accomplish this objective, we seek to acquire real estate with a combination of debt and equity capital and with cash from operations that we do not distribute to our stockholders. When we sell properties, we generally reinvest the cash proceeds from those sales in new property acquisitions. Our short-term liquidity requirements also include the funding needs associated with 23 properties where we have agreed to provide construction financing or reimburse the tenant for certain development, construction and renovation costs in exchange for contractually-specified interest or rent that generally increases in proportion with our funding. As of December 31, 2019, we had agreed to provide construction financing or reimburse the tenant for certain development, construction and renovation costs in an aggregate amount of $78.7 million, and, as of the same date, we had funded $47.9 million of this commitment. We expect to fund the balance of such commitment by December 31, 2021. Additionally, as of February 28, 2020, we were under contract to acquire 29 properties with an aggregate purchase price of $65.5 million, subject to completion of our due diligence procedures and customary closing conditions. We expect to meet our short-term liquidity requirements, including our investment in potential future acquisitions, primarily with cash and cash equivalents, net cash from operating activities and borrowings under the Revolving Credit Facility. Our long-term liquidity requirements consist primarily of funds necessary to acquire additional properties and repay indebtedness. We expect to meet our long-term liquidity requirements through various sources of capital, including net cash from operating activities, borrowings under our revolving credit and term loan facilities, future financings, sale of common stock under our ATM Program, proceeds from select sales of our properties and other secured and unsecured borrowings (including potential issuances under the Master Trust Funding Program). However, at any point in time, there may be a number of factors that could have a material and adverse effect on our ability to access these capital sources, including unfavorable conditions in the overall equity and credit markets, our degree of leverage, our unencumbered asset base, borrowing restrictions imposed by our lenders, general market conditions for REITs, our operating performance, liquidity and market perceptions about us. The success of our business strategy will depend, to a significant degree, on our ability to access these various capital sources. An additional liquidity need is funding the distributions that are among the requirements for us to continue to qualify for taxation as a REIT. During the year ended December 31, 2019, our board of directors declared total cash distributions of $0.88 per share of common stock. Holders of OP Units are entitled to distributions per unit equivalent to those paid by us per share of common stock. During the year ended December 31, 2019, we paid $63.9 million of distributions to common stockholders and OP Unit holders, and as of December 31, 2019, we recorded $19.4 million of distributions payable to common stockholders and OP Unit holders. To continue to qualify for taxation as a REIT, we must make distributions to our stockholders aggregating annually at least 90% of our REIT taxable income, determined without regard to the dividends paid deduction and excluding any net capital gain. As a result of this requirement, we cannot rely on retained earnings to fund our business needs to the same extent as other entities that are not REITs. If we do not have sufficient funds available to us from our operations to fund our business needs, we will need to find alternative ways to fund those needs. Such alternatives may include, among other things, selling properties (whether or not the sales price is optimal or otherwise meets our strategic long-term objectives), incurring additional indebtedness or issuing equity securities in public or private transactions. The availability and attractiveness of the terms of these potential sources of financing cannot be assured. Generally, our debt capital is initially provided on a short-term, temporary basis through our Revolving Credit Facility. We manage our long-term leverage position through the issuance of long-term fixed-rate debt on a secured or unsecured basis. By seeking to match the expected cash inflows from our long-term leases with the expected cash outflows for our long-term, we seek to “lock in,” for as long as is economically feasible, the expected positive difference between our scheduled cash inflows on the leases and the cash outflows on our debt obligations. In this way, we seek to reduce the risk that increases in interest rates would adversely impact our results of operations. We use various financial instruments designed to mitigate the impact of interest rate fluctuations on our cash flows and earnings, including hedging strategies such as interest rate swaps and caps, depending on our analysis of the interest rate environment and the costs and risks of such strategies. Although we are not required to maintain a particular leverage ratio and may not be able to do so, we generally intend to target, over time, a level of net debt (which includes recourse and non-recourse borrowings and any outstanding preferred stock less unrestricted cash and cash held for the benefit of lenders) that is less than six times our annualized adjusted EBITDAre. As of December 31, 2019, all of our long-term debt was fixed-rate debt or was effectively converted to a fixed-rate for the term of the debt and our weighted average debt maturity was 5.2 years. As we grow our real estate portfolio, we intend to manage our long-term debt maturities to reduce the risk that a significant amount of our debt will mature in any single year in the future. Over time, we may access additional long-term debt capital with future debt issuances through our Master Trust Funding Program. Future sources of debt capital may also include term borrowings from insurance companies, banks and other sources, single-asset mortgage financing and CMBS borrowings, and may offer us the opportunity to lower our cost of funding and further diversify our sources of debt capital. Over time, we may choose to issue preferred equity as a part of our overall funding strategy. As our outstanding debt matures, we may refinance it as it comes due or choose to repay it using cash and cash equivalents or borrowings under the Revolving Credit Facility. Management believes that the cash generated by our operations, together with our cash and cash equivalents at December 31, 2019, our borrowing availability under the Revolving Credit Facility and the November 2019 Term Loan and our potential access to additional sources of capital, will be sufficient to fund our operations for the foreseeable future and allow us to acquire the real estate for which we currently have made commitments. Description of Certain Debt Unsecured Revolving Credit Facility and April 2019 Term Loan Through our Operating Partnership, we are party to an Amended Credit Agreement with a group of lenders, which provides for revolving loans of up to $400.0 million (the “Revolving Credit Facility”) and up to an additional $200.0 million in term loans (the “April 2019 Term Loan”). Under the Revolving Credit Facility, as of December 31, 2019, we had $46.0 million in outstanding borrowings and had $354.0 million of unused borrowing capacity. Additionally, as of December 31, 2019, we had $200.0 million of principal borrowings outstanding under the April 2019 Term Loan. The Revolving Credit Facility matures on April 12, 2023, with an extension option of up to one year exercisable by the Operating Partnership, subject to certain conditions, and the April 2019 Term Loan matures on April 12, 2024. The loans under each of the Revolving Credit Facility and the April 2019 Term Loan initially bear interest at an annual rate of applicable LIBOR plus the applicable margin (which applicable margin varies between the Revolving Credit Facility and the April 2019 Term Loan). The applicable LIBOR is the rate with a term equivalent to the interest period applicable to the relevant borrowing. The applicable margin initially is a spread set according to a leverage-based pricing grid. At the Operating Partnership’s election, on and after receipt of an investment grade corporate credit rating from S&P or Moody’s, the applicable margin will be a spread set according to the credit ratings provided by S&P and/or Moody’s. Each of the Revolving Credit Facility and the April 2019 Term Loan is freely pre-payable at any time and is mandatorily payable if borrowings exceed the borrowing base or the revolving facility limit. The Operating Partnership may re-borrow amounts paid down on the Revolving Credit Facility but not on the April 2019 Term Loan. The Operating Partnership is required to pay revolving credit fees throughout the term of the Revolving Credit Agreement based upon its usage of the Revolving Credit Facility, at a rate which depends on its usage of such facility during the period before we receive an investment grade corporate credit rating from S&P or Moody’s, and which rate shall be based on the corporate credit rating from S&P and/or Moody’s after the time, if applicable, we receive such a rating. The Amended Credit Agreement has an accordion feature to increase, subject to certain conditions, the maximum availability of credit (either through increased revolving commitments or additional term loans) by up to $200.0 million. The Operating Partnership is the borrower under the Amended Credit Agreement, and we and each of the subsidiaries of the Operating Partnership that owns a direct or indirect interest in an eligible real property asset are guarantors under the Amended Credit Agreement. Under the terms of the Amended Credit Agreement, we are subject to various restrictive financial and nonfinancial covenants which, among other things, require us to maintain certain leverage ratios, cash flow and debt service coverage ratios, secured borrowing ratios and a minimum level of tangible net worth. The Amended Credit Agreement restricts our ability to pay distributions to our stockholders under certain circumstances. However, we may make distributions to the extent necessary to maintain our qualification as a REIT under the Code. The Amended Credit Agreement contains certain additional covenants that, subject to exceptions, limit or restrict our incurrence of indebtedness and liens, disposition of assets, transactions with affiliates, mergers and fundamental changes, modification of organizational documents, changes to fiscal periods, making of investments, negative pledge clauses and lines of business and REIT qualification. November 2019 Term Loan On November 26, 2019, we, through our Operating Partnership, entered into a $430.0 million term loan credit facility (the “November 2019 Term Loan”) with a group of lenders. The November 2019 Term Loan provides for term loans to be drawn up to an aggregate amount of $430.0 million with a maturity of November 26, 2026. The loans under the November 2019 Term Loan are available to be drawn in up to three draws during the six-month period beginning on November 26, 2019. On December 9, 2019, we borrowed $250.0 million under the November 2019 Term Loan. Borrowings under the November 2019 Term Loan bear interest at an annual rate of applicable LIBOR plus the applicable margin. The applicable LIBOR will be the rate with a term equivalent to the interest period applicable to the relevant borrowing. The applicable margin will initially be a spread set according to a leverage-based pricing grid. At the Operating Partnership’s irrevocable election, on and after receipt of an investment grade corporate credit rating from S&P or Moody’s, the applicable margin will be a spread set according to our corporate credit ratings provided by S&P and/or Moody’s. The November 2019 Term Loan is pre-payable at any time by the Operating Partnership, provided, that if the loans under the November 2019 Term Loan are repaid on or before November 26, 2020, they are subject to a two percent prepayment premium, and if repaid thereafter but on or before November 26, 2021, they are subject to a one percent prepayment premium. After November 26, 2021 the loans may be repaid without penalty. The Operating Partnership may not re-borrow amounts paid down on the November 2019 Term Loan. The Operating Partnership is required to pay a ticking fee on any undrawn portion of the November 2019 Term Loan for the period from and including the 91st day after November 26, 2019 until the earlier of the date the initial term loans are fully drawn or May 26, 2020. The November 2019 Term Loan has an accordion feature to increase, subject to certain conditions, the maximum availability of the facility up to an aggregate of $500 million. The Operating Partnership is the borrower under the November 2019 Term Loan, and our Company and each of its subsidiaries that owns a direct or indirect interest in an eligible real property asset are guarantors under the facility. Under the terms of the November 2019 Term Loan, we are subject to various restrictive financial and nonfinancial covenants which, among other things, require us to maintain certain leverage ratios, cash flow and debt service coverage ratios, secured borrowing ratios and a minimum level of tangible net worth. The November 2019 Term Loan restricts our ability to pay distributions to our stockholders under certain circumstances. However, we may make distributions to the extent necessary to maintain our qualification as a REIT under the Code. The November 2019 Term Loan contains certain additional covenants that, subject to exceptions, limit or restrict our incurrence of indebtedness and liens, disposition of assets, transactions with affiliates, mergers and fundamental changes, modification of organizational documents, changes to fiscal periods, making of investments, negative pledge clauses and lines of business and REIT qualification. Master Trust Funding Program SCF RC Funding I LLC, SCF RC Funding II LLC and SCF RC Funding III LLC (collectively, the “Master Trust Issuers”), all of which are indirect wholly-owned subsidiaries of the Operating Partnership, have issued net-lease mortgage notes payable (the “Notes”) with an aggregate outstanding gross principal balance of $239.1 million as of December 31, 2019. The Notes are secured by all assets owned by the Master Trust Issuers. We provide property management services with respect to the mortgaged properties owned by the Master Trust Issuers and service the related leases pursuant to an amended and restated property management and servicing agreement, dated as of July 11, 2017, among the Master Trust Issuers, the Operating Partnership (as property manager and as special servicer), Midland Loan Services, a division of PNC Bank, National Association, (as back-up manager) and Citibank, N.A. (as indenture trustee). Beginning in 2016, two series of Notes, each comprised of two classes, were issued under the program: (i) Notes originally issued by SCF RC Funding I LLC and SCF RC Funding II LLC (the “Series 2016-1 Notes”), which were repaid in full in November 2019 and (ii) Notes originally issued by SCF RC Funding I LLC, SCF RC Funding II LLC and SCF RC Funding III LLC (the “Series 2017-1 Notes”), with an aggregate outstanding principal balance of $239.1 million as of December 31, 2019. The Notes are the joint obligations of all Master Trust Issuers. Notes issued under our Master Trust Funding Program are secured by a lien on all of the property owned by the Master Trust Issuers and the related leases. A substantial portion of our real estate investment portfolio serves as collateral for borrowings outstanding under our Master Trust Funding Program. As of December 31, 2019, we had pledged 355 properties, with a net investment amount of $601.3 million, under the Master Trust Funding Program. The agreement governing our Master Trust Funding Program permits substitution of real estate collateral from time to time, subject to certain conditions. Absent a plan to issue additional long-term debt through the Master Trust Funding Program, we are not required to add assets to, or substitute collateral in, the existing collateral pool. We can voluntarily elect to substitute assets in the collateral pool, subject to meeting prescribed conditions that are designed to protect the collateral pool by requiring the substitute assets to be of equal or greater measure in attributes such as: the asset’s fair value, monthly rent payments, remaining lease term and weighted average coverage ratios. In addition, we can sell underperforming assets and reinvest the proceeds in new properties. Any substitutions and sales are subject to an overall limitation of 35% of the collateral pool which is typically reset at each new issuance unless the substitution or sale is credit- or risk-based, in which case there are no limitations. A significant portion of our cash flows are generated by the special purpose entities comprising our Master Trust Funding Program. For the year ended December 31, 2019, excess cash flow from the Master Trust Funding Program, after payment of debt service and servicing and trustee expenses, totaled $8.6 million on cash collections of $14.6 million, which represents a debt service coverage ratio (as defined in the program documents) of 2.33x. If at any time the monthly debt service coverage ratio (as defined in the program documents) generated by the collateral pool is less than or equal to 1.25x, excess cash flow from the Master Trust Funding Program entities will be deposited into a reserve account to be used for payments to be made on the Notes, to the extent there is a shortfall; if at any time the three month average debt service coverage ratio generated by the collateral pool is less than or equal to 1.15x, excess cash flow from the Master Trust Funding Program entities will be applied to an early amortization of the Notes. If cash generated by our properties held in the Master Trust Funding Program is required to be held in a reserve account or applied to an early amortization of the Notes, it would reduce the amount of cash available to us and could limit or eliminate our ability to make distributions to our common stockholders. The Notes require monthly payments of principal and interest. The payment of principal and interest on any Class B Notes is subordinate to the payment of principal and interest on any Class A Notes. The Series 2017-1 Notes mature in June 2047 and have a weighted average interest rate of 4.17% as of December 31, 2019. However, the anticipated repayment date for the Series 2017-1 Notes is June 2024, and if the notes are not repaid in full on or before such anticipated repayment date, additional interest will begin to accrue on the notes. The Series 2017-1 Notes may be voluntarily prepaid, in whole or in part, at any time on or after the date that is 31 months prior to the anticipated repayment date in June 2024 without the payment of a make whole amount. Voluntary prepayments may be made before 31 months prior to the anticipated repayment date but will be subject to the payment of a make whole amount. An event of default will occur under the Master Trust Funding Program if, among other things, the Master Trust Issuers fail to pay interest or principal on the Notes when due, materially default in complying with the material covenants contained in the documents evidencing the Notes or the mortgages on the mortgaged property collateral or if a bankruptcy or other insolvency event occurs. Under the master trust indenture, we have a number of Master Trust Issuer covenants including requirements to pay any taxes and other charges levied or imposed upon the Master Trust Issuers and to comply with specified insurance requirements. We are also required to ensure that all uses and operations on or of our properties comply in all material respects with all applicable environmental laws. As of December 31, 2019, we were in material compliance with all such covenants. As of December 31, 2019, scheduled principal repayments on the Notes issued under the Master Trust Funding Program during 2020 were $3.9 million. We expect to meet these repayment requirements primarily through our net cash from operating activities. Cash Flows The following discussion of changes in cash flows includes the results of the Company and the Predecessor collectively for the periods presented. The term Predecessor refers to Essential Properties Realty Trust LLC, the predecessor of our Operating Partnership, and EPRT Holdings LLC, its parent prior to a series of transactions that took place to facilitate the IPO. Comparison of the years ended December 31, 2019 and 2018 As of December 31, 2019, we had $8.3 million of cash and cash equivalents and $13.0 million of restricted cash as compared to $4.2 million and $12.0 million, respectively, as of December 31, 2018. Cash Flows for the year ended December 31, 2019 During the year ended December 31, 2019, net cash provided by operating activities was $88.6 million. Our cash flows from operating activities primarily depend on the occupancy of our portfolio, the rental rates specified in our leases, and the collectability of such rent and our operating expenses and other general and administrative costs. Cash inflows related to net income adjusted for non-cash items of $86.1 million (net income of $48.0 million adjusted for non-cash items, including depreciation and amortization of tangible, intangible and right-of-use real estate assets, amortization of deferred financing costs and other assets, loss on repurchase of secured borrowings, provision for impairment of real estate, gain on dispositions of real estate, net, straight-line rent receivable, equity-based compensation expense and adjustment to rental revenue for tenant credit, of $38.1 million), an increase in accrued liabilities and other payables of $1.2 million and a decrease in prepaid expenses and other assets of $1.2 million. Net cash used in investing activities during the year ended December 31, 2019 was $607.8 million. Our net cash used in investing activities is generally used to fund our investments in real estate, including capital expenditures, the development of our construction in progress and investments in loans receivable, offset by cash provided from the disposition of real estate and principal collections on our loans and direct financing lease receivables. The cash used in investing activities included $570.0 million to fund investments in real estate, including capital expenditures, $17.9 million to fund construction in progress, $94.6 million of investments in loans receivable and $2.1 million paid to tenants as lease incentives. These cash outflows were partially offset by $66.8 million of proceeds from sales of investments, net of disposition costs and $9.5 million of principal collections on our loans and direct financing lease receivables. Net cash provided by financing activities of $524.4 million during the year ended December 31, 2019 related to cash inflows of $411.6 million from the issuance of common stock in the Follow-On Offering and through our ATM Program, $459.0 million of borrowings under the Revolving Credit Facility, $450.0 million of combined borrowings under the April 2019 Term Loan and November 2019 Term Loan and $1.7 million of principal collected on repurchased Master Trust Funding Notes. These cash inflows were partially offset by a net $277.4 million outflow related to principal payments and the repurchase and subsequent repayment of Master Trust Funding notes, payment of deferred financing costs of $6.1 million related to the Amended Credit Agreement, $447.0 million of repayments on the Revolving Credit Facility, the payment of $63.9 million in dividends and $1.8 million of offering costs related to the Follow-On Offering and the ATM Program. Cash Flows for the year ended December 31, 2018 During the year ended December 31, 2018, net cash provided by operating activities was $45.9 million. Our cash flows from operating activities primarily depend on the occupancy of our portfolio, the rental rates specified in our leases, and the collectability of such rent and our operating expenses and other general and administrative costs. Cash inflows related to a net income adjusted for non-cash items of $48.3 million (net income of $20.6 million adjusted for non-cash items, including depreciation and amortization of tangible and intangible real estate assets, amortization of deferred financing costs, provision for impairment of real estate, gains on dispositions of investments, net, straight-line rent receivable, equity-based compensation and allowance for doubtful accounts, of $27.7 million). These cash inflows were partially offset by a decrease of $1.6 million in accrued liabilities and other payables and an increase of $0.8 million in prepaid expenses and other assets. Net cash used in investing activities during the year ended December 31, 2018 was $461.9 million. Our net cash used in investing activities is generally used to fund our investments in real estate, including capital expenditures, the development of our construction in progress and investments in loans receivable, offset by cash provided from the disposition of real estate and principal collections on our loans and direct financing lease receivables. The cash used in investing activities included $490.0 million to fund investments in real estate, including capital expenditures, $15.3 million to fund construction in progress, $14.9 million of investments in loans receivable, $1.7 million for capital expenditures subsequent to acquisition, $0.5 million paid to tenants as lease incentives and an increase of $1.7 million in deposits on prospective real estate investments. These cash outflows were partially offset by $60.4 million of proceeds from sales of investments, net of disposition costs, and $0.1 million of principal collections on our direct financing lease receivables. Net cash provided by financing activities of $412.8 million during the year ended December 31, 2018 related to cash inflows of $464.2 million from the issuance of common stock in the IPO (inclusive of the shares issued pursuant to the partial exercise by the underwriters of their option to purchase additional shares), $109.0 million from a private placement of common stock that took place concurrently with the IPO, $16.0 million from a private placement of OP Units that took place concurrently with the IPO, $154.0 million from the issuance of notes payable to related parties, $34.0 million of borrowings under the Revolving Credit Facility and $50.0 million of capital contributions to the Predecessor. These cash inflows were partially offset by the payment of $5.5 million of IPO costs, $384.0 million of payments of principal on notes payable to related parties, $7.8 million of repayments of secured borrowing principal, payment of $3.1 million of deferred financing costs related to the Revolving Credit Facility and the payment of $14.1 million in dividends. Off-Balance Sheet Arrangements We had no off-balance sheet arrangements as of December 31, 2019. Contractual Obligations The following table provides information with respect to our commitments as of December 31, 2019: (1) Includes interest payments on outstanding indebtedness issued under our Master Trust Funding Program through the anticipated repayment dates. (2) Borrowings under the April 2019 Term Loan and November 2019 Term Loan bear interest at an annual rate of applicable LIBOR plus an applicable margin. (3) Balances on the Revolving Credit Facility bear interest at an annual rate of applicable LIBOR plus an applicable margin. We also pay a facility fee on the total unused commitment amount of 0.15% or 0.25%, depending on our current unused commitment. (4) Includes obligations to reimburse certain of our tenants for construction costs that they incur in connection with construction at our properties in exchange for contractually-specified rent that generally increases proportionally with our funding. (5) Includes $5.5 million of rental payments due under ground lease arrangements where our tenants are directly responsible for payment. Additionally, we may enter into commitments to purchase goods and services in connection with the operation of our business. These commitments generally have terms of one-year or less and reflect expenditure levels comparable to our historical expenditures, as adjusted for our growth. We have made an election to be taxed as a REIT for federal income tax purposes beginning with our taxable year ended December 31, 2018; accordingly, we generally will not be subject to federal income tax for the year ended December 31, 2019, if we distribute all of our REIT taxable income, determined without regard to the dividends paid deduction, to our stockholders. Critical Accounting Policies and Estimates Our accounting policies are determined in accordance with GAAP. The preparation of our financial statements requires us to make estimates and assumptions that are subjective in nature and, as a result, our actual results could differ materially from our estimates. Estimates and assumptions include, among other things, subjective judgments regarding the fair values and useful lives of our properties for depreciation and lease classification purposes, the collectability of receivables and asset impairment analysis. Set forth below are the more critical accounting policies that require management judgment and estimates in the preparation of our consolidated financial statements. Real Estate Investments Investments in real estate are carried at cost less accumulated depreciation and impairment losses, if any. The cost of investments in real estate reflects their purchase price or development cost. We evaluate each acquisition transaction to determine whether the acquired asset meets the definition of a business. Under Accounting Standards Update (“ASU”) 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business, an acquisition does not qualify as a business when there is no substantive process acquired or substantially all of the fair value is concentrated in a single identifiable asset or group of similar identifiable assets or the acquisition does not include a substantive process in the form of an acquired workforce or an acquired contract that cannot be replaced without significant cost, effort or delay. Transaction costs related to acquisitions that are asset acquisitions are capitalized as part of the cost basis of the acquired assets, while transaction costs for acquisitions that are deemed to be acquisitions of a business are expensed as incurred. Improvements and replacements are capitalized when they extend the useful life or improve the productive capacity of the asset. Costs of repairs and maintenance are expensed as incurred. We allocate the purchase price of acquired properties accounted for as asset acquisitions to tangible and identifiable intangible assets or liabilities based on their relative fair values. Tangible assets may include land, site improvements and buildings. Intangible assets may include the value of in-place leases and above- and below-market leases and other identifiable intangible assets or liabilities based on lease or property specific characteristics. We incur various costs in the leasing and development of our properties. Amounts paid to tenants that incentivize them to extend or otherwise amend an existing lease or to sign a new lease agreement are capitalized to lease incentive on our consolidated balance sheets. Tenant improvements are capitalized to building and improvements within our consolidated balance sheets. Costs incurred which are directly related to properties under development, which include pre-construction costs essential to the development of the property, development costs, construction costs, interest costs and real estate taxes and insurance, are capitalized during the period of development as construction in progress. After the determination is made to capitalize a cost, it is allocated to the specific component of a project that benefited. Determination of when a development project commences and capitalization begins, and when a development project has reached substantial completion and is available for occupancy and capitalization must cease, involves a degree of judgment. We do not engage in speculative real estate development. We do, however, opportunistically agree to reimburse certain of our tenants for development costs at our properties in exchange for contractually specified rent that generally increases proportionally with our funding. The fair value of the tangible assets of an acquired property with an in-place operating lease is determined by valuing the property as if it were vacant, and the “as-if-vacant” value is then allocated to the tangible assets based on the fair value of the tangible assets. The fair value of in-place leases is determined by considering estimates of carrying costs during the expected lease-up periods, current market conditions, as well as costs to execute similar leases based on the specific characteristics of each tenant’s lease. We estimate the cost to execute leases with terms similar to the remaining lease terms of the in-place leases, including leasing commissions, legal and other related expenses. Factors we consider in this analysis include an estimate of the carrying costs during the expected lease-up periods considering current market conditions and costs to execute similar leases. In estimating carrying costs, we include real estate taxes, insurance and other operating expenses, and estimates of lost rentals at market rates during the expected lease-up periods, which primarily range from six to 12 months. The fair value of above- or below-market leases is recorded based on the net present value (using a discount rate that reflects the risks associated with the leases acquired) of the difference between the contractual amount to be paid pursuant to the in-place lease and our estimate of the fair market lease rate for the corresponding in-place lease, measured over the remaining non-cancelable term of the lease including any below-market fixed rate renewal options for below-market leases. In making estimates of fair values for purposes of allocating purchase price, we use a number of sources, including real estate valuations prepared by independent valuation firms. We also consider information and other factors including market conditions, the industry that the tenant operates in, characteristics of the real estate, e.g., location, size, demographics, value and comparative rental rates, tenant credit profile and the importance of the location of the real estate to the operations of the tenant’s business. Additionally, we consider information obtained about each property as a result of our pre-acquisition due diligence, marketing and leasing activities in estimating the fair value of the tangible and intangible assets acquired. We use the information obtained as a result of our pre-acquisition due diligence as part of our consideration of the accounting standard governing asset retirement obligations and, when necessary, will record an asset retirement obligation as part of the purchase price allocation. Real estate investments that are intended to be sold are designated as “held for sale” on the consolidated balance sheets at the lesser of carrying amount and fair value less estimated selling costs. Real estate investments are no longer depreciated when they are classified as held for sale. If the disposal, or intended disposal, of certain real estate investments represents a strategic shift that has had or will have a major effect on our operations and financial results, the operations of such real estate investments would be presented as discontinued operations in the consolidated statements of operations and comprehensive income for all applicable periods. Depreciation and Amortization Depreciation is computed using the straight-line method over the estimated useful lives of up to 40 years for buildings and 15 years for site improvements. Lease incentives are amortized on a straight-line basis as a reduction of rental income over the remaining non-cancellable terms of the respective leases. If a tenant terminates its lease, the unamortized portion of the lease incentive is charged to rental revenue. Construction in progress is not depreciated until the development has reached substantial completion. Tenant improvements are depreciated over the non-cancellable term of the related lease or their estimated useful life, whichever is shorter. Capitalized above-market lease values are amortized on a straight-line basis as a reduction of rental revenue over the remaining non-cancellable terms of the respective leases. Capitalized below-market lease values are accreted on a straight-line basis as an increase to rental revenue over the remaining non-cancellable terms of the respective leases including any below-market fixed rate renewal option periods. Capitalized above-market ground lease values are accreted as a reduction of property expenses over the remaining terms of the respective leases. Capitalized below-market ground lease values are amortized as an increase to property expenses over the remaining terms of the respective leases and any expected below-market renewal option periods where renewal is considered probable. The value of in-place leases, exclusive of the value of above-market and below-market lease intangibles, is amortized to depreciation and amortization expense on a straight-line basis over the remaining periods of the respective leases. If a tenant terminates its lease, the unamortized portion of each intangible, including in-place lease values, is charged to depreciation and amortization expense, while above- and below-market lease adjustments are recorded within rental revenue in the consolidated statement of operations and comprehensive income. Loans Receivable We hold our loans receivable for long-term investment. Loans receivable are carried at amortized cost, including related unamortized discounts or premiums, if any. We recognize interest income on loans receivable using the effective-interest method applied on a loan-by-loan basis. Direct costs associated with originating loans are offset against any related fees received and the balance, along with any premium or discount, is deferred and amortized as an adjustment to interest income over the term of the related loan receivable using the effective-interest method. We periodically evaluate the collectability of our loans receivable, including accrued interest, by analyzing the underlying property-level economics and trends, collateral value and quality and other relevant factors in determining the adequacy of our allowance for loan losses. A loan is determined to be impaired when, in management’s judgment based on current information and events, it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. Specific allowances for loan losses are provided for impaired loans on an individual loan basis in the amount by which the carrying value exceeds the estimated fair value of the underlying collateral less disposition costs. Direct Financing Lease Receivables Certain of our real estate investment transactions are accounted for as direct financing leases. We record the direct financing lease receivables at their net investment, determined as the aggregate minimum lease payments and the estimated non-guaranteed residual value of the leased property less unearned income. The unearned income is recognized over the life of the related lease contracts so as to produce a constant rate of return on the net investment in the asset. Our investment in direct financing lease receivables is reduced over the applicable lease term to its non-guaranteed residual value by the portion of rent allocated to the direct financing lease receivables. If and when an investment in direct financing lease receivables is identified for impairment evaluation, we will apply the guidance in both the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 310, Receivables (“ASC 310”) and ASC 840, Leases (“ASC 840”). Under ASC 310, the lease receivable portion of the net investment in a direct financing lease receivable is evaluated for impairment when it becomes probable we, as the lessor, will be unable to collect all rental payments associated with our investment in the direct financing lease receivable. Under ASC 840, we review the estimated non-guaranteed residual value of a leased property at least annually. If the review results in a lower estimate than had been previously established, we determine whether the decline in estimated non-guaranteed residual value is other than temporary. If a decline is judged to be other than temporary, the accounting for the transaction is revised using the changed estimate and the resulting reduction in the net investment in direct financing lease receivables is recognized by us as a loss in the period in which the estimate is changed. Impairment of Long-Lived Assets If circumstances indicate that the carrying value of a property may not be recoverable, we review the asset for impairment. This review is based on an estimate of the future undiscounted cash flows, excluding interest charges, expected to result from the property’s use and eventual disposition. These estimates consider factors such as expected future operating income, market and other applicable trends and residual value, as well as the effects of leasing demand, competition and other factors. If impairment exists due to the inability to recover the carrying value of a property, an impairment loss is recorded to the extent that the carrying value exceeds the estimated fair value of the property for properties to be held and used. For properties held for sale, the impairment loss is the adjustment to fair value less estimated cost to dispose of the asset. Impairment assessments have a direct impact on the consolidated statements of operations and comprehensive income, because recording an impairment loss results in an immediate negative adjustment to the consolidated statements of operations and comprehensive income. Cash and Cash Equivalents Cash and cash equivalents includes cash in the our bank accounts. We consider all cash balances and highly liquid investments with original maturities of three months or less to be cash and cash equivalents. We deposit cash with high quality financial institutions. These deposits are guaranteed by the Federal Deposit Insurance Corporation (“FDIC”) up to an insurance limit. Restricted Cash Restricted cash primarily consists of cash held with the trustee for our Master Trust Funding Program. This restricted cash is used to make principal and interest payments on our secured borrowings, to pay trust expenses and to acquire future real estate investments which will be pledged as collateral under the Master Trust Funding Program. See Note 6-Secured Borrowings to our financial statements for the year ended December 31, 2019, included elsewhere in this Annual Report on Form 10-K, for further discussion of our Master Trust Funding Program. Adjustment to Rental Revenue for Tenant Credit/Allowance for Doubtful Accounts We continually review receivables related to rent and unbilled rent receivables and determines collectability by taking into consideration the tenant’s payment history, the financial condition of the tenant, business conditions in the industry in which the tenant operates and economic conditions in the area in which the property is located. Prior to January 1, 2019, if the collectability of a receivable was in doubt, the accounts receivable and straight-line rent receivable balances were reduced by an allowance for doubtful accounts on the consolidated balance sheets or a direct write-off of the receivable was recorded in the consolidated statements of operations. The provision for doubtful accounts was included in property expenses in our consolidated statements of operations. If the accounts receivable balance or straight-line rent receivable balance was subsequently deemed to be uncollectible, such receivable amounts were written-off to the allowance for doubtful accounts. As of January 1, 2019, if the assessment of the collectability of substantially all payments due under a lease changes from probable to not probable, any difference between the rental revenue recognized to date and the lease payments that have been collected is recognized as a current period adjustment to rental revenue in the consolidated statements of operations. Deferred Financing Costs Financing costs related to establishing our Revolving Credit Facility were deferred, are being amortized as an increase to interest expense in the consolidated statements of operations over the term of the facility and are reported as a component of prepaid expenses and other assets, net on the consolidated balance sheets. Financing costs related to the issuance of our secured borrowings under the Master Trust Funding Program, the April 2019 Term Loan and November 2019 Term Loan were deferred, are being amortized as an increase to interest expense in the consolidated statements of operations over the term of the related debt instrument and are reported as a reduction of the related debt balance on the consolidated balance sheets. Derivative Instruments In the normal course of business, we use derivative financial instruments, which may include interest rate swaps, caps, options, floors and other interest rate derivative contracts, to protect us against adverse fluctuations in interest rates by reducing our exposure to variability in cash flows on a portion of our floating-rate debt. Instruments that meet these hedging criteria are formally designated as hedges at the inception of the derivative contract. We record all derivatives on the consolidated balance sheets at fair value. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether we have elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Hedge accounting generally provides for the matching of the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk in a fair value hedge or the earnings effect of the hedged forecasted transactions in a cash flow hedge. We may also enter into derivative contracts that are intended to economically hedge certain risk, even though hedge accounting does not apply or we elect not to apply hedge accounting. The accounting for subsequent changes in the fair value of these derivatives depends on whether each has been designed and qualifies for hedge accounting treatment. If a derivative is designated and qualifies for cash flow hedge accounting treatment, the change in the estimated fair value of the derivative is recorded in other comprehensive income (loss) in the consolidated statements of comprehensive income to the extent that it is effective. Any ineffective portion of a change in derivative fair value is immediately recorded in earnings. If we elect not to apply hedge accounting treatment (or for derivatives that do not qualify as hedges), any change in the fair value of these derivative instruments is recognized immediately in gains (losses) on derivative instruments in the consolidated statements of operations. We do not intend to use derivative instruments for trading or speculative purposes. Fair Value Measurement We estimate fair value of financial and non-financial assets and liabilities based on the framework established in fair value accounting guidance. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (an exit price). The hierarchy described below prioritizes inputs to the valuation techniques used in measuring the fair value of assets and liabilities. This hierarchy maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring the most observable inputs to be used when available. The hierarchy is broken down into three levels based on the reliability of inputs as follows: Level 1-Quoted prices in active markets for identical assets and liabilities that we have the ability to access at the measurement date. Level 2-Inputs other than quoted prices included within Level 1 that are observable for the asset and liability or can be corroborated with observable market data for substantially the entire contractual term of the asset or liability. Level 3-Unobservable inputs that reflect our own assumptions that market participants would use in the pricing of the asset or liability and are consequently not based on market activity, but rather through particular valuation techniques. Revenue Recognition Our rental revenue is primarily related to rent received from tenants. Rent from tenants is recorded in accordance with the terms of each lease on a straight-line basis over the non-cancellable initial term of the lease from the later of the date of the commencement of the lease and the date of acquisition of the property subject to the lease. Rental revenue recognition begins when the tenant controls the space and continues through the term of the related lease. Because substantially all of the leases provide for rental increases at specified intervals, we record a straight-line rent receivable and recognize revenue on a straight-line basis through the expiration of the non-cancellable term of the lease. We take into account whether the collectability of rents is reasonably assured in determining the amount of straight-line rent to record. We defer rental revenue related to lease payments received from tenants in advance of their due dates. These amounts are presented within accrued liabilities and other payables on our consolidated balance sheets. Certain properties in our investment portfolio are subject to leases that provide for contingent rent based on a percentage of the tenant’s gross sales. For these leases, we recognize contingent rental revenue when the threshold upon which the contingent lease payment is based is actually reached. Gains and Losses on Dispositions of Real Estate Through December 31, 2017, gains and losses on dispositions of real estate investments were recorded in accordance with ASC 360-20, Property, Plant and Equipment-Real Estate Sales, and include realized proceeds from real estate disposed of in the ordinary course of business, less their related net book value and less any costs incurred in association with the disposition. On January 1, 2018, we adopted ASU 2017-05, “Other Income - Gains and Losses from the Derecognition of Nonfinancial Assets (Subtopic 610-20): Clarifying the Scope of Asset Derecognition Guidance and Accounting for Partial Sales of Nonfinancial Assets” (“ASU 2017-05”), using the modified retrospective transition method. As leasing is our primary activity, we determined that our sales of real estate, which are nonfinancial assets, are sold to noncustomers and fall within the scope of ASC 610-20. We recognize the full gain on the disposition of our real estate investments as we (i) have no controlling financial interest in the real estate and (ii) have no continuing interest or obligation with respect to the disposed real estate. We re-assessed and determined that there were no open contracts or partial sales and that the adoption of ASU 2017-05 (i) did not result in a cumulative adjustment as of January 1, 2018 and (ii) did not have any impact on our consolidated financial statements. Income Taxes We have elected and qualified to be taxed as a REIT under sections 856 through 860 of the Code, commencing with our taxable year ended December 31, 2018. REITs are subject to a number of organizational and operational requirements, including a requirement that 90% of ordinary “REIT taxable income” (as determined without regard to the dividends paid deduction or net capital gains) be distributed. As a REIT, we will generally not be subject to U.S. federal entity-level income tax to the extent that we meet the organizational and operational requirements and our distributions equal or exceed REIT taxable income. For the period subsequent to the effective date of our intended REIT election, we intend to meet the organizational and operational requirements and expect distributions to exceed net taxable income. Accordingly, no provision has been made for U.S. federal income taxes. Even if we qualify for taxation as a REIT, we may be subject to state and local income and franchise taxes, and to federal income and excise tax on our undistributed income. Franchise taxes and federal excise taxes on our undistributed income, if any, are included in general and administrative expenses on the accompanying consolidated statements of operations and comprehensive income. Additionally, taxable income from our non-REIT activities managed through our taxable REIT subsidiary is subject to federal, state and local taxes. From the Predecessor’s commencement of operations through January 31, 2017, the Predecessor and its subsidiaries included in the consolidated financial statements were treated as disregarded entities for U.S. federal and state income tax purposes, and, accordingly, the Predecessor was not subject to entity-level tax. Therefore, until the Predecessor’s issuance of Class A and Class C units on January 31, 2017, the Predecessor’s net income flowed through to SCF Funding LLC, its initial sole member, for federal income tax purposes. Following the issuance of Class A and Class C units, the Predecessor’s net income flowed through to Class A and Class C unitholders for federal income tax purposes. With regard to state income taxes, the Predecessor was a taxable entity only in certain states that tax all entities, including partnerships. We analyze our tax filing positions in all of the U.S. federal, state and local tax jurisdictions where we are required to file income tax returns, as well as for all open tax years in such jurisdictions. We follow a two-step process to evaluate uncertain tax positions. Step one, recognition, occurs when an entity concludes that a tax position, based solely on its technical merits, is more-likely-than-not to be sustained upon examination. Step two, measurement, determines the amount of benefit that is more-likely-than-not to be realized upon settlement. Derecognition of a tax position that was previously recognized would occur when we subsequently determine that a tax position no longer meets the more-likely-than-not threshold of being sustained. The use of a valuation allowance as a substitute for derecognition of tax positions is prohibited. Equity-Based Compensation In 2019 and 2018, we granted shares of restricted common stock and restricted share units (“RSUs”) to our directors, executive officers and other employees that vest over multiple periods, subject to the recipient’s continued service. In 2019, we also granted performance-based RSUs to our executive officers, the final number of which is determined based on market and subjective performance conditions and which vest over a multi-year period, subject to the recipient’s continued service. In 2017, the Predecessor granted unit-based compensation awards to certain of its employees and managers, as well as non-employees, consisting of units that vest over a multi-year period, subject to the recipient’s continued service. We account for the restricted common stock, RSUs and unit-based compensation in accordance with ASC 718, Compensation - Stock Compensation, which requires that such compensation be recognized in the financial statements based on their estimated grant-date fair value. The value of such awards is recognized as compensation expense in general and administrative expenses in the accompanying consolidated statements of operations over the requisite service periods. We recognize compensation expense for equity-based compensation using the straight-line method based on the terms of the individual grant. Variable Interest Entities The FASB provides guidance for determining whether an entity is a variable interest entity (a “VIE”). VIEs are defined as entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support. A VIE is required to be consolidated by its primary beneficiary, which is the party that (i) has the power to control the activities that most significantly impact the VIE’s economic performance and (ii) has the obligation to absorb losses, or the right to receive benefits, of the VIE that could potentially be significant to the VIE. Following the completion of the Formation Transactions, we concluded that the Operating Partnership is a VIE of which we are the primary beneficiary, as we have the power to direct the activities that most significantly impact the economic performance of the Operating Partnership. Substantially all of our assets and liabilities are held by the Operating Partnership. The assets and liabilities of the Operating Partnership are consolidated and reported as assets and liabilities on our consolidated balance sheet as of December 31, 2019. As of December 31, 2019, we concluded that seven entities to which we had provided mortgage loans were VIEs because the entities’ equity was not sufficient to finance their activities without additional subordinated financial support. However, we were not the primary beneficiary of the entities, because we did not have the power to direct the activities that most significantly impact the entities’ economic performance. As of December 31, 2019, the carrying amount of our loans receivable with these entities was $60.5 million and our maximum exposure to loss in these entities is limited to the carrying amount of our investment. We had no liabilities associated with these VIEs as of December 31, 2019. Net Income per Share Net income per share has been computed pursuant to the guidance in the FASB ASC Topic 260, Earnings Per Share. The guidance requires the classification of our unvested restricted common stock and units, which contain rights to receive non-forfeitable dividends, as participating securities requiring the two-class method of computing net income per share. Diluted net income per share of common stock further considers the effect of potentially dilutive shares of common stock outstanding during the period, including the assumed vesting of restricted share units with a market-based or service-based vesting condition, where dilutive. The OP Units held by non-controlling interests represent potentially dilutive securities, as the OP Units may be redeemed for cash or, at our election, exchanged for shares of our common stock on a one-for-one basis. Recently Issued Accounting Pronouncements In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842) (“ASU 2016-02”) to amend the accounting for leases. This standard requires lessees to classify leases as either finance or operating leases based on certain criteria and record a right-of-use asset and a lease liability for all leases with a term of greater than 12 months, regardless of their classification. The new standard requires lessors to account for leases using an approach that is substantially equivalent to the previous guidance for sales-type leases, direct financing leases and operating leases. The standard also eliminates current real estate-specific provisions and changes the guidance on sale-leaseback transactions, initial direct costs, lease modifications and lease executory costs for all entities. Certain changes to the guidance pertaining to sale-leaseback transactions may impact us. For example, the inclusion of a purchase option in the lease associated with a sale-leaseback transaction will now result in the lessor accounting for such transaction as a financing arrangement. ASU 2016-02 was effective for us on January 1, 2019 and, in accordance with the provisions of ASU 2018-11, Leases (Topic 842), Targeted Improvements, was adopted by us using the modified retrospective approach as of the beginning of the period of adoption. There was no impact to retained earnings at the time of adoption and, therefore, no cumulative-effect adjustment was recorded. At the time of adoption, both lessees and lessors are permitted to make an election to apply a package of practical expedients available for implementation under the standard. We applied this package of practical expedients and, as such, at the time of adoption did not reassess the classification of existing lease contracts, whether existing or expired contracts contain a lease or whether a portion of initial direct costs for existing leases should have been expensed. In addition, we adopted the practical expedient provided in ASU 2018-11 that allows lessors to not separate non-lease components from the related lease components. We made this determination as the timing and pattern of transfer for the lease and non-lease components associated with our leases are the same and the lease components, if accounted for separately, would be classified as operating leases in accordance with ASC 842. The accounting applied by a lessor is largely unchanged under ASU 2016-02; however, the standard requires that lessors expense, on an as-incurred basis, certain initial direct costs that are not incremental in obtaining a lease. Under the previous standards, certain of these costs were capitalizable. Although primarily a lessor, we are also a lessee under several ground lease arrangements and under our corporate office and office equipment leases. We completed our inventory and evaluation of these leases, calculated a right-of-use asset and a lease liability for the present value of the minimum lease payments and recognized an initial $4.8 million right-of-use asset and lease liability upon adoption on January 1, 2019. For a portion of our ground lease arrangements, the sublessees, or our tenants, are responsible for making payment directly to the ground lessors. Prior to the new standard such amounts were presented on a net basis; however, upon adoption of ASU 2016-02 the expense related to the ground lease obligations, along with the related sublease revenues, is presented on a gross basis in the consolidated statements of operations. ASU 2016-02 also requires additional disclosures within the notes accompanying the consolidated financial statements. Substantially all of our lease contracts (under which we are the lessor) are “triple-net” leases, which means that our tenants are responsible for making payments to third parties for operating expenses such as property taxes and insurance costs associated with the properties we lease to them. Under the previous lease accounting guidance, these payments were excluded from rental revenue. In December 2018, the FASB issued ASU 2018-20 Leases (Topic 842), Narrow-Scope Improvements for Lessors. This update requires us to exclude from variable lease payments, and therefore revenue and expense, costs paid by our tenants directly to third parties (a net presentation). Costs paid by us and reimbursed by our tenants are included in rental revenue and property expenses (a gross presentation) in our consolidated statements of operations. In June 2018, the FASB issued ASU 2018-07, Compensation - Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting (“ASU 2018-07”), which expands the scope of Topic 718 to include share-based payment transactions for acquiring goods and services from nonemployees, with the result of aligning the guidance on share-based payments to nonemployees with that for share-based payments to employees, with certain exceptions, and eliminating the need to re-value awards to nonemployees at each balance sheet date. ASU 2018-07 is effective for annual periods, and interim periods within those years, beginning after December 15, 2018, with early adoption permitted for companies who have previously adopted ASU 2017-09. We early adopted ASU 2018-07 effective July 1, 2018 for accounting for our liability-classified non-employee awards that had not vested as of that date. No adjustment to our retained earnings was required as a result of the adoption of ASU 2018-07. In August 2017, the FASB issued ASU 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities (ASU 2017-12), which amends and simplifies existing guidance in order to allow companies to more accurately present the economic effects of risk management activities in the financial statements. We adopted ASU 2017-12 while accounting for the interest rate swaps that we entered into in 2019. As we did not have other derivatives outstanding at the time of adoption, no prior period adjustments were required. Pursuant to the provisions of ASU 2017-12, we are no longer required to separately measure and recognize hedge ineffectiveness. Instead, we recognize the entire change in the fair value of cash flow hedges included in the assessment of hedge effectiveness in other comprehensive (loss) income. The amounts recorded in other comprehensive (loss) income will subsequently be reclassified to earnings when the hedged item affects earnings. The adoption of ASU 2017-12 did not have a material impact on our consolidated financial statements. In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement: Changes to the Disclosure Requirements for Fair Value Measurement (“ASU 2018-13”), which changes the disclosure requirements for fair value measurements by removing, adding and modifying certain disclosures. ASU 2018-13 is effective for annual periods beginning after December 15, 2019, with early adoption permitted. We are currently evaluating the impact of adopting ASU 2018-13 on our related disclosures. In February 2016, the FASB issued ASU 2016-13, Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”) establishing ASC Topic 326, Financial Instruments - Credit Losses (“ASC 326”), as amended by subsequent ASUs on the topic. ASU 2016-13 changes how entities will account for credit losses for most financial assets and certain other instruments that are not measured at fair value through net income. The guidance replaces the current “incurred loss” model with an “expected loss” model that requires consideration of a broader range of information to estimate expected credit losses over the lifetime of the financial asset. ASU 2016-13 is effective for interim and annual reporting periods in fiscal years beginning after December 15, 2019. The adoption will not materially impact our consolidated financial statements with an adjustment to beginning retained earnings of less than 0.50% of our total loan portfolio. Additionally, the adoption had no material impact on our internal control framework. Results of Operations The following discussion includes the changes in the results of the Company’s and the Predecessor’s operations collectively for the years ended December 31, 2019 and 2018. A discussion of the changes in our results of operations for the years ended December 31, 2018 and 2017 has been omitted from this Annual Report but may be found in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations-Results of Operations-Comparison of the years ended December 31, 2018 and 2017” in our Annual Report on Form 10-K for the year ended December 31, 2018. Comparison of the years ended December 31, 2019 and 2018 Revenues: Rental revenue. Rental revenue increased by $40.7 million for the year ended December 31, 2019, as compared to the year ended December 31, 2018. The increase in revenues period over period was driven primarily by the growth in the size of our real estate investment portfolio, which generated additional rental revenues. Our real estate investment portfolio grew from 677 properties, representing $1.4 billion in net investments in real estate, as of December 31, 2018 to 1,000 properties, representing $1.9 billion in net investments in real estate, as of December 31, 2019. Our real estate investments were made throughout the periods presented and were not all outstanding for the entire period; accordingly, a significant portion of the increase in revenues between periods is related to recognizing revenue in 2019 on acquisitions that were made during 2018. A smaller component of the increase in revenues between periods is related to rent escalations recognized on our lease contracts; these rent increases can be a source of revenue growth. Interest on loans and direct financing lease receivables. Interest on loans and direct financing lease receivables increased by $2.4 million during the year ended December 31, 2019, as compared to the year ended December 31, 2018, primarily due to our investments in loans receivable beginning in 2018 and additional investments in loans receivable during 2019, which led to a higher average daily balance of loans receivable outstanding during year ended December 31, 2019. Other revenue. Other revenue for the year ended December 31, 2019, increased by approximately $40,000, as compared to year ended December 31, 2018, primarily due to the receipt of lease termination fees from former tenants during the year ended December 31, 2019. No lease termination income was recorded during the year ended December 31, 2018. Expenses: Interest expense. Interest expense decreased by $3.2 million for the year ended December 31, 2019, as compared to the year ended December 31, 2018. In May 2019, the Company borrowed the entire amount available under its April 2019 Term Loan and used the proceeds to repurchase Master Trust Funding notes with a face value of $200 million. The repurchase and retirement of Master Trust Funding notes resulted in a decrease of $6.2 million in cash interest expense and a $0.8 million decrease of amortization of deferred financing costs for the year ended December 31, 2019. In May 2019, we repurchased $200 million of Series 2016-1 Notes and in November 2019, we canceled the repurchased Series 2016-1 Notes and repaid the remaining Series 2016-1 Notes that were outstanding. Repayment of notes payable to related parties in 2018 resulted in a decrease in cash interest expense of $4.6 million for year ended December 31, 2019, as compared to the year ended December 31, 2018. These decreases were partially offset by additional borrowings under the 2018 Credit Facility (as defined below) and the Revolving Credit Facility which resulted in additional interest expense of $2.6 million and unused facility fees of $0.3 million for the year ended December 31, 2019. Borrowing of funds under the April 2019 Term Loan and November 2019 Term Loan resulted in additional cash interest expense of $4.9 million during for the year ended December 31, 2019. In addition, amortization of deferred financing costs incurred for obtaining the 2018 Credit Facility, the Amended Credit Agreement and the November 2019 Term Loan resulted in additional expenses of $0.8 million, for the year ended December 31, 2019 as compared for year ended December 31, 2018. General and administrative expenses. General and administrative expenses increased $8.0 million for the year ended December 31, 2019. as compared to the year ended December 31, 2018. This increase in general and administrative expenses was primarily due to the increased costs of operating as a public company in 2019 and operating our larger real estate portfolio, including increased equity-based compensation expense, legal fees and directors’ fees. Property expenses. Property expenses increased by $1.1 million for the year ended December 31, 2019, as compared to the year ended December 31, 2018. The increase in property expenses was primarily due to reimbursable costs, insurance expenses and operational costs during the year ended December 31, 2019. Depreciation and amortization expense. Depreciation and amortization expense increased by $11.4 million for the year ended December 31, 2019 as compared to the year ended December 31, 2018. Depreciation and amortization expense increased in proportion to the increase in the size of our real estate portfolio. Provision for impairment of real estate. Impairment charges on real estate investments were $2.9 million and $4.5 million, for the years ended December 31, 2019 and 2018, respectively. During the years ended December 31, 2019 and 2018, we recorded a provision for impairment of real estate at 8 and 20 of our real estate investments, respectively. We strategically seek to identify non-performing properties that we may re-lease or dispose of in an effort to improve our returns and manage risk exposure. An increase in vacancy associated with our disposition or re-leasing strategies may trigger impairment charges when the expected future cash flows from the properties from sale or re-lease are less than their net book value. Other operating income: Gain on dispositions of real estate, net. Gain on dispositions of real estate, net, increased by $5.5 million for the year ended December 31, 2019, as compared to the year ended December 31, 2018. We disposed of 37 real estate properties during the year ended December 31, 2019, compared to 45 real estate properties during the year ended December 31, 2018. Other income and expenses: Loss on repurchase of secured borrowings. Loss on repurchase of secured borrowings of $5.2 million during the year ended December 31, 2019, relates to the repurchase by the Company of its Class A Series 2016-1 Notes with a face value of $200.0 million for $201.4 million. The repurchase was accounted for as a debt extinguishment and, accordingly, the Company recorded a loss on repurchase of $4.4 million, which includes the premium paid on the repurchase, and other associated legal expenses. Furthermore, the repurchased notes were subsequently canceled and the Series 2016-1 Notes that remained outstanding were fully repaid in November 2019. The Company wrote off $0.8 million related to the remaining unamortized deferred financing costs and included it in the loss related to the repurchase. Interest income. Interest income decreased by $0.1 million for the year ended December 31, 2019, as compared to the year ended December 31, 2018. The decrease in interest income was primarily due to higher average daily cash balances in our interest-bearing bank accounts for, the year ended December 31, 2018 because of funds we had on hand following our IPO in June 2018. Income tax expense. Income tax expense increased by $0.1 million for the year ended December 31, 2019 , as compared to the year ended December 31, 2018. We are organized and operate as a REIT and are generally not subject to U.S. federal taxation. However, the Operating Partnership is subject to taxation in certain state and local jurisdictions that impose income taxes on a partnership. The changes in income tax expense are primarily due to changes in the proportion of our real estate portfolio located in jurisdictions where we are subject to taxation. Comparison of the years ended December 31, 2018 and 2017 See our Annual Report on Form 10-K for the year ended December 31, 2018, “Item 7. Management Discussion and Analysis: Results of Operations” for the comparison discussion between the years ended December 31, 2018 and 2017. Non-GAAP Financial Measures Our reported results are presented in accordance with GAAP. We also disclose the following non-GAAP financial measures: funds from operations (“FFO”), core funds from operations (“Core FFO”), adjusted funds from operations (“AFFO”), earnings before interest, taxes, depreciation and amortization (“EBITDA”), EBITDA further adjusted to exclude gains (or losses) on sales of depreciable property and real estate impairment losses (“EBITDAre”), adjusted EBITDAre, annualized adjusted EBITDAre, net debt, net operating income (“NOI”) and cash NOI (“Cash NOI”). We believe these non-GAAP financial measures are industry measures used by analysts and investors to compare the operating performance of REITs. We compute FFO in accordance with the definition adopted by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”). NAREIT defines FFO as GAAP net income or loss adjusted to exclude extraordinary items (as defined by GAAP), net gain or loss from sales of depreciable real estate assets, impairment write-downs associated with depreciable real estate assets and real estate-related depreciation and amortization (excluding amortization of deferred financing costs and depreciation of non-real estate assets), including the pro rata share of such adjustments of unconsolidated subsidiaries. FFO is used by management, and may be useful to investors and analysts, to facilitate meaningful comparisons of operating performance between periods and among our peers primarily because it excludes the effect of real estate depreciation and amortization and net gains and losses on sales (which are dependent on historical costs and implicitly assume that the value of real estate diminishes predictably over time, rather than fluctuating based on existing market conditions). We compute Core FFO by adjusting FFO, as defined by NAREIT, to exclude certain GAAP income and expense amounts that we believe are infrequent and unusual in nature and/or not related to our core real estate operations. Exclusion of these items from similar FFO-type metrics is common within the equity REIT industry, and management believes that presentation of Core FFO provides investors with a metric to assist in their evaluation of our operating performance across multiple periods and in comparison to the operating performance of our peers, because it removes the effect of unusual items that are not expected to impact our operating performance on an ongoing basis. Core FFO is used by management in evaluating the performance of our core business operations. Items included in calculating FFO that may be excluded in calculating Core FFO include certain transaction related gains, losses, income or expense or other non-core amounts as they occur. To derive AFFO, we modify our computation of Core FFO to include other adjustments to GAAP net income related to certain items that we believe are not indicative of our operating performance, including straight-line rental revenue, non-cash interest expense, non-cash compensation expense, other amortization and non-cash charges, capitalized interest expense and transaction costs. Such items may cause short-term fluctuations in net income but have no impact on operating cash flows or long-term operating performance. We believe that AFFO is an additional useful supplemental measure for investors to consider when assessing our operating performance without the distortions created by non-cash items and certain other revenues and expenses. FFO, Core FFO and AFFO do not include all items of revenue and expense included in net income, they do not represent cash generated from operating activities and they are not necessarily indicative of cash available to fund cash requirements; accordingly, they should not be considered alternatives to net income as a performance measure or cash flows from operations as a liquidity measure and should be considered in addition to, and not in lieu of, GAAP financial measures. Additionally, our computation of FFO, Core FFO and AFFO may differ from the methodology for calculating these metrics used by other equity REITs and, therefore, may not be comparable to similarly titled measures reported by other equity REITs. The following table reconciles net income (which is the most comparable GAAP measure) to FFO, Core FFO and AFFO attributable to stockholders and members and non-controlling interests: (1) Includes non-recurring expenses of $2.4 million for costs and charges incurred in connection with the Eldridge secondary offering, our $5.2 million loss on repurchase and retirement of secured borrowings and $0.3 million for a provision for settlement of litigation during the year ended December 31, 2019. We compute EBITDA as earnings before interest, income taxes and depreciation and amortization. In 2017, NAREIT issued a white paper recommending that companies that report EBITDA also report EBITDAre. We compute EBITDAre in accordance with the definition adopted by NAREIT. NAREIT defines EBITDAre as EBITDA (as defined above) excluding gains (or losses) from the sales of depreciable property and real estate impairment losses. We present EBITDA and EBITDAre as they are measures commonly used in our industry. We believe that these measures are useful to investors and analysts because they provide supplemental information concerning our operating performance, exclusive of certain non-cash items and other costs. We use EBITDA and EBITDAre as measures of our operating performance and not as measures of liquidity. EBITDA and EBITDAre do not include all items of revenue and expense included in net income, they do not represent cash generated from operating activities and they are not necessarily indicative of cash available to fund cash requirements; accordingly, they should not be considered alternatives to net income as a performance measure or cash flows from operations as a liquidity measure and should be considered in addition to, and not in lieu of, GAAP financial measures. Additionally, our computation of EBITDA and EBITDAre may differ from the methodology for calculating these metrics used by other equity REITs and, therefore, may not be comparable to similarly titled measures reported by other equity REITs. The following table reconciles net income (which is the most comparable GAAP measure) to EBITDA and EBITDAre attributable to stockholders and members and non-controlling interests: We further adjust EBITDAre for the most recently completed quarter i) based on an estimate calculated as if all investment and disposition activity that took place during the quarter had been made on the first day of the quarter, ii) to exclude certain GAAP income and expense amounts that we believe are infrequent and unusual in nature and iii) to eliminate the impact of lease termination fees and contingent rental revenue from certain of our tenants, which is subject to sales thresholds specified in the applicable leases (“Adjusted EBITDAre”). We then annualize quarterly Adjusted EBITDAre by multiplying it by four (“Annualized Adjusted EBITDAre”), which we believe provides a meaningful estimate of our current run rate for all of our investments as of the end of the most recently completed quarter. You should not unduly rely on this measure, as it is based on assumptions and estimates that may prove to be inaccurate. Our actual reported EBITDAre for future periods may be significantly less than our current Annualized Adjusted EBITDAre. The following table reconciles net income (which is the most comparable GAAP measure) to Annualized Adjusted EBITDAre attributable to stockholders and non-controlling interests for the three months ended December 31, 2019: (1) Adjustment assumes all investments and dispositions of real estate investments made during the three months ended December 31, 2019 had occurred on October 1, 2019. (2) Adjustment excludes contingent rent (based on a percentage of the tenant’s gross sales at the leased property) where payment is subject to exceeding a sales threshold specified in the lease. We calculate our net debt as our gross debt (defined as total debt plus net deferred financing costs on our secured borrowings) less cash and cash equivalents and restricted cash deposits held for the benefit of lenders. We believe excluding cash and cash equivalents and restricted cash deposits held for the benefit of lenders from gross debt, all of which could be used to repay debt, provides an estimate of the net contractual amount of borrowed capital to be repaid, which we believe is a beneficial disclosure to investors and analysts. The following table reconciles total debt (which is the most comparable GAAP measure) to net debt: We compute NOI as total revenues less property expenses. NOI excludes all other items of expense and income included in the financial statements in calculating net income or loss in accordance with GAAP. Cash NOI further excludes non-cash items included in total revenues and property expenses, such as straight-line rental revenue and other amortization and non-cash charges. We believe NOI and Cash NOI provide useful and relevant information because they reflect only those revenue and expense items that are incurred at the property level and present such items on an unlevered basis. NOI and Cash NOI are not measures of financial performance under GAAP. You should not consider our NOI and Cash NOI as alternatives to net income or cash flows from operating activities determined in accordance with GAAP. Additionally, our computation of NOI and Cash NOI may differ from the methodology for calculating these metrics used by other equity REITs and, therefore, may not be comparable to similarly titled measures reported by other equity REITs. The following table reconciles net income (which is the most comparable GAAP measure) to NOI and Cash NOI attributable to stockholders and members and non-controlling interests:
0.054668
0.054771
0
<s>[INST] Overview We are an internally managed real estate company that acquires, owns and manages primarily singletenant properties that are net leased on a longterm basis to middlemarket companies operating serviceoriented or experiencebased businesses. We generally acquire and lease freestanding, singletenant commercial real estate facilities where a tenant services its customers and conducts activities that are essential to the generation of the tenant’s sales and profits. We were organized on January 12, 2018 as a Maryland corporation. We have elected to be taxed as a real estate investment trust (“REIT”) for federal income tax purposes beginning with the year ended December 31, 2018, and we believe that our current organization, operations and intended distributions has allowed and will continue to allow us to continue to so qualify. On June 25, 2018, we completed the initial public offering (“IPO”) of our common stock. Our common stock is listed on the New York Stock Exchange under the ticker symbol “EPRT”. We generally lease each of our properties to a single tenant on a triplenet longterm lease basis, and we generate our cash from operations primarily through the monthly lease payments, or base rent we receive from the tenants that occupy our properties. As of December 31, 2019, we had a portfolio of 1,000 properties (inclusive of one undeveloped land parcel and ninetyone properties which secure our investments in mortgage loans receivable) that was diversified by tenant, industry, concept and geography, had annualized base rent of $151.2 million and was 100.0% occupied. Substantially all our leases provide for periodic contractual rent escalations. As of December 31, 2019, leases contributing 98.6% of our annualized base rent provided for increases in future annual base rent, generally ranging from 1% to 4%, with a weighted average annual escalation equal to 1.5% of base rent. As of December 31, 2019, leases contributing 93.5% of annualized base rent were triplenet, which means that our tenant is responsible for all operating expenses, such as maintenance, insurance, utility and tax, related to the leased property (including any increases in those costs that may occur as a result of inflation). Our remaining leases were “double net,” where the tenant is responsible for certain expenses, such as taxes and insurance, but we retain responsibility for other expenses, generally related to maintenance and structural component replacement that may be required at such leased properties. Also, we incur propertylevel expenses associated with our vacant properties and we occasionally incur nominal propertylevel expenses that are not paid by our tenants, such as the costs of periodically making site inspections of our properties. We do not currently anticipate incurring significant capital expenditures or property costs. Since our properties are predominantly singletenant properties, which are generally subject to longterm leases, it is not necessary for us to perform any significant ongoing leasing activities on our properties. As of December 31, 2019, the weighted average remaining term of our leases was 14.6 years (based on annualized base rent), excluding renewal options that have not been exercised, with 6.8% of our annualized base rent attributable to leases expiring prior to January 1, 2025. Renewal options are exercisable at the option of our tenants upon expiration of their base lease term. Our leases providing for tenant renewal options generally provide for periodic contractual rent escalations during any renewed term that are similar to those applicable during the initial term of the lease. As of December 31, 2019, 60.3% of our annualized base rent was attributable to master leases, where we have leased multiple properties to a tenant under a master lease. Since properties are generally leased under a master lease on an “all or none” basis, the structure prevents a tenant from “cherry picking” locations, where it unilaterally gives up underperforming properties while maintaining its leasehold interest in wellperforming properties. Liquidity and Capital Resources As of December 31 [/INST] Positive. </s>
2,020
14,503
1,659,323
Iterum Therapeutics plc
2019-03-25
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 and the other financial information included elsewhere in this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10-K, including information with respect to our plans and strategy for our business and related financing, includes forward-looking statements that involve risks and uncertainties. As a result of many factors, including those factors set forth in the “Risk Factors” section of this Annual Report on Form 10-K, our actual results could 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 dedicated to developing and commercializing sulopenem to be potentially the first and only oral and intravenous (IV) branded penem available globally. Penems, including thiopenems and carbapenems, belong to a class of antibiotics more broadly defined as ß-lactam antibiotics, the original example of which was penicillin, but which now also includes cephalosporins. Sulopenem is a potent, thiopenem antibiotic delivered intravenously which is active against bacteria that belong to the group of organisms known as gram-negatives and cause urinary tract and intra-abdominal infections. We have successfully developed sulopenem in an oral tablet formulation, sulopenem etzadroxil-probenecid, which we refer to herein as oral sulopenem. Both sulopenem product candidates have the potential to be important new treatment alternatives to address growing concerns related to antibacterial resistance without the known toxicities of some of the most widely used antibiotics, specifically fluoroquinolones. We see two distinct opportunities for our sulopenem program: patients at elevated risk for treatment failure in the community setting suffering from uncomplicated urinary tract infections (uUTI) and hospitalized patients suffering from complicated, antibiotic-resistant infections. During the third quarter of 2018, we initiated all three clinical trials in our Phase 3 development program which includes: a Phase 3 uUTI clinical trial, known as SUlopenem for Resistant Enterobacteriaceae (SURE) 1, comparing oral sulopenem to oral ciprofloxacin in women with uUTI, a Phase 3 complicated urinary tract infections (cUTI) clinical trial known as SURE 2, comparing IV sulopenem followed by oral sulopenem to IV ertapenem followed by oral ciprofloxacin in adults with cUTI and a Phase 3 complicated intra-abdominal infections (cIAI) clinical trial known as SURE 3, comparing IV sulopenem followed by oral sulopenem to IV ertapenem followed by a combination of oral ciprofloxacin and oral metronidazole in adults with cIAI. We designed one Phase 3 clinical trial in each indication based on our end of Phase 2 meeting with the U.S. Food and Drug Administration (FDA) and feedback from the European Medicines Agency (EMA). We are conducting the Phase 3 clinical trials under Special Protocol Assessment (SPA) agreements from the FDA. We expect to complete enrollment and produce topline data for all three clinical trials in the second half of 2019, and submit our new drug applications (NDAs) to the FDA by the end of 2019. On May 30, 2018 we completed an initial public offering, or IPO, of our ordinary shares, and issued and sold 6,150,000 ordinary shares at a public offering price of $13.00 per share, resulting in net proceeds of $71.8 million after deducting underwriting discounts and commissions and offering costs payable by us. On June 26, 2018, we issued and sold an additional 200,000 ordinary shares at the IPO price of $13.00 per share pursuant to the underwriters’ partial exercise of their option to purchase additional ordinary shares, resulting in additional net proceeds of $2.4 million after deducting underwriting discounts and commissions and offering costs payable by us. Aggregate net proceeds from the IPO totalled $74.2 million after deducting underwriting discounts and commissions and offering costs payable 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 oral sulopenem and sulopenem. Our net losses for 2018, 2017 and 2016 were $77.1 million, $29.4 million and $13.5 million respectively. As of December 31, 2018, we had an accumulated deficit of $131.8 million. We expect to continue to incur significant expenses for the foreseeable future as we advance our sulopenem program through Phase 3 clinical trials, seek regulatory approval and engage in market preparation and pre-commercialization activities. In addition, if we obtain marketing approval for oral sulopenem and sulopenem, we expect to incur significant commercialization expenses related to product manufacturing, marketing, sales and distribution. We are currently evaluating our commercialization strategy in the United States and other territories. We may also incur expenses in connection with the establishment of additional sources for the manufacture of sulopenem tablets and IV vials or the in-license or acquisition of additional product candidates. Additionally, we have incurred and expect to incur additional costs associated with operating as a public company, including significant legal, accounting, investor relations and other expenses that we did not incur as a private company. As a result, we will require additional capital to fund our operations, to continue to develop our sulopenem program and to execute our strategy. Until such time as we can obtain marketing approval for oral sulopenem, sulopenem or any future product candidate and generate significant revenue from product sales, if ever, we expect to finance our operations through a combination of equity offerings, debt financings, collaboration agreements, other third-party funding, strategic alliances, licensing arrangements, marketing and distribution arrangements or government funding. We may be unable to raise additional funds or enter into such other agreements or arrangements when needed on favorable terms, or at all. If we fail to raise capital or enter into such agreements as, and when, needed, we may have to significantly delay, scale back or discontinue the development and commercialization of our sulopenem program, or otherwise change our strategy. Because of the numerous risks and uncertainties associated with product development, we are unable to predict the timing or amount of increased expenses or when or if we will be able to achieve or maintain profitability. Even if we are able to generate product sales, we may not become profitable. If we fail to become profitable or are unable to sustain profitability on a continuing basis, then we may be unable to continue our operations at planned levels and be forced to reduce or terminate our operations. As of December 31, 2018, we had cash, cash equivalents, restricted cash and short-term investments of $84.7 million. We believe that our existing cash, cash equivalents, restricted cash, short-term investments and available borrowings under our credit facility, will enable us to fund our operating expenses and capital expenditure requirements through the first quarter of 2020. 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 the section titled “-Liquidity and Capital Resources.” Components of Our Results of Operations Revenue To date, we have not generated any revenue from product sales and do not expect to generate any revenue from the sale of oral sulopenem or sulopenem in 2019. If our development efforts for our sulopenem program are successful and result in regulatory approval and/or license agreements with third parties, we may generate revenue in the future from product sales. To date, all of our revenue has been derived from our Combating Antibiotic Resistant Bacteria Biopharmaceutical Accelerator Award (CARB-X Award). We expect that our revenue in 2019 will be derived primarily from payments under the CARB-X Award or government awards that we may enter into in the future. In June 2017, CARB-X awarded us funds of up to $1.5 million to advance the development of our sulopenem program. We receive funding from CARB-X as we incur qualifying expenses. During the years ended December 31, 2018 and 2017 we recognized revenue of $0.9 million and $0.5 million, respectively, under this award. Operating Expenses Research and Development Expenses Research and development expenses consist primarily of costs incurred in connection with the development of our sulopenem program, which include: • expenses incurred under agreements with contract research organizations (CROs), contract manufacturing organizations (CMOs), as well as investigative sites and consultants that conduct our clinical trials, preclinical studies and other scientific development services; • manufacturing scale-up expenses and the cost of acquiring and manufacturing preclinical and clinical trial materials and commercial materials, including manufacturing validation batches; • employee-related expenses, including salaries, related benefits, travel and share-based compensation expense for employees engaged in research and development functions; • costs related to compliance with regulatory requirements; • facilities costs, depreciation and other expenses, which include rent and utilities; and • payments made in cash, equity securities or other forms of consideration under third-party licensing agreements. We expense research and development costs as incurred. Advance payments we make for goods or services to be received in the future for use in research and development activities are recorded as prepaid expenses. We recognize external development costs based on an evaluation of the progress to completion of specific tasks using information provided to us by our service providers. Research and development activities are central to our business model. Product candidates in advanced 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. As a result, we expect that our research and development expenses will increase substantially in 2019 as we increase personnel costs, including share-based compensation, substantially complete the Phase 3 clinical trials for our sulopenem program, conduct other clinical trials and prepare regulatory filings for oral sulopenem and sulopenem. Clinical milestone payments totaling $15.0 million were paid to Pfizer, Inc., or Pfizer, with whom we have entered into an exclusive license agreement to in-license certain patent rights and know-how related to oral sulopenem and certain know-how related to sulopenem IV (the “Pfizer License”), upon first patient dosing in a Phase 3 trial for oral sulopenem and sulopenem. These milestone payments were recorded in research and development expense in the consolidated statement of operations and comprehensive loss. The successful development and commercialization of oral sulopenem and sulopenem is highly uncertain. At this time, we cannot reasonably estimate or know the nature, timing and costs of the efforts that will be necessary to complete the clinical development of our sulopenem program or when, if ever, material net cash inflows may commence from any of our product candidates. This uncertainty is due to the numerous risks and uncertainties associated with product development and commercialization, including the uncertainty of: • the scope, progress, outcome and costs of our clinical trials and other research and development activities; • successful patient enrollment in, and the initiation and completion of, clinical trials; • the timing, receipt and terms of any marketing approvals from applicable regulatory authorities; • establishing commercial manufacturing capabilities or making arrangements with third-party manufacturers; • development and timely delivery of commercial drug formulations (i) that can be used in our clinical trials; and (ii) that are available for commercial launch; • obtaining, maintaining, defending and enforcing patent claims and other intellectual property rights; • significant and changing government regulation; • launching commercial sales of our product candidates, if and when approved, whether alone or in collaboration with others; and • maintaining a continued acceptable safety profile of the product candidates following approval. We may never succeed in achieving regulatory approval for any of our product candidates. We may obtain unexpected results from our clinical trials. We may elect to discontinue, delay or modify clinical trials of some product candidates or focus on others. Any changes in the outcome of any of these variables with respect to the development of our product candidates in clinical development could mean a significant change in the costs and timing associated with the development of these product candidates. For example, if we experience significant delays in enrollment in any of our ongoing or planned clinical trials, or are required to add additional patients to a study to remain consistent with our original trial design assumptions, we could be required to expend significant additional financial resources and time on the completion of clinical development of that product candidate. General and Administrative Expenses General and administrative expenses consist primarily of salaries, related benefits, travel and share-based compensation expense for personnel in executive, finance, market research and administrative functions. General and administrative expenses also include director compensation and travel expenses, insurance, professional fees for legal, patent, consulting, accounting and audit services and market preparation expenses. We anticipate that our general and administrative expenses will increase in the future as we increase our headcount to support the continued development of our sulopenem program. We also anticipate that we will incur increased accounting, audit, legal, regulatory, compliance, director compensation, director and officer insurance costs as well as investor and public relations expenses associated with being a public company. Additionally, if and when we believe regulatory approval of oral sulopenem and sulopenem appears likely, we anticipate an increase in payroll and expenses as a result of our preparation for commercial operations. Interest (Expense) Income, Net Interest (expense) income, net consists of interest paid and amortization of debt costs on our loan from Silicon Valley Bank (SVB), partially offset by interest earned on our cash and cash equivalents, which are generally invested in money market accounts, as well as interest earned on our investments in marketable securities. Other Income, Net Other income, net consists of realized and unrealized gains on our investments in marketable securities, partially offset by realized and unrealized foreign currency gains (losses) incurred in the normal course of business based on movement in the applicable exchange rates. Provision for Income Taxes We recognize income taxes under the asset and liability method. Deferred income taxes are recognized for differences between the financial reporting and tax bases of assets and liabilities at enacted statutory tax rates in effect for the years in which the differences are expected to reverse. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. In evaluating our ability to recover our deferred tax assets, we consider all available positive and negative evidence including past operating results, the existence of cumulative income in the most recent fiscal years, changes in the business in which we operate and our forecast of future taxable income. In determining future taxable income, we are responsible for assumptions utilized including the amount of Irish, U.S. and other foreign pre-tax operating income, the reversal of temporary differences and the implementation of feasible and prudent tax planning strategies. These assumptions require significant judgment about the forecasts of future taxable income and are consistent with the plans and estimates that we are using to manage the underlying business. Valuation allowances are provided if it is more likely than not that some portion or all of the deferred tax assets will not be realized. We account for uncertain tax positions using a more-likely-than-not threshold for recognizing and resolving uncertain tax positions. The evaluation of uncertain tax positions is based on factors including, but not limited to, changes in tax law, the measurement of tax positions taken or expected to be taken in tax returns, the effective settlement of matters subject to audit, new audit activity and changes in facts or circumstances related to a tax position. We evaluate our tax positions on a quarterly basis. We also accrue for potential interest and penalties related to unrecognized tax benefits in income tax expense. On December 22, 2017, the United States federal government enacted the Tax Act, marking a change from a worldwide tax system to a modified territorial tax system in the United States. As part of this change, the Tax Act, among other changes, provided a reduction of the U.S. federal corporate income tax rate from 34% to 21%, an indefinite carryforward of net operating losses incurred in 2018 and future periods, and an interest limitation starting in 2018 with an indefinite carryforward. Any impact to the Company related to these items were accounted for in the 2017 and 2018 tax provisions with minimal impact. Critical Accounting Policies and Significant Judgments and Estimates Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States. The preparation of our consolidated financial statements and related disclosures requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue, costs and expenses, and the disclosure of contingent assets and liabilities in our financial statements. We base our estimates on historical experience, known trends and events and various other factors that we believe are 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. We evaluate our estimates and assumptions on an ongoing basis. Our 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 Expenses As part of the process of preparing our consolidated financial statements, we are required to estimate our accrued research and development expenses. 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 actual costs. The majority of our service providers invoice us in arrears for services performed, on a pre-determined schedule or when contractual milestones are met; however, some require advanced payments. We make estimates of our accrued expenses as of each balance sheet date in the consolidated financial statements based on facts and circumstances known to us at that time. We periodically confirm the accuracy of these estimates with the service providers and make adjustments if necessary. Examples of estimated accrued research and development expenses include fees paid to: • vendors, including central laboratories, in connection with preclinical development activities; • CROs and investigative sites in connection with preclinical studies and clinical trials; and • CMOs in connection with drug substance and drug product formulation of preclinical and clinical trial materials. We base our expenses related to preclinical studies and clinical trials on our estimates of the services received and efforts expended pursuant to quotes and contracts with multiple research institutions and CROs that conduct and manage preclinical studies and clinical trials 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 expense. Payments under some of these contracts depend on factors such as the successful enrollment of patients and the completion of clinical trial milestones. 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 the estimate, we adjust the accrual or the amount of prepaid expenses 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 may result in reporting amounts that are too high or too low in any particular period. To date, there have not been any material adjustments to our prior estimates of accrued research and development expenses. Share-Based Compensation We measure share options and other share-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 over the requisite service period, which is generally the vesting period of the respective award. We have issued share awards with both service-based and performance-based vesting conditions and record the expense for these awards over the requisite service or performance periods. For share-based awards granted to consultants and non-employees, we recognize compensation expense over the period during which services are rendered by such consultants and non-employees until completed. At the end of each financial reporting period prior to completion of the service, the fair value of these awards is remeasured using the then-current fair value of our ordinary shares and updated assumption inputs in the Black-Scholes option-pricing model. We estimate the fair value of each share option grant using the Black-Scholes option-pricing model, which uses as inputs the fair value of our ordinary shares and assumptions we make for the volatility of our ordinary shares, the expected term of our share options, the risk-free interest rate for a period that approximates the expected term of our share options and our expected dividend yield. Determination of the Fair Value of Ordinary Shares prior to IPO Since our IPO in May 2018, the fair value of our ordinary shares has been determined based on the quoted market price of our ordinary shares. Prior to our IPO, the estimated fair value of our ordinary shares 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 valuation of our ordinary shares as well as 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 third-party valuation through the date of the grant. Our board of directors considered various objective and subjective factors to determine the fair value of our ordinary shares as of each grant date, including: • the prices at which we sold preferred shares and the superior rights and preferences of the preferred shares relative to our ordinary shares at the time of each grant; • the progress of our research and development programs, including the status of preclinical studies and clinical trials for our product candidates; • our stage of development and commercialization and our business strategy; • external market conditions affecting the pharmaceutical industry and trends within the pharmaceutical industry; • our financial position, including cash on hand, and our historical and forecasted performance and operating results; • the lack of an active public market for our ordinary shares and our preferred shares; • the likelihood of achieving a liquidity event, such as an initial public offering or a sale of our company in light of prevailing market conditions; and • the analysis of initial public offerings and the market performance of similar companies in the pharmaceutical and biotechnology industries. Our third-party valuations of ordinary shares were prepared using the option-pricing method (OPM), which used an income and market approach to estimate our enterprise value. The OPM treats ordinary shares and preferred shares as call options on the total equity value of a company, with exercise prices based on the value thresholds at which the allocation among the various holders of a company’s securities changes. Under this method, the ordinary shares have value only if the funds available for distribution to shareholders exceeded the value of the preferred share liquidation preferences at the time of the liquidity event, such as a strategic sale or a merger. Discounts for lack of control and marketability of the ordinary shares were applied directly or were inherent in the methodologies employed to arrive at an indication of the value for the ordinary shares. The assumptions underlying these valuations represent management’s best estimates, which involve inherent uncertainties and the application of management judgment. As a result, if factors or expected outcomes change and we use significantly different assumptions or estimates, our share-based compensation expense could be materially different. Results of Operations Comparison of the Years Ended December 31, 2018 and 2017 The following table summarizes our operating losses for the years ended December 31, 2018 and 2017: Revenue In June 2017, CARB-X awarded us funds of up to $1.5 million to advance the development of our sulopenem program. We receive funding from CARB-X as we incur qualifying expenses. During the years ended December 31, 2018 and 2017, we recognized $0.9 million and $0.5 million of revenue, respectively, under this award. Research and Development Expenses The increase in CRO and other preclinical, clinical trial and milestone related expenses of $36.8 million was primarily due to costs incurred related to our three Phase 3 clinical trials, which initiated in the year, as well as an increase in preclinical and Phase 1 clinical trial activity. During the year, we made clinical milestone payments totaling $15.0 million to Pfizer, upon first patient dosing of oral sulopenem and sulopenem in a Phase 3 clinical trial. These milestone payments were recorded as research and development expenses. CMC related expenses increased by $2.5 million primarily due to process validation activities necessary for our regulatory filings. Personnel related expenses increased by $4.7 million as a result of an increase in headcount in our clinical development, CMC and regulatory functions. Personnel related expenses for the years ended December 31, 2018 and 2017 included share-based compensation expense of $0.4 million and $0.1 million, respectively. The decrease in consulting fees of $0.8 million was primarily due to the increase in employee headcount, reducing our need for outside consultants. General and Administrative Expenses Personnel related expenses increased by $2.0 million as a result of an increase in headcount in our general and administrative function. Personnel related expenses for the years ended December 31, 2018 and 2017 included share-based compensation expense of $0.9 million and $0.3 million, respectively. Professional and consulting fees increased by $1.3 million as a result of pre-commercialization activities. Facility related and other costs increased by $1.0 million primarily as a result of higher lease charges relating to our offices, increased insurance related costs and higher board of directors compensation. Comparison of the Years Ended December 31, 2017 and 2016 The following table summarizes our operating losses for the years ended December 31, 2017 and 2016: Revenue In June 2017, CARB-X awarded us funds of up to $1.5 million to advance the development of our sulopenem program. We receive funding from CARB-X as we incur qualifying expenses. During the year ended December 31, 2017, we recognized $0.5 million of revenue under this award. Research and Development Expenses The increase in CMC related expenses of $11.2 million was primarily due to formulation development, manufacturing process, and manufacturing of clinical trial material in anticipation of our Phase 3 clinical trials in the second half of 2018. CRO and other preclinical and clinical trial related expenses increased by $1.8 million due to increased Phase 1 clinical trial activity and a Ciprofloxacin Phase 4 clinical trial study. Personnel related expenses increased by $1.8 million as a result of an increase in headcount in our CMC, clinical development and regulatory functions. Personnel related expenses for the years ended December 31, 2017 and 2016 included share-based compensation expense of $0.1 million and $0.1 million, respectively. The increase in consulting fees of $0.6 million was primarily due to the increase in consultants used for preclinical and clinical trial activity. General and Administrative Expenses The increase in facility related and other costs of $0.7 million was primarily due to the lease of office space in Dublin that we entered into at the end of 2016, software costs, director compensation and travel expenses, and general support costs for the increase in headcount. Personnel related expenses increased by $0.5 million as a result of an increase in headcount in our general and administrative function. Personnel related expenses for the years ended December 31, 2017 and 2016 included share-based compensation expense of $0.3 million and $0.2 million, respectively. Liquidity and Capital Resources Since our inception, we have incurred significant operating losses and negative cash flows from our operations. We have generated limited revenue to date from a funding arrangement with CARB-X Award. We have funded our operations to date primarily with proceeds from the sale of preferred shares and ordinary shares, debt raised under our financing arrangement with SVB and payments received under the funding arrangement with CARB-X. Through December 31, 2018, we had received cash proceeds of $195.1 million from sales of our Series A and Series B preferred shares and ordinary shares and $15.0 million from the first drawdown of our SVB loan. As of December 31, 2018, we had cash, cash equivalents, restricted cash and short-term investments of $84.7 million. Secured credit facility On April 27, 2018, our subsidiaries, Iterum Therapeutics International Limited, Iterum Therapeutics US Holding Limited and Iterum Therapeutics US Limited (Borrowers) entered into a loan and security agreement with SVB pursuant to which SVB agreed to lend the Borrowers up to $30.0 million in two term loans. $15.0 million of the secured credit facility was funded on closing and the other $15.0 million is available at our option upon the satisfaction of either of the following conditions which we refer to as the Second Draw Conditions: (i) the achievement of both non-inferiority and superiority primary endpoints from our Phase 3 clinical uUTI trial and reporting satisfactory safety data; or (ii) the achievement of non-inferiority primary endpoints from both our Phase 3 uUTI and cUTI clinical trials as well as reporting satisfactory safety data, in each case as determined by SVB at its sole discretion. Our option to draw the second term loan will terminate upon the earliest to occur of October 31, 2019, the thirtieth day following the occurrence of either of the Second Draw Conditions, or the occurrence of an event of default. A non-utilization fee of 1.50% of the aggregate undrawn principal amount shall apply if we satisfy the Second Draw Conditions but choose not to draw down the second term loan. The principal borrowed under the secured credit facility bears interest at a floating per annum rate equal to the greater of (i) 8.31%; or (ii) 3.89% above the Wall Street Journal prime rate, which interest is payable monthly in arrears. The initial draw requires monthly amortization payments commencing November 1, 2019, which will be extended to April 1, 2020 if the second draw is made. All outstanding principal, plus a 4.2% final payment fee, will be due and payable on the earliest to occur of March 1, 2022 (Maturity Date), the acceleration of either term loan or the prepayment of either term loan. The final payment fee of $0.6 million, which represents 4.2% of the funded loan, is accreted using the effective interest method over the life of the loan as interest expense. The secured credit facility draws are subject to prepayment fees of 3.00% in the first year, 2.00% in the second year and 1.00% thereafter in the event of prepayment at any time prior to the Maturity Date. In connection with the initial $15.0 million draw, we issued SVB and Life Sciences Fund II LLC (LSF) warrants to purchase an aggregate of 19,890 Series B-2 preferred shares (which converted to ordinary shares in connection with our IPO) at an exercise price of $18.85 per share. If we draw down the second term loan, each of SVB and LSF will be entitled, pursuant to additional share warrants issued to each of them at closing, to purchase such number of additional ordinary shares in an aggregate amount equal to 2.50% of the funded amount, divided by the applicable exercise price. Obligations under the secured credit facility are secured by substantially all of our existing and future assets and the existing and future assets of our subsidiaries, including intellectual property. Cash Flows The following table summarizes our cash flows for each of the periods presented: Operating Activities During the year ended December 31, 2018, operating activities used $75.9 million of cash, resulting from our net loss of $77.1 million and net cash used by changes in our operating assets and liabilities of $1.6 million, partially offset by non-cash charges of $2.8 million. Net cash used by changes in our operating assets and liabilities for the year ended December 31, 2018 consisted primarily of increases in prepaid expenses and other current assets, largely related to advance payments to contract research organizations, and other assets, largely related to a deposit paid for the Dublin commercial lease and advance payments to CMOs, partially offset by increases in accounts payable and accrued expenses, primarily due to an increase in clinical trial expenses. During the year ended December 31, 2017, operating activities used $30.6 million of cash, resulting from our net loss of $29.4 million and net cash used by changes in our operating assets and liabilities of $1.6 million, partially offset by non-cash charges of $0.4 million. Net cash used by changes in our operating assets and liabilities for the year ended December 31, 2017 consisted of increases in prepaid expenses and other assets primarily related to advance payments to CMOs, partially offset by increases in accrued expenses and accounts payable primarily due to increases in clinical trial supply and costs. During the year ended December 31, 2016, operating activities used $11.3 million of cash, resulting from our net loss of $13.5 million, partially offset by non-cash charges of $0.4 million and net cash provided by changes in our operating assets and liabilities of $1.8 million. Net cash provided by changes in our operating assets and liabilities for the year ended December 31, 2016 consisted primarily of increases in accrued expenses and accounts payable primarily due to increases in clinical trial supply and costs, partially offset by increases in prepaid expenses and other assets primarily related to advance payments to CMOs. Investing Activities During the year ended December 31, 2018, net cash used in investing activities of $8.7 million was primarily related to purchases of short-term investments of $96.5 million and purchases of property and equipment of $0.1 million, partially offset by sales of short-term investments of $87.9 million. During the year ended December 31, 2017, net cash used in investing activities of $31.6 million was primarily related to purchases of short-term investments of $53.3 million and fixed asset purchases of $0.8 million, partially offset by sales of short-term investments of $22.5 million. We did not use any cash for investing activities during the year ended December 31, 2016. Financing Activities During the year ended December 31, 2018 net cash provided by financing activities was $120.8 million and consisted of net cash proceeds from the issuance of Series B-2 preferred shares in February 2018 (which converted to ordinary shares in connection with our IPO) of $32.2 million, net cash proceeds from the issuance of ordinary shares in May and June 2018 associated with our IPO of $74.2 million and net cash proceeds from the SVB loan drawdown of $14.4 million. During the year ended December 31, 2017, net cash provided by financing activities was $45.9 million, and consisted of gross cash proceeds from the issuance of Series B-1 preferred shares in May 2017. During the year ended December 31, 2016, net cash provided by financing activities was $20.9 million, and consisted of gross cash proceeds from the issuance of Series A preferred shares in December 2016. Funding Requirements We expect to continue to incur significant expenses and increasing operating losses as we conduct our ongoing and planned clinical trials of oral sulopenem and sulopenem, seek marketing approval for such product candidates if clinical trials are successful, and pursue the development of our sulopenem program in additional indications through preclinical and clinical development. Our expenses will also increase substantially if and as we: • conduct additional clinical trials for oral sulopenem and sulopenem, which include our three ongoing Phase 3 clinical trials, and our ongoing and planned Phase 1 clinical trials, which we expect to occur through 2019; • initiate other studies as part of our sulopenem program, some of which may be required for regulatory approval of our product candidates; • establish a sales, marketing and distribution infrastructure to commercialize oral sulopenem and sulopenem in the United States if we obtain marketing approval from the U.S. Food and Drug Administration (FDA) and we choose to commercialize directly in the United States; • establish manufacturing and supply chain capacity sufficient to provide commercial quantities of oral sulopenem and sulopenem, if we obtain marketing approval; • pursue the development of our sulopenem program in additional indications; • maintain, expand, defend and protect our intellectual property portfolio; • hire additional clinical, scientific and commercial personnel; • add operational, financial and management information systems and personnel, including personnel to support our product development and planned future commercialization efforts, as well as to support our ongoing transition to a public reporting company; and • acquire or in-license other product candidates or technologies. We believe that our existing cash, cash equivalents, restricted cash, short-term investments and available borrowings under our credit facility, will enable us to fund our operating expenses and capital expenditure requirements through the first quarter of 2020. We have based these estimates on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we expect. We expect that we will require additional capital to file with regulatory agencies and commercialize oral sulopenem and sulopenem, if we receive regulatory approval, and to pursue in-licenses or acquisitions of other product candidates. If we receive regulatory approval for oral sulopenem or sulopenem, we expect to incur significant commercialization expenses related to product manufacturing, sales, marketing and distribution, depending on where we choose to commercialize. Because of the numerous risks and uncertainties associated with research, development and commercialization of pharmaceutical product candidates, we are unable to estimate the exact amount of our working capital requirements. Our future funding requirements, both short-term and long-term, will depend on many factors, including: • the timing and costs of our ongoing clinical trials of oral sulopenem and sulopenem, including our three Phase 3 clinical trials in our three initial indications; • the initiation, progress, timing, costs and results of preclinical studies and clinical trials of other potential product candidates and of our current product candidates in additional indications; • the amount of funding that we receive under government awards that we have applied for or may apply for in the future; • the number and characteristics of product candidates that we pursue; • the outcome, timing and costs of seeking regulatory approvals; • the costs of commercialization activities for oral sulopenem and sulopenem and other product candidates if we receive marketing approval, including the costs and timing of establishing product sales, marketing, distribution and manufacturing capabilities; • the receipt of marketing approval and revenue received from any potential commercial sales of oral sulopenem and sulopenem; • the terms and timing of any future collaborations, licensing or other arrangements that we may establish; • the amount and timing of any payments we may be required to make, or that we may receive, in connection with the licensing, filing, prosecution, defense and enforcement of any patents or other intellectual property rights, including milestone and royalty payments and patent prosecution fees that we are obligated to pay pursuant to the Pfizer License or other future license agreements; • the costs of preparing, filing and prosecuting patent applications, maintaining and protecting our intellectual property rights and defending against any intellectual property related claims; • the costs of operating as a public company; and • the extent to which we in-license or acquire other products and technologies. Until such time, if ever, that we can generate product revenue sufficient to achieve profitability, we expect to finance our cash needs through a combination of public or private equity offerings, debt financings, collaboration agreements, other third-party funding, strategic alliances, licensing arrangements, marketing and distribution arrangements or government funding. To the extent that we raise additional capital through the sale of equity or convertible debt securities, our shareholders’ ownership interest will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect the rights of our ordinary shareholders. Debt financing and preferred 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. Our secured credit facility with SVB imposes operating and other restrictions on us. Such restrictions affect, and in many cases limit or prohibit, our ability to dispose of certain assets, pay dividends and incur additional indebtedness, among other things. If we raise additional funds through other third-party funding, collaboration agreements, strategic alliances, licensing arrangements or marketing and distribution arrangements, 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. 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 products or product candidates that we would otherwise prefer to develop and market ourselves. Contractual Obligations and Commitments 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: Under the Pfizer License, we have agreed to make certain regulatory and sales milestone payments, pay royalties and make a potential one-time payment related to sublicensing income that exceeds a certain threshold. We have not included any contingent payment obligations, such as milestones, royalties, or one-time payments, in the table above as the amount, timing and likelihood of such payments are not known. We are obligated to pay Pfizer royalties ranging from a single-digit to mid-teens percentage based on marginal net sales of each licensed product. In June 2016, we entered into an agreement with a supplier whereby we agreed to pay $2.9 million to the supplier to acquire equipment, which will be used solely to manufacture product for us. In June 2018, we entered into a supplemental agreement with this supplier whereby we agreed to pay an additional $2.3 million for additional equipment and dedicated personnel under the same terms of the original agreement. These payments will be offset against the price of the product to be supplied under a future supply agreement. As of December 31, 2018, $1.6 million remained outstanding to the supplier. Emerging Growth Company Status The Jumpstart Our Business Startups Act of 2012 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. 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 Securities and Exchange Commission (SEC). Recently Issued Accounting Pronouncements 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 elsewhere in this Annual Report on Form 10-K.
0.114547
0.114641
0
<s>[INST] Overview We are a pharmaceutical company dedicated to developing and commercializing sulopenem to be potentially the first and only oral and intravenous (IV) branded penem available globally. Penems, including thiopenems and carbapenems, belong to a class of antibiotics more broadly defined as ßlactam antibiotics, the original example of which was penicillin, but which now also includes cephalosporins. Sulopenem is a potent, thiopenem antibiotic delivered intravenously which is active against bacteria that belong to the group of organisms known as gramnegatives and cause urinary tract and intraabdominal infections. We have successfully developed sulopenem in an oral tablet formulation, sulopenem etzadroxilprobenecid, which we refer to herein as oral sulopenem. Both sulopenem product candidates have the potential to be important new treatment alternatives to address growing concerns related to antibacterial resistance without the known toxicities of some of the most widely used antibiotics, specifically fluoroquinolones. We see two distinct opportunities for our sulopenem program: patients at elevated risk for treatment failure in the community setting suffering from uncomplicated urinary tract infections (uUTI) and hospitalized patients suffering from complicated, antibioticresistant infections. During the third quarter of 2018, we initiated all three clinical trials in our Phase 3 development program which includes: a Phase 3 uUTI clinical trial, known as SUlopenem for Resistant Enterobacteriaceae (SURE) 1, comparing oral sulopenem to oral ciprofloxacin in women with uUTI, a Phase 3 complicated urinary tract infections (cUTI) clinical trial known as SURE 2, comparing IV sulopenem followed by oral sulopenem to IV ertapenem followed by oral ciprofloxacin in adults with cUTI and a Phase 3 complicated intraabdominal infections (cIAI) clinical trial known as SURE 3, comparing IV sulopenem followed by oral sulopenem to IV ertapenem followed by a combination of oral ciprofloxacin and oral metronidazole in adults with cIAI. We designed one Phase 3 clinical trial in each indication based on our end of Phase 2 meeting with the U.S. Food and Drug Administration (FDA) and feedback from the European Medicines Agency (EMA). We are conducting the Phase 3 clinical trials under Special Protocol Assessment (SPA) agreements from the FDA. We expect to complete enrollment and produce topline data for all three clinical trials in the second half of 2019, and submit our new drug applications (NDAs) to the FDA by the end of 2019. On May 30, 2018 we completed an initial public offering, or IPO, of our ordinary shares, and issued and sold 6,150,000 ordinary shares at a public offering price of $13.00 per share, resulting in net proceeds of $71.8 million after deducting underwriting discounts and commissions and offering costs payable by us. On June 26, 2018, we issued and sold an additional 200,000 ordinary shares at the IPO price of $13.00 per share pursuant to the underwriters’ partial exercise of their option to purchase additional ordinary shares, resulting in additional net proceeds of $2.4 million after deducting underwriting discounts and commissions and offering costs payable by us. Aggregate net proceeds from the IPO totalled $74.2 million after deducting underwriting discounts and commissions and offering costs payable 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 oral sulopenem and sulopenem. Our net losses for 2018, 2017 and 2016 were $77.1 million, $29.4 million and $13.5 million respectively. As of December 3 [/INST] Positive. </s>
2,019
7,307
1,659,323
Iterum Therapeutics plc
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 and analysis of our financial condition and results of operations together with our consolidated financial statements and the related notes and the other financial information included elsewhere in this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10-K, including information with respect to our plans and strategy for our business and related financing, includes forward-looking statements that involve risks and uncertainties. As a result of many factors, including those factors set forth in the “Risk Factors” section of this Annual Report on Form 10-K, our actual results could 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 dedicated to developing and commercializing sulopenem to be potentially the first and only oral and intravenous (IV) branded penem available globally. Penems, including thiopenems and carbapenems, belong to a class of antibiotics more broadly defined as ß-lactam antibiotics, the original example of which was penicillin, but which now also includes cephalosporins. Sulopenem is a potent, thiopenem antibiotic delivered intravenously which is active against bacteria that belong to the group of organisms known as gram-negatives and cause urinary tract and intra-abdominal infections. We have also successfully developed sulopenem in an oral tablet formulation, sulopenem etzadroxil-probenecid, which we refer to herein as oral sulopenem. Both sulopenem product candidates have the potential to be important new treatment alternatives to address growing concerns related to antibacterial resistance without the known toxicities of some of the most widely used antibiotics, specifically fluoroquinolones. We see two distinct opportunities for our sulopenem program: patients at elevated risk for treatment failure in the community setting suffering from uncomplicated urinary tract infections (uUTI) and hospitalized patients suffering from complicated, antibiotic-resistant infections. During the third quarter of 2018, we initiated all three clinical trials in our Phase 3 development program which includes: a Phase 3 uUTI clinical trial, known as Sulopenem for Resistant Enterobacteriaceae (SURE) 1, comparing oral sulopenem to oral ciprofloxacin in women with uUTI, a Phase 3 complicated urinary tract infection (cUTI) clinical trial known as SURE 2, comparing IV sulopenem followed by oral sulopenem to IV ertapenem followed by oral ciprofloxacin in adults with cUTI and a Phase 3 complicated intra-abdominal infection (cIAI) clinical trial known as SURE 3, comparing IV sulopenem followed by oral sulopenem to IV ertapenem followed by a combination of oral ciprofloxacin and oral metronidazole in adults with cIAI. We designed one Phase 3 clinical trial in each indication based on our end of Phase 2 meeting with the U.S. Food and Drug Administration (FDA) and feedback from the European Medicines Agency (EMA). We are conducting the Phase 3 clinical trials under Special Protocol Assessment (SPA) agreements from the FDA. We completed enrollment in our uUTI and cUTI clinical trials in the fourth quarter of 2019 and expect to produce topline data around the end of the first quarter of 2020. If these data are positive, we expect to have an opportunity to file two new drug applications (NDAs), one for oral sulopenem and one for IV sulopenem, around mid-2020, which we expect would enable potential FDA approval in the first half of 2021. In December 2019, we announced that sulopenem did not meet the primary endpoint of statistical non-inferiority compared to the control therapy for the cIAI trial; however, we believe the secondary supporting analyses and safety data support the potential of sulopenem in the treatment of multi-drug resistant infections. EMA Scientific Advice received by us, consistent with the existing Guidance for this indication, supports an endpoint assessed earlier than the primary study endpoint and a non-inferiority margin of -12.5%. On May 30, 2018 we completed an initial public offering, or IPO, of our ordinary shares, and issued and sold 6,150,000 ordinary shares at a public offering price of $13.00 per share, resulting in net proceeds of $71.8 million after deducting underwriting discounts and commissions and offering costs payable by us. On June 26, 2018, we issued and sold an additional 200,000 ordinary shares at the IPO price of $13.00 per share pursuant to the underwriters’ partial exercise of their option to purchase additional ordinary shares, resulting in additional net proceeds of $2.4 million after deducting underwriting discounts and commissions and offering costs payable by us. Aggregate net proceeds from the IPO totalled $74.2 million after deducting underwriting discounts and commissions and offering costs payable by us. On July 5, 2019, we filed a universal shelf registration statement on Form S-3 (Registration No. 333-232569) with the SEC, which was declared effective on July 16, 2019, and pursuant to which we registered for sale up to $150.0 million of any combination of our ordinary shares, preferred shares, debt securities, warrants and/or units from time to time and at prices and on terms that we may determine. On January 21, 2020, we completed a private placement (Private Placement) pursuant to which our wholly owned subsidiary, Iterum Therapeutics Bermuda Limited (Iterum Bermuda) issued and sold approximately $51.6 million aggregate principal amount of 6.500% Exchangeable Senior Subordinated Notes due 2025 (Exchangeable Notes) and $0.1 million aggregate principal amount of Limited Recourse Royalty-Linked Subordinated Notes (RLNs and, together with the Exchangeable Notes, the Securities) to a group of accredited investors. The Securities were sold in units (the Units) with each Unit consisting of an Exchangeable Note in the original principal amount $1,000 and 50 RLNs. The Units were sold at a price of $1,000 per Unit. The Exchangeable Notes are exchangeable for our ordinary shares at an initial exchange rate of 1,000 shares per $1,000 of principal and interest on the Exchangeable Notes (equivalent to an initial exchange price of approximately $1.00 per ordinary share), subject to specified limitations. The RLNs entitle holders to payments based on a percentage of our net revenues from potential U.S. sales of specified sulopenem products subject to the terms and conditions of the indenture governing the RLNs. Pursuant to the indenture governing the RLNs, the payments on the RLNs will be up to either 15% or 20% of net revenues from U.S. sales of such products, depending on the indication approved by the FDA. The aggregate amount of payments on each RLN is capped at $160.00 (or 4,000 times the principal amount of such RLN). Iterum Bermuda received net proceeds from the sale of the Securities of approximately $46.7 million, after deducting placement agent fees and estimated offering expenses. 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 oral sulopenem and sulopenem. As of December 31, 2019, we had an accumulated deficit of $234.9 million. We expect to continue to incur significant expenses for the foreseeable future as we advance our sulopenem program through Phase 3 clinical trials, seek regulatory approval and engage in market preparation and pre-commercialization activities. In addition, if we obtain marketing approval for oral sulopenem and sulopenem, we expect to incur significant commercialization expenses related to product manufacturing, marketing, sales and distribution. We are currently evaluating our commercialization strategy in the United States and other territories. We may also incur expenses in connection with the establishment of additional sources for the manufacture of sulopenem tablets and IV vials or the in-license or acquisition of additional product candidates. Additionally, we have incurred and expect to incur additional costs associated with operating as a public company, including significant legal, accounting, investor relations and other expenses that we did not incur as a private company. As a result, we will require additional capital to fund our operations, to continue to develop our sulopenem program and to execute our strategy. Until such time as we can obtain marketing approval for oral sulopenem, sulopenem or any future product candidate and generate significant revenue from product sales, if ever, we expect to finance our operations through a combination of equity offerings, debt financings, collaboration agreements, other third-party funding, strategic alliances, licensing arrangements, marketing and distribution arrangements or government funding. We may be unable to raise additional funds or enter into such other agreements or arrangements when needed on favorable terms, or at all. If we fail to raise capital or enter into such agreements as, and when, needed, we may have to significantly delay, scale back or discontinue the development and commercialization of our sulopenem program, or otherwise change our strategy. Because of the numerous risks and uncertainties associated with product development, we are unable to predict the timing or amount of increased expenses or when or if we will be able to achieve or maintain profitability. Even if we are able to generate product sales, we may not become profitable. If we fail to become profitable or are unable to sustain profitability on a continuing basis, then we may be unable to continue our operations at planned levels and be forced to reduce or terminate our operations. As of December 31, 2019, we had cash, cash equivalents and restricted cash of $4.9 million. In January 2020, we received net proceeds of approximately $46.7 million from the sale of the Securities. Our expected cash usage for the next 12 months assumes that planned programs and expenditure continue and that we do not reduce or eliminate some or all of our research and development programs or commercialization efforts. Our future viability is dependent on our ability to raise additional capital to finance our operations. Without additional external funding, we do not believe that our existing cash and cash equivalents will enable us to fund our operating expenses and capital expenditure requirements for the next 12 months. As such, we believe there is substantial doubt about our ability to continue as a going concern for at least one year from the date this Annual Report on Form 10-K is issued. The financial statements do not include any adjustments relating to the recoverability and classification of liabilities that might be necessary should we be unable to continue as a going concern. Components of Our Results of Operations Revenue To date, we have not generated any revenue from product sales and do not expect to generate any revenue from the sale of oral sulopenem or sulopenem in the near future. If our development efforts for our sulopenem program are successful and result in regulatory approval and/or license agreements with third parties, we may generate revenue in the future from product sales. To date, all of our revenue has been derived from our Combating Antibiotic Resistant Bacteria Biopharmaceutical Accelerator, or CARB-X, award. We expect that our revenue for the foreseeable future will be derived primarily from payments under government awards that we may enter into in the future. In June 2017, CARB-X awarded us funds of up to $1.5 million to advance the development of our sulopenem program. We received funding from CARB-X as we incurred qualifying expenses. During the years ended December 31, 2019, 2018 and 2017 we recognized revenue of $0.0 million, $0.9 million and $0.5 million, respectively, under this award. Operating Expenses Research and Development Expenses Research and development expenses consist primarily of costs incurred in connection with the development of our sulopenem program, which include: • expenses incurred under agreements with contract research organizations (CROs), contract manufacturing organizations (CMOs), as well as investigative sites and consultants that conduct our clinical trials, preclinical studies and other scientific development services; • manufacturing scale-up expenses and the cost of acquiring and manufacturing preclinical and clinical trial materials and commercial materials, including manufacturing validation batches; • employee-related expenses, including salaries, related benefits, travel and share-based compensation expense for employees engaged in research and development functions; • costs related to compliance with regulatory requirements; • facilities costs, depreciation and other expenses, which include rent under operating lease agreements and utilities; and • payments made in cash, equity securities or other forms of consideration under third-party licensing agreements. We expense research and development costs as incurred. Advance payments we make for goods or services to be received in the future for use in research and development activities are recorded as prepaid expenses. We recognize external development costs based on an evaluation of the progress to completion of specific tasks using information provided to us by our service providers. Research and development activities are central to our business model. Product candidates in advanced 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. As a result, our research and development expenses increased substantially throughout 2019 as we substantially completed the Phase 3 clinical trials for our sulopenem program, increased personnel costs, including share-based compensation, conducted other clinical trials and prepared regulatory filings for oral sulopenem and sulopenem. This 2019 increase in research and development expenses was partially offset by clinical milestone payments of $15.0 million made to Pfizer in 2018 upon first patient dosing of oral sulopenem and sulopenem in a Phase 3 clinical trial. The successful development and commercialization of oral sulopenem and sulopenem is highly uncertain. At this time, we cannot reasonably estimate or know the nature, timing and costs of the efforts that will be necessary to complete the clinical development of our sulopenem program or when, if ever, material net cash inflows may commence from any of our product candidates. This uncertainty is due to the numerous risks and uncertainties associated with product development and commercialization, including the uncertainty of: • the scope, progress, outcome and costs of our clinical trials and other research and development activities; • successful patient enrollment in, and the initiation and completion of, clinical trials; • the timing, receipt and terms of any marketing approvals from applicable regulatory authorities; • establishing commercial manufacturing capabilities or making arrangements with third-party manufacturers; • development and timely delivery of commercial drug formulations (i) that can be used in our clinical trials; and (ii) that are available for commercial launch; • obtaining, maintaining, defending and enforcing patent claims and other intellectual property rights; • significant and changing government regulation; • launching commercial sales of our product candidates, if and when approved, whether alone or in collaboration with others; and • maintaining a continued acceptable safety profile of the product candidates following approval. We may never succeed in achieving regulatory approval for any of our product candidates. We may obtain unexpected results from our clinical trials, including unexpected topline data of our uUTI and cUTI clinical trials, which we currently expect to report around the end of the first quarter of 2020. For example, in the results of our cIAI clinical trial, sulopenem did not meet the primary endpoint of statistical non-inferiority compared to the control therapy for the cIAI trial; however, we believe the secondary supporting analyses and safety data support the potential of sulopenem in the treatment of multi-drug resistant infections. We may elect to discontinue, delay or modify clinical trials of some product candidates or focus on others. Any changes in the outcome of any of these variables with respect to the development of our product candidates in clinical development could mean a significant change in the costs and timing associated with the development of these product candidates. General and Administrative Expenses General and administrative expenses consist primarily of salaries, related benefits, travel and share-based compensation expense for personnel in executive, finance, market research and administrative functions. General and administrative expenses also include director compensation and travel expenses, insurance, professional fees for legal, patent, consulting, accounting and audit services and market preparation expenses. We anticipate that our general and administrative expenses will increase in the future as we increase our headcount to support the continued development of our sulopenem program. We also anticipate that we will incur increased accounting, audit, legal, regulatory, compliance, director compensation, director and officer insurance costs as well as investor and public relations expenses associated with being a public company. Additionally, if and when we believe regulatory approval of oral sulopenem and sulopenem appears likely, we anticipate an increase in payroll and expenses as a result of our preparation for commercial operations. Interest (Expense) Income, Net Interest (expense) income, net consists of interest paid and amortization of debt costs on our loan from Silicon Valley Bank (SVB), partially offset by interest earned on our cash and cash equivalents, which are generally invested in money market accounts, as well as interest earned on our investments in marketable securities. Other Income, Net Other income, net consists of realized and unrealized gains on our investments in marketable securities, partially offset by realized and unrealized foreign currency gains (losses) incurred in the normal course of business based on movement in the applicable exchange rates. Provision for Income Taxes We recognize income taxes under the asset and liability method. Deferred income taxes are recognized for differences between the financial reporting and tax bases of assets and liabilities at enacted statutory tax rates in effect for the years in which the differences are expected to reverse. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. In evaluating our ability to recover our deferred tax assets, we consider all available positive and negative evidence including past operating results, the existence of cumulative income in the most recent fiscal years, changes in the business in which we operate and our forecast of future taxable income. In determining future taxable income, we are responsible for assumptions utilized including the amount of Irish, U.S. and other foreign pre-tax operating income, the reversal of temporary differences and the implementation of feasible and prudent tax planning strategies. These assumptions require significant judgment about the forecasts of future taxable income and are consistent with the plans and estimates that we are using to manage the underlying business. Valuation allowances are provided if it is more likely than not that some portion or all of the deferred tax assets will not be realized. We account for uncertain tax positions using a more-likely-than-not threshold for recognizing and resolving uncertain tax positions. The evaluation of uncertain tax positions is based on factors including, but not limited to, changes in tax law, the measurement of tax positions taken or expected to be taken in tax returns, the effective settlement of matters subject to audit, new audit activity and changes in facts or circumstances related to a tax position. We evaluate our tax positions on a quarterly basis. We also accrue for potential interest and penalties related to unrecognized tax benefits in income tax expense. Critical Accounting Policies and Significant Judgments and Estimates Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States. The preparation of our consolidated financial statements and related disclosures requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue, costs and expenses, and the disclosure of contingent assets and liabilities in our financial statements. We base our estimates on historical experience, known trends and events and various other factors that we believe are 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. We evaluate our estimates and assumptions on an ongoing basis. Our 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 Expenses As part of the process of preparing our consolidated financial statements, we are required to estimate our accrued research and development expenses. 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 actual costs. The majority of our service providers invoice us in arrears for services performed, on a pre-determined schedule or when contractual milestones are met; however, some require advanced payments. We make estimates of our accrued expenses as of each balance sheet date in the consolidated financial statements based on facts and circumstances known to us at that time. We periodically confirm the accuracy of these estimates with the service providers and make adjustments if necessary. Examples of estimated accrued research and development expenses include fees paid to: • vendors, including central laboratories, in connection with preclinical development activities; • CROs and investigative sites in connection with preclinical studies and clinical trials; and • CMOs in connection with drug substance and drug product formulation of preclinical and clinical trial materials. We base our expenses related to preclinical studies and clinical trials on our estimates of the services received and efforts expended pursuant to quotes and contracts with multiple research institutions and CROs that conduct and manage preclinical studies and clinical trials 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 expense. Payments under some of these contracts depend on factors such as the successful enrollment of patients and the completion of clinical trial milestones. 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 the estimate, we adjust the accrual or the amount of prepaid expenses 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 may result in reporting amounts that are too high or too low in any particular period. To date, there have not been any material adjustments to our prior estimates of accrued research and development expenses. Share-Based Compensation We measure share options and other share-based awards granted to employees and directors with service based vesting conditions only based on the fair value on the date of grant using the Black-Scholes option-pricing model. Compensation expense of those awards is recognized over the requisite service period, which is generally the vesting period of the respective award, using the straight-line method. We measure share-based awards granted to employees and directors with both performance and service based vesting conditions based on the fair value on the date of grant using the Monte Carlo simulation model. Compensation expense of those awards is recognized over the determined vesting period, the period over which all the specified vesting conditions are to be satisfied, using the straight-line method. For awards granted to consultants and non-employees, compensation expense is recognized over the period during which services are rendered until completed. At the end of each financial reporting period prior to completion of the service, the fair value of these awards is remeasured using the then-current fair value of our ordinary shares and updated assumption inputs in the Black-Scholes option-pricing model or the Monte Carlo simulation model. We classify share-based compensation expense in the consolidated statement of operations and comprehensive loss in the same manner in which the award recipient’s payroll costs are classified or in which the award recipient’s service payments are classified. The Black-Scholes option-pricing model uses key inputs and assumptions including the expected term of the option, share price volatility, risk-free interest rate, dividend yield, share price and exercise price which is equivalent to closing market value on the date of grant. Many of the assumptions require significant judgment and any changes could have a material impact in the determination of share-based compensation expense. The Monte Carlo simulation model uses key inputs and assumptions including share price volatility, risk-free interest rate, the expected date of satisfaction of vesting conditions and share price. Many of the assumptions require significant judgment and any changes could have a material impact in the determination of share-based compensation expense. We have elected to account for forfeitures as they occur. Determination of the Fair Value of Ordinary Shares prior to IPO Since our IPO in May 2018, the fair value of our ordinary shares has been determined based on the quoted market price of our ordinary shares. Prior to our IPO, the estimated fair value of our ordinary shares 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 valuation of our ordinary shares as well as 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 third-party valuation through the date of the grant. Our board of directors considered various objective and subjective factors to determine the fair value of our ordinary shares as of each grant date, including: • the prices at which we sold preferred shares and the superior rights and preferences of the preferred shares relative to our ordinary shares at the time of each grant; • the progress of our research and development programs, including the status of preclinical studies and clinical trials for our product candidates; • our stage of development and commercialization and our business strategy; • external market conditions affecting the pharmaceutical industry and trends within the pharmaceutical industry; • our financial position, including cash on hand, and our historical and forecasted performance and operating results; • the lack of an active public market for our ordinary shares and our preferred shares; • the likelihood of achieving a liquidity event, such as an initial public offering or a sale of our company in light of prevailing market conditions; and • the analysis of initial public offerings and the market performance of similar companies in the pharmaceutical and biotechnology industries. Our third-party valuations of ordinary shares were prepared using the option-pricing method (OPM), which used an income and market approach to estimate our enterprise value. The OPM treats ordinary shares and preferred shares as call options on the total equity value of a company, with exercise prices based on the value thresholds at which the allocation among the various holders of a company’s securities changes. Under this method, the ordinary shares have value only if the funds available for distribution to shareholders exceeded the value of the preferred share liquidation preferences at the time of the liquidity event, such as a strategic sale or a merger. Discounts for lack of control and marketability of the ordinary shares were applied directly or were inherent in the methodologies employed to arrive at an indication of the value for the ordinary shares. The assumptions underlying these valuations represent management’s best estimates, which involve inherent uncertainties and the application of management judgment. As a result, if factors or expected outcomes change and we use significantly different assumptions or estimates, our share-based compensation expense could be materially different. Results of Operations Comparison of the Years Ended December 31, 2019 and 2018 The following table summarizes our operating losses for the years ended December 31, 2019 and 2018: Revenue In June 2017, CARB-X awarded us funds of up to $1.5 million to advance the development of our sulopenem program. We received funding from CARB-X as we incurred qualifying expenses. During the years ended December 31, 2019 and 2018, we recognized $0.0 million and $0.9 million of revenue, respectively, under this award. CARB-X funding was fully recognized as of March 31, 2019. Research and Development Expenses The increase in CRO and other preclinical, clinical trial and milestone related expenses of $30.5 million was primarily due to costs incurred related to our three Phase 3 clinical trials, which initiated in the third quarter of 2018, partially offset by clinical milestone payments of $15.0 million made to Pfizer in 2018 upon first patient dosing of oral sulopenem and sulopenem in a Phase 3 clinical trial. Personnel related expenses decreased by $0.2 million as a result of an increase in the recognition of U.S. and Irish research and development tax credits in 2019, partially offset by an increase in headcount in our CMC, clinical, regulatory and quality functions. Personnel related expenses for the years ended December 31, 2019 and 2018 included share-based compensation expense of $0.7 million and $0.4 million, respectively. CMC related expenses decreased by $10.2 million primarily as a result of the completion of manufacturing of clinical trial materials for our Phase 3 clinical trials in 2018 by our primary suppliers. The increase in consulting fees of $2.0 million was primarily due to an increase in consultants used for clinical trial activity. General and Administrative Expenses Personnel related expenses increased by $0.7 million as a result of an increase in headcount in our general and administrative function. Personnel related expenses for the years ended December 31, 2019 and 2018 included share-based compensation expense of $1.0 million and $0.5 million, respectively. Facility related and other costs increased by $0.8 million primarily as a result of increased lease expenses, increased insurance related costs and higher board of directors compensation. Facility related and other costs for the years ended December 31, 2019 and 2018 included directors’ share-based compensation expense of $0.5 million and $0.4 million, respectively. Professional and consulting fees increased by $0.9 million primarily as a result of increased costs associated with operating as a public company. Comparison of the Years Ended December 31, 2018 and 2017 The following table summarizes our operating losses for the years ended December 31, 2018 and 2017: Revenue In June 2017, CARB-X awarded us funds of up to $1.5 million to advance the development of our sulopenem program. We received funding from CARB-X as we incurred qualifying expenses. During the years ended December 31, 2018 and December 31, 2017, we recognized $0.9 million and $0.5 million of revenue under this award. Research and Development Expenses The increase in CRO and other preclinical, clinical trial and milestone related expenses of $36.8 million was primarily due to costs incurred related to our three Phase 3 clinical trials, which initiated in the year, as well as an increase in preclinical and Phase 1 clinical trial activity. During 2018, we made clinical milestone payments totaling $15.0 million to Pfizer, upon first patient dosing of oral sulopenem and sulopenem in a Phase 3 clinical trial. These milestone payments were recorded as research and development expenses. CMC related expenses increased by $2.5 million primarily due to process validation activities necessary for our regulatory filings. Personnel related expenses increased by $4.7 million as a result of an increase in headcount in our clinical development, CMC and regulatory functions. Personnel related expenses for the years ended December 31, 2018 and 2017 included share-based compensation expense of $0.4 million and $0.1 million, respectively. The decrease in consulting fees of $0.8 million was primarily due to the increase in employee headcount, reducing our need for outside consultants. General and Administrative Expenses Personnel related expenses increased by $1.7 million as a result of an increase in headcount in our general and administrative function. Personnel related expenses for the years ended December 31, 2018 and 2017 included share-based compensation expense of $0.5 million and $0.3 million respectively. Facility related and other costs increased by $1.4 million primarily as a result of higher lease charges relating to our offices, increased insurance related costs and higher board of directors compensation. Facility related and other costs for the year ended December 31, 2018 included directors share-based compensation expense of $0.4 million. Professional and consulting fees increased by $1.3 million as a result of pre-commercialization activities. Liquidity and Capital Resources Since our inception, we have incurred significant operating losses and negative cash flows from our operations. We have generated limited revenue to date from a funding arrangement with CARB-X. We have funded our operations to date primarily with proceeds from the sale of preferred shares and ordinary shares, debt raised under our financing arrangement with SVB and payments received under the funding arrangement with CARB-X. Through December 31, 2019, we had received cash proceeds of $198.2 million from sales of our Series A and Series B preferred shares and ordinary shares and $15.0 million from the first drawdown of our SVB loan. As of December 31, 2019, we had cash, cash equivalents, restricted cash and short-term investments of $4.9 million. In January 2020, we received net proceeds of approximately $46.7 million from the sale of units in the Private Placement. On July 5, 2019, we filed a universal shelf registration statement on Form S-3 with the SEC, which was declared effective on July 16, 2019, and pursuant to which we registered for sale up to $150.0 million of any combination of our ordinary shares, preferred shares, debt securities, warrants and/or units from time to time and at prices and on terms that we may determine. As discussed in the Overview in this Management’s Discussion and Analysis of Financial Condition and Results of Operations, we believe there is substantial doubt about our ability to continue as a going concern. Should we be unable to adequately finance our business, our results of operations, liquidity and financial condition would be materially and negatively affected, and we would be unable to continue as a going concern. The financial statements do not include any adjustments relating to the recoverability and classification of liabilities that might be necessary should we be unable to continue as a going concern. Secured credit facility On April 27, 2018, our subsidiaries, Iterum Therapeutics International Limited, Iterum Therapeutics US Holding Limited and Iterum Therapeutics US Limited (Borrowers), entered into a Loan and Security Agreement with SVB (Loan Agreement) pursuant to which SVB agreed to lend the Borrowers up to $30.0 million in two term loans. $15.0 million of the secured credit facility was funded on closing. A second draw of up to $15.0 million was available to us through October 31, 2019, upon satisfaction of either of the following: (i) the achievement by us of both non-inferiority and superiority primary endpoints from our Phase 3 uUTI trial, as well as reporting satisfactory safety data from the trial, or (ii) the achievement of non-inferiority primary endpoints from both our Phase 3 uUTI and cUTI trials, as well as reporting satisfactory safety data from the trials. A non-utilization fee of 1.50% of the aggregate undrawn principal amount was to apply if we satisfied the above conditions but chose not to draw down the second term loan. We did not satisfy the conditions for the second draw above before the deadline of October 31, 2019. Required monthly amortization payments for the initial $15.0 million draw commenced on November 1, 2019 and total principal repayments of $1.0 million were made during the year ended December 31, 2019. Interest accrues at a floating per annum rate equal to the greater of (i) 8.31%; or (ii) 3.89% above the Wall Street Journal prime rate, and is payable monthly in arrears. All outstanding principal, plus a 4.20% final interest payment, will be due and payable on the earliest to occur of March 1, 2022 (the maturity date), the acceleration of either the term loan or the prepayment of the term loan. The final payment fee of $0.6 million, which represents 4.2% of the funded loan, is accreted using the effective interest method over the life of the loan as interest expense. Voluntary prepayments are permitted at any time, subject to a prepayment fee of 4.00% in the first year, 3.00% in the second year, and 2.00% thereafter. In connection with the initial $15.0 million draw, we issued SVB and Life Sciences Fund II LLC (LSF) warrants to purchase an aggregate of 19,890 Series B convertible preferred shares (which converted into warrants to purchase 19,890 ordinary shares upon our IPO) at an exercise price of $18.85 per share. If the second term loan had been drawn down, each of SVB and LSF would have been automatically entitled to purchase additional ordinary shares in an aggregate amount equal to 2.50% of the second term loan divided by the applicable exercise price. Obligations under the secured credit facility are secured by substantially all of our existing and future assets and the existing and future assets of our subsidiaries, including intellectual property. In connection with the Private Placement, Iterum Bermuda was joined as a party to the Loan Agreement as a borrower and the Loan Agreement was amended to, among other things, modify the definition of subordinated debt to include the RLNs and Exchangeable Notes. Cash Flows The following table summarizes our cash flows for each of the periods presented: Operating Activities During the year ended December 31, 2019, operating activities used $78.9 million of cash, resulting from our net loss of $103.1 million, partially offset by net cash provided by changes in our operating assets and liabilities of $17.9 million and non-cash charges of $6.3 million. Net cash provided by changes in our operating assets and liabilities for the year ended December 31, 2019 consisted primarily of increases in accounts payable and accrued expenses, primarily due to increases in clinical trial expenses, and a decrease in prepaid expenses and other current assets, largely related to the use of prepayments previously made to contract research organizations, partially offset by an increase in other assets, primarily related to advance payments to a supplier for equipment, and a decrease in other liabilities as a result of payments made for operating leases. During the year ended December 31, 2018, operating activities used $75.9 million of cash, resulting from our net loss of $77.1 million and net cash used by changes in our operating assets and liabilities of $1.6 million, partially offset by non-cash charges of $2.8 million. Net cash used by changes in our operating assets and liabilities for the year ended December 31, 2018 consisted primarily of increases in prepaid expenses and other current assets, largely related to advance payments to contract research organizations, and other assets, largely related to a deposit paid for the Dublin commercial lease and advance payments to CMOs, partially offset by increases in accounts payable and accrued expenses, primarily due to an increase in clinical trial expenses. During the year ended December 31, 2017, operating activities used $30.6 million of cash, resulting from our net loss of $29.4 million and net cash used by changes in our operating assets and liabilities of $1.6 million, partially offset by non-cash charges of $0.4 million. Net cash used by changes in our operating assets and liabilities for the year ended December 31, 2017 consisted of increases in prepaid expenses and other assets primarily related to advance payments to CMOs, partially offset by increases in accrued expenses and accounts payable primarily due to increases in clinical trial supply and costs. Investing Activities During the year ended December 31, 2019, net cash provided by investing activities of $40.1 million was primarily related to sales of short-term investments. During the year ended December 31, 2018, net cash used in investing activities of $8.7 million was related to purchases of short-term investments of $96.5 million and purchases of property and equipment of $0.1 million, partially offset by sales of short-term investments of $87.9 million. During the year ended December 31, 2017, net cash used in investing activities of $31.6 million was related to purchases of short-term investments of $53.3 million and fixed asset purchases of $0.8 million, partially offset by sales of short-term investments of $22.5 million. Financing Activities During the year ended December 31, 2019, net cash used in financing activities of $1.0 million was primarily related to principal repayments made to SVB. During the year ended December 31, 2018, net cash provided by financing activities was $120.8 million and consisted of net cash proceeds from the issuance of Series B-2 preferred shares in February 2018 (which converted to ordinary shares in connection with our IPO) of $32.2 million, net cash proceeds from the issuance of ordinary shares in May and June 2018 associated with our IPO of $74.2 million and net cash proceeds from the SVB loan drawdown of $14.4 million. During the year ended December 31, 2017, net cash provided by financing activities was $45.9 million, and consisted of gross cash proceeds from the issuance of Series B-1 preferred shares in May 2017. Funding Requirements We expect to continue to incur significant expenses and increasing operating losses as we conduct our ongoing and planned clinical trials of oral sulopenem and sulopenem, seek marketing approval for such product candidates if clinical trials are successful, and pursue the development of our sulopenem program in additional indications through preclinical and clinical development. Our expenses will also increase substantially if and as we: • conduct additional clinical trials for oral sulopenem and sulopenem, which include our planned Phase 1 clinical trials related to pediatric indications; • initiate other studies as part of our sulopenem program, some of which may be required for regulatory approval of our product candidates; • establish a sales, marketing and distribution infrastructure to commercialize oral sulopenem and sulopenem in the United States if we obtain marketing approval from the FDA and we choose to commercialize directly in the United States; • establish manufacturing and supply chain capacity sufficient to provide commercial quantities of oral sulopenem and sulopenem, if we obtain marketing approval; • pursue the development of our sulopenem program in additional indications; • maintain, expand, defend and protect our intellectual property portfolio; • hire additional clinical, scientific and commercial personnel; • add operational, financial and management information systems and personnel, including personnel to support our product development and planned future commercialization efforts, as well as to support our ongoing transition to a public reporting company; and • acquire or in-license other product candidates or technologies. Because of the numerous risks and uncertainties associated with research, development and commercialization of pharmaceutical product candidates, we are unable to estimate the exact amount of our working capital requirements. Our future funding requirements, both short-term and long-term, will depend on many factors, including: • the timing and costs of our ongoing clinical trials of oral sulopenem and sulopenem, including our two ongoing Phase 3 clinical trials; • the initiation, progress, timing, costs and results of preclinical studies and clinical trials of other potential product candidates and of our current product candidates in additional indications; • the amount of funding that we receive under government awards that we have applied for or may apply for in the future; • the number and characteristics of product candidates that we pursue; • the outcome, timing and costs of seeking regulatory approvals; • the costs of commercialization activities for oral sulopenem and sulopenem and other product candidates if we receive marketing approval, including the costs and timing of establishing product sales, marketing, distribution and manufacturing capabilities; • the receipt of marketing approval and revenue received from any potential commercial sales of oral sulopenem and sulopenem; • the terms and timing of any future collaborations, licensing or other arrangements that we may establish; • the amount and timing of any payments we may be required to make, or that we may receive, in connection with the licensing, filing, prosecution, defense and enforcement of any patents or other intellectual property rights, including milestone and royalty payments and patent prosecution fees that we are obligated to pay pursuant to the Pfizer License or other future license agreements; • the amount and timing of any payments we are obligated to make in connection with the RLNs; • the costs of preparing, filing and prosecuting patent applications, maintaining and protecting our intellectual property rights and defending against any intellectual property related claims; • the costs of operating as a public company; and • the extent to which we in-license or acquire other products and technologies. Until such time, if ever, that we can generate product revenue sufficient to achieve profitability, we expect to finance our cash needs through a combination of public or private equity offerings, debt financings, collaboration agreements, other third-party funding, strategic alliances, licensing arrangements, marketing and distribution arrangements or government funding. To the extent that we raise additional capital through the sale of equity or convertible debt securities, our shareholders’ ownership interest will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect the rights of our ordinary shareholders. Debt financing and preferred 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. Our secured credit facility with SVB, the RLNs and the Exchangeable Notes each impose operating and other restrictions on us. Such restrictions affect, and in many cases limit or prohibit, our ability to dispose of certain assets, pay dividends, incur additional indebtedness, undergo a change of control and enter into certain collaborations, strategic alliances or other similar partnerships, among other things. If we raise additional funds through other third-party funding, collaboration agreements, strategic alliances, licensing arrangements or marketing and distribution arrangements, 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. 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 products or product candidates that we would otherwise prefer to develop and market ourselves. Contractual Obligations and Commitments 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: Under the Pfizer License, we have agreed to make certain regulatory and sales milestone payments, pay royalties and make a potential one-time payment related to sublicensing income that exceeds a certain threshold. We have not included any contingent payment obligations, such as milestones, royalties, or one-time payments, in the table above as the amount, timing and likelihood of such payments are not known. We are obligated to pay Pfizer royalties ranging from a single-digit to mid-teens percentage based on marginal net sales of each licensed product. In June 2016, we entered into an agreement with a supplier whereby we agreed to pay $2.8 million (€2.5 million) to the supplier to acquire equipment, which will be used solely to manufacture product for us. In June 2018, we entered into a supplemental agreement with this supplier whereby we agreed to pay an additional $2.3 million (€2.1 million) for additional equipment and dedicated personnel under the same terms of the original agreement. These payments will be offset against the price of the product to be supplied under a future supply agreement. No balance remained outstanding to the supplier as of as of December 31, 2019. Emerging Growth Company Status The Jumpstart Our Business Startups Act of 2012 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. 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 Securities and Exchange Commission (SEC). Recently Issued Accounting Pronouncements 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 elsewhere in this Annual Report on Form 10-K.
-0.038003
-0.037525
0
<s>[INST] Overview We are a pharmaceutical company dedicated to developing and commercializing sulopenem to be potentially the first and only oral and intravenous (IV) branded penem available globally. Penems, including thiopenems and carbapenems, belong to a class of antibiotics more broadly defined as ßlactam antibiotics, the original example of which was penicillin, but which now also includes cephalosporins. Sulopenem is a potent, thiopenem antibiotic delivered intravenously which is active against bacteria that belong to the group of organisms known as gramnegatives and cause urinary tract and intraabdominal infections. We have also successfully developed sulopenem in an oral tablet formulation, sulopenem etzadroxilprobenecid, which we refer to herein as oral sulopenem. Both sulopenem product candidates have the potential to be important new treatment alternatives to address growing concerns related to antibacterial resistance without the known toxicities of some of the most widely used antibiotics, specifically fluoroquinolones. We see two distinct opportunities for our sulopenem program: patients at elevated risk for treatment failure in the community setting suffering from uncomplicated urinary tract infections (uUTI) and hospitalized patients suffering from complicated, antibioticresistant infections. During the third quarter of 2018, we initiated all three clinical trials in our Phase 3 development program which includes: a Phase 3 uUTI clinical trial, known as Sulopenem for Resistant Enterobacteriaceae (SURE) 1, comparing oral sulopenem to oral ciprofloxacin in women with uUTI, a Phase 3 complicated urinary tract infection (cUTI) clinical trial known as SURE 2, comparing IV sulopenem followed by oral sulopenem to IV ertapenem followed by oral ciprofloxacin in adults with cUTI and a Phase 3 complicated intraabdominal infection (cIAI) clinical trial known as SURE 3, comparing IV sulopenem followed by oral sulopenem to IV ertapenem followed by a combination of oral ciprofloxacin and oral metronidazole in adults with cIAI. We designed one Phase 3 clinical trial in each indication based on our end of Phase 2 meeting with the U.S. Food and Drug Administration (FDA) and feedback from the European Medicines Agency (EMA). We are conducting the Phase 3 clinical trials under Special Protocol Assessment (SPA) agreements from the FDA. We completed enrollment in our uUTI and cUTI clinical trials in the fourth quarter of 2019 and expect to produce topline data around the end of the first quarter of 2020. If these data are positive, we expect to have an opportunity to file two new drug applications (NDAs), one for oral sulopenem and one for IV sulopenem, around mid2020, which we expect would enable potential FDA approval in the first half of 2021. In December 2019, we announced that sulopenem did not meet the primary endpoint of statistical noninferiority compared to the control therapy for the cIAI trial; however, we believe the secondary supporting analyses and safety data support the potential of sulopenem in the treatment of multidrug resistant infections. EMA Scientific Advice received by us, consistent with the existing Guidance for this indication, supports an endpoint assessed earlier than the primary study endpoint and a noninferiority margin of 12.5%. On May 30, 2018 we completed an initial public offering, or IPO, of our ordinary shares, and issued and sold 6,150,000 ordinary shares at a public offering price of $13.00 per share, resulting in net proceeds of $71.8 million after deducting underwriting discounts and commissions and offering costs payable by us. On June 26, 2018, we issued and sold an additional 200,000 ordinary shares at the IPO price of $13.00 per share pursuant to the underwriters’ partial [/INST] Negative. </s>
2,020
8,075
1,668,105
Talend SA
2019-02-28
2018-12-31
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements, related notes and other financial information included elsewhere in this Annual Report. The following discussion contains forward-looking statements, including, without limitation, our expectations and statements regarding our outlook and future revenue, expenses, results of operations, liquidity, plans, strategies and objectives of management and any assumptions underlying any of the foregoing. Our actual results could differ materially from those discussed in the forward-looking statements. Our forward-looking statements and factors that might cause future actual results to differ materially from our recent results or those projected in the forward-looking statements include, but are not limited to, those discussed in “Special Note Regarding Forward-Looking Statements” and “Item 1A. Risk Factors”. Overview Our mission is to enable every organization to realize the power of their data with trust and speed. We are a key enabler of the data-driven enterprise where data is a strategic asset powering business. Talend Data Fabric allows customers in any industry to improve business performance by using their data to create new insights and to automate business processes. Our customers rely on our software to better understand their customers, offer new apps and services, and improve operations with predictive maintenance. Our employee base has grown from 679 employees as of December 31, 2016 to 886 employees as of December 31, 2017, and 1,136 employees as of December 31, 2018. We plan to continue to expand our non-U.S. presence to address the needs of our global customers as well as to acquire customers in new geographies. We also plan to continue to invest in new product development. Our open source approach is a key component of our go-to-market strategy. We have been able to rapidly expand awareness and usage of our products through our free open source versions. This enables developers and users to download and try the free version of our products, creating sales leads for our more feature-rich commercial solutions. Users of our open source products often catalyze adoption of our commercial solutions by their organizations, primarily to benefit from enterprise-grade features that include the scaling out of our offering to a larger set of users, among others. Following an initial deployment of our paid subscription products, organizations often purchase more subscriptions or expand usage to additional products from our fully integrated suite after realizing the benefits of additional features or scale. We sell our product offerings as subscriptions based primarily on the number of users of our platform. We generate the majority of our revenue from subscriptions of our commercial solutions. We primarily sell annual contracts billed in advance. Our subscription offering includes enterprise-grade features and capabilities to scale our solutions across production environments and customer infrastructures. These product features and capabilities include scheduling, management and monitoring of data integration flows, collaboration across a team of users and technical support. We also provide professional services to implement our solutions. Our subscription revenue represents a significant portion of our revenue, growing from 84% of our total revenue in the year ended December 31, 2016, to 85% in the year ended December 31, 2017, to 86% in the year ended December 31, 2018. Our financial results include: Total revenue increased from $106.0 million for 2016 to $148.6 million for 2017 to $204.3 million for 2018; Subscription revenue increased from $88.6 million for 2016 to $125.9 million for 2017 to $174.9 million for 2018; Subscription revenue grew 39% year-over-year for 2018; and Net loss was $24.2 million for 2016, $31.2 million for 2017 and $40.4 million for 2018. We intend to generate profits based on increased sales of our solutions to new and existing customers, including by the continued conversion of free open source users to paid users. We currently anticipate that at some point in the future we will be able to increase revenues at a greater rate than increases in our operating expenses. However, there can be no assurance that we will achieve or maintain profitability on a consistent basis, that we will increase our sales to new and existing customers, or that our operating expenses will increase at a lower rate than our revenue may grow. Key Factors Affecting Our Performance Expansion within Existing Customers. Our business model relies on rapidly and efficiently landing new customers and expanding our relationship with these customers over time. We have designed our apps for ease-of-use and with strong integrations between apps to encourage broad adoption within organizations. As customers gain awareness of our solutions and as their data integration and integrity requirements evolve, they may recognize additional use cases for our software and expand their use of our solutions accordingly, and our growth strategy is dependent on our ability to demonstrate the value of these additional apps to our customers. We believe this provides us with substantial operating leverage because the costs of additional sales within existing customers are significantly less than costs of sales to new customers. Our future revenue growth and profitability rely on customers continuing to expand user and app adoption within their organizations. Adoption of Modern Data Technologies. We believe our cloud and big data integration capabilities are a key competitive differentiator and driver of new customer adoptions. We expect that as organizations adopt and scale out deployments of modern data technologies such as cloud data warehouses, machine learning, and big data processing, they will continue to use Talend to facilitate the integration of these big data technologies within their IT environments. The continued shift to cloud is driving rapid growth in cloud integration. The adoption and usage of Talend Cloud and Talend Stitch Data Loader drives demand for other Talend Data Fabric apps. The continued adoption of big data technologies, and our ability to differentiate between our app offerings and those of our competitors, in both functionality and pricing, is critical to our continued revenue growth. Average Subscription Contract Duration. We primarily sell annual contracts, although we have some contracts that extend for multiple years. The average contract duration impacts our cash flows because we bill and collect payment for the full term in advance. Prior to 2014, we incentivized our sales force to pursue multi-year contracts paid in advance, which generally carry larger discounts on average relative to annual contracts. We changed our sales strategy in 2014 to focus to a greater degree on annual contracts as our business began to demonstrate greater operating leverage. As a result, our average contract term has shortened and we generate a smaller proportion of our deferred revenue as long-term. Although this results in lower subscription billings relative to multi-year pre-payments in a given period, it increases the annualized value of our subscriptions. Going forward, we intend to continue to enter into multi-year contracts with annual payment schedules. For the twelve-month periods ended December 31, 2017 and 2018, subscription sales, excluding monthly contracts, had an average pre-billed duration of 1.3 years and 1.1 years, respectively. Open Source Strategy. Our open source strategy consists of providing free open source versions of our apps, fostering a community of users and developers and selling commercial versions of our solutions. This strategy creates awareness and generates leads within organizations that may purchase a commercial version of our apps and thereby generates subscription revenue. Our open source developer community helps lower our research and development costs by contributing components and connectors, testing beta versions of our apps, identifying enhancements and providing free advice to other community members. To evaluate our open source strategy, we periodically review data points such as the volume of downloads of our open source apps, the number of open source users that are members of our open source community and the approximate number of leads that are generated from users of our open source apps. Given that our open source users register with us voluntarily, we do not use a conversion rate to evaluate our strategy. We believe the continued adoption of open source software by organizations as well as the vitality of our open source community is a critical part of our performance. Investment in Sales and Marketing. We continue to focus on long-term growth and expect to continue to invest aggressively in sales and marketing to grow our customer base and expand within existing customers. We also expect to increase investments in sales and marketing in markets outside of France and the United States. As we continue to focus on new customer acquisition, we will need to devote additional time and effort to the new customer sales cycle, which requires more time, education and effort than expanding our relationship with existing customers. Any investments that we make in sales and marketing will occur in advance of our experiencing benefits from such investments, as new sales hires take time to fully ramp. The success of these efforts will also be affected by our ability to hire and retain sales personnel, and attrition of these employees may slow our efforts. As a result, it may be difficult for us to determine if we are efficiently allocating our resources in these areas. Increasing new customer bookings, particularly among large enterprise customers, is key to our growth strategy, and we also anticipate continuing to invest in expanding our international operations and increasing sales of Talend Big Data Integration and Talend Cloud. Sales to large enterprise customers have reflected larger deal sizes and have been one of the principal drivers of our revenue growth. However, sales to large enterprise customers involve risks that may not be present with sales to smaller customers, including increased competition from companies that traditionally target larger enterprise customers and a longer sales cycle. These factors result in less visibility and create difficulties in assessing deal cyclicality for these customers. Foreign Currency Exchange Risk. A portion of our subscription agreements and operating expenses are incurred outside the United States and denominated in foreign currencies and are subject to fluctuations due to changes in foreign currency exchange rates, particularly changes in the Euro. Because our reporting currency is the U.S. dollar, the impact of foreign currency exchange on our business is primarily material to our financial reporting, and less to the ongoing operations of our business, as our cash inflows generally exceed our expenses in a given currency, creating a partial hedge. We believe that as the portion of U.S. business increases relative to our global business, the impact of foreign currency exchange on our financial reporting will be reduced. As our international operations grow, we will continue to reassess our approach to managing the risks relating to fluctuations in currency rates. Key Business Metrics We review a number of metrics to evaluate our business, measure our performance, identify trends affecting our business, formulate business plans and make strategic decisions. These key business metrics include the following: Annualized Recurring Revenue Annual Recurring Revenue (“ARR”) represents the annualized recurring value of all active contracts at the end of a reporting period. ARR includes subscriptions for use of premise-based products and SaaS offerings and excludes original equipment manufacturer ("OEM") sales. Both multi-year contracts and contracts with terms less than one year are annualized by dividing the total committed contract value by the number of months in the subscription term and then multiplied by twelve. As of December 31, 2018, ARR was $198.1 million, representing growth of 33% from December 31, 2017. Stitch accounted for 2% of ARR as of December 31, 2018. ARR does not have any standardized meaning and is therefore unlikely to be comparable to similarly titled measures presented by other companies. ARR should be viewed independently of revenue and deferred revenue and is not intended to be combined with or to replace either of those items. ARR is not a forecast and the active contracts at the end of a reporting period used in calculating ARR may or may not be extended or renewed by our customers. Subscription Revenue Growth Rate Subscription revenue is primarily derived from the sale of subscription-based license agreements to our customers. The growth of our subscription revenue reflects our ability to renew subscriptions with our existing customers, expand the sales of existing and new products within our existing customer base and sell our products to new customers. We believe subscription revenue growth is an important performance metric because it reflects the adoption of our software. Due to the significant portion of our customers who are invoiced in non-U.S. Dollar denominated currencies, we also calculate our subscription revenue growth rate on a constant currency basis, thereby removing the effect of currency fluctuation on our results of operations. The table below shows our subscription revenue growth rate on both an actual and constant currency basis for each quarter in the years ended December 31, 2017 and December 31, 2018, calculated against the corresponding quarter in the prior year, as well as the years ended December 31, 2016, 2017 and 2018. We calculate revenue on a constant currency basis by applying the average monthly currency rate for each month in the comparative period to the corresponding month in the current period. Number of Customers Above a Certain Subscription Revenue Threshold We believe our ability to increase the number of customers above a certain subscription revenue threshold over time is an indicator of our ability to penetrate large enterprise customers. We track our performance in this area by measuring the number of customers which generates an annualized subscription revenue of $0.1 million or above, calculated by multiplying the total subscription revenue from a customer in the given quarter by four. As we continue to expand the sales of existing and new products within our existing customer base, we expect more of our existing customers will cross the $0.1 million threshold. However, this may be offset if we do not successfully renew subscriptions with our existing customers. The following table summarizes on a quarterly basis the number of customers above $0.1 million of annualized subscription revenue since March 31, 2017. Dollar-Based Net Expansion Rate Our ability to generate and increase revenue is dependent on our ability to maintain and grow our relationships with our existing customers. We believe our ability to retain customers and expand their subscription revenue over time is an indicator of the stability of our revenue base and the long-term value of our customer relationships. We track our performance in this area by measuring our dollar-based net expansion rate. Our dollar-based net expansion rate increases when customers expand their number of subscribed users or use additional Talend Data Fabric components. Our dollar-based net expansion rate is reduced when customers reduce their number of subscribed users, use fewer Talend Data Fabric components, or cease to be customers. We calculate our dollar-based net expansion rate by dividing our recurring customer revenue by our base revenue. We define base revenue as the subscription revenue we recognized from all customers during the four quarters ended one year prior to the date of measurement. We define our recurring customer revenue as the subscription revenue we recognized during the four quarters ended on the date of measurement from the same customer base included in our measure of base revenue, including revenue resulting from additional sales to those customers. This analysis excludes revenue derived from our OEM sales. We expect our dollar-based net expansion rate to potentially decline as we scale our business, particularly as we continue to focus on increasing sales of our cloud-based solutions to new customers. The dollar-based net expansion rate will also face a potential decline as the benefit from the adoption of ASC 606 will not repeat in 2019. The following table summarizes our quarterly dollar-based net expansion rate since January 1, 2017 on both an actual and constant currency basis. Free Cash Flow To provide additional information regarding our financial results, we use free cash flow, a financial measure not calculated in accordance with GAAP, within this Annual Report. We define free cash flow as net cash (used in) from operating activities less net cash used in investing activities for purchases of property and equipment and intangible assets, except for those acquired as part of a business combination. We have included free cash flow in this Annual Report because it is a key measure used by our management and board of directors to understand and evaluate our core operating performance and trends, to prepare and approve our annual budget and to develop short- and long-term operational plans. We believe that free cash flow provides useful information in understanding and evaluating our results of operations in the same manner as our management and board of directors. Although free cash flow measures are frequently used by investors and securities analysts in their evaluation of companies, free cash flow measures each have limitations as an analytical tool, and you should not consider them in isolation or as a substitute for analysis of our cash flows as reported under GAAP. Free cash flow as defined by us may not be comparable to similar measures used by other companies. The table below shows our free cash flow for each of the years ended December 31, 2016, 2017 and 2018, and a reconciliation to the most directly comparable GAAP measure for such period. Key Components of Results of Operations Revenue We primarily derive our revenue from the sale of subscriptions and professional services engagements. Subscription revenue. Subscription revenue consists of fees earned from arrangements to provide customers with the right to use our commercial software either in a cloud-based infrastructure that we provide or installed within the customer’s own environment. Our subscriptions include unspecified future updates, upgrades and enhancements and technical product support. Subscription fees are based primarily on the number of users of our software and to a lesser extent the processing power required to operate the software. Our subscription-based arrangements generally have a minimum contractual term of one year and are invoiced in advance for the full subscription term. Subscription fees are generally non-refundable regardless of the actual use of the service. Professional services revenue. Professional services revenue consists of fees earned for consulting engagements related to the deployment and configuration of our product offering, training customers and associated expenses. These engagements are generally provided by our own team of specialized consultants or by third-party consultants to whom we contract on a periodic basis. Consulting engagements consist of time-based arrangements for which the revenue is recognized using a time and material basis. Training revenue results from contracts to provide educational services to customers and partners regarding the use of our technologies and is recognized as delivered. We expect our professional services revenue will grow at a slower rate than our subscription revenue as we work with more systems integrators, who assist our customers with the implementation of our solutions. Cost of Revenue Cost of subscription revenue. Cost of subscription revenue consists primarily of employee-related costs, including salaries and bonuses, sales commissions, share-based payment expense and employee benefit costs associated with our customer support organization. It also includes expenses related to hosting and operating our cloud infrastructure, license of third-party intellectual property and related overhead. We use a third-party cloud platform provider to provide our cloud solution. We allocate overhead such as information technology infrastructure, rent and occupancy charges in each expense category based on headcount in that category. As such, general overhead expenses are reflected in cost of subscription revenue and operating expense categories. We intend to continue to invest additional resources in our cloud-based offering and services. We expect that the cost of hosting fees to provide our cloud-based offering will increase over time as we sell more of our cloud integration products. The timing of these expenses will affect our cost of subscription revenue in the affected periods. Cost of professional services revenue. Cost of professional services revenue consists primarily of personnel costs for employees including salaries and bonuses, sales commissions, share-based payment expense and employee benefit costs and fees to external consultants associated with our professional service contracts, travel costs and allocated shared costs. We allocate overhead such as information technology infrastructure, rent and occupancy charges in each expense category based on headcount in that category. As such, general overhead expenses are reflected in the cost of professional services revenue and operating expense categories. Gross Profit and Gross Margin Gross profit is total revenue less total cost of revenue. Gross margin is gross profit expressed as a percentage of total revenue. We expect that our gross margin may fluctuate from period to period as a result of changes in the mix of our subscription and professional services revenue. Over time, we expect revenue from our cloud integration business to grow as a percentage of our total revenue. As a result, the cost of hosting fees to third-party cloud infrastructure providers, as a percentage of revenue will increase, which may affect our gross margin. Operating Expenses Our operating expenses are classified as sales and marketing, research and development and general and administrative. For each functional category, the largest component is employee and labor-related expenses, which include salaries and bonuses, sales commissions, share-based payment expense, employee benefit costs and contractor costs. We allocate overhead such as information technology infrastructure, rent and occupancy charges in each expense category based on headcount in that category. Sales and marketing. Sales and marketing expenses consist primarily of salaries, sales commissions and related expenses, including share-based payment expense, for our sales and marketing employees, marketing programs and related overhead. Our sales and marketing employees include quota carrying headcount, sales administration, sales engineering, marketing and management. Marketing programs consist of advertising, promotional events, corporate communications, brand building, product marketing activities such as online lead generation, and developing sales strategies that emphasize particular products or services. We plan to continue to invest in sales and marketing by expanding our global promotional activities, building brand awareness, attracting new customers and sponsoring additional marketing events. The timing of these events, such as our annual sales kickoff, will affect our sales and marketing costs in a particular quarter. We also plan to invest in training and retention of our sales team. Research and development. Research and development expenses consist primarily of salaries and related expenses, including share-based payment expense, contractor software development costs and related overhead, as well as amortization of acquired developed technology, less any research and development subsidies. We continue to focus our research and development efforts on building new products, adding new features and services, increasing functionality and enhancing our integration cloud infrastructure. We expect that, in the future, research and development expenses will increase in absolute dollars as we invest in building the necessary employee and system infrastructure required to enhance existing and support development of new, technologies and the integration of acquired businesses and technologies. General and administrative. General and administrative expenses consist of salaries and related expenses, including share-based payment expense, for finance, legal, human resources and management information systems personnel, as well as external legal, accounting and other professional fees, other corporate expenses and related overhead. We will continue to incur additional expenses associated with being a publicly traded company, including higher legal, corporate insurance and accounting costs as well as costs of achieving and maintaining compliance with other public company regulations. We expect that in the future, general and administrative expenses will increase as we invest in our infrastructure and we incur additional employee related costs and professional fees related to the growth of our business. Critical Accounting Policies and Estimates We prepare our financial statements in conformity with generally accepted accounting principles in the United States of America, or GAAP. The preparation of the consolidated financial statements in accordance with GAAP requires us to make judgments, estimates and assumptions that affect the reported amounts of assets, liabilities, contingent liabilities, revenues and expenses. We base our judgments and estimates on historical experience and various other factors we believe to be reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. Actual results may differ from these estimates under different assumptions and conditions and may materially affect the financial results or the financial position reported in future periods. While our significant accounting policies are more fully described in the notes to the consolidated financial statements, the following accounting policies involve a greater degree of judgment and complexity. Accordingly, these are the accounting policies we believe are the most critical to aid in fully understanding and evaluating our financial condition and results of operations. Revenue Recognition We primarily derive revenue from two sources: subscription revenue which is comprised of direct or indirect sales of subscription-based license agreements for Talend technologies; and related professional services revenue. Subscription revenue Subscriptions for our on-premise licenses include both a right to use the underlying software and a right to receive technical support and fixes and updates to the software, on a when-and-if available basis, during the subscription term. We have concluded that the rights to use the software, which is recognized at the outset of the arrangement, and to receive technical support and software fixes and updates, which is recognized over the term of the arrangement, are separate performance obligations. We have concluded that the right to use the software generally represents approximately 10% of the value of the contract and the remainder is allocated to the right to receive technical support and software fixes and updates. Subscriptions for our cloud-based offerings represent the right of access to our software as a service for which revenue is recognized ratably over the term of the arrangement. Subscriptions have a contractual term of one to three years and are generally billed annually in advance and are non-cancelable. We sell subscriptions to customers either directly or indirectly through non-exclusive value-added channel partners and resellers (collectively, “resellers”). Resellers market, sell and provide us products and support services to end-users and we do not have the ability or the contractual right to establish pricing between resellers and end users Professional services revenue We offer professional services which include consulting and training and associated expenses. Consulting services include implementation support to our customers during subscription setup and consist of time-based arrangements for which the revenue is recognized as the services are rendered. Training revenue results from contracts to provide educational services to customers and partners regarding the use of our technologies and is recognized as training is delivered. Contracts with multiple performance obligations We may enter into transactions that contain multiple performance obligations where a subscription and consulting and training services are sold together. 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 are able to determine reliably the standalone selling price of a consulting or training service component based on historical pricing for the component or a similar component that has been sold on a standalone basis. The transaction price allocated to each performance obligation is recognized as revenue when each performance obligation is satisfied. Contract acquisition costs Contract acquisition costs consist of sales commissions earned by our sales force and are considered incremental and recoverable costs of obtaining a contract with a customer. The majority of these costs are deferred and then amortized on a straight-line basis over a period of benefit, which we have determined to be five years based on historical patterns of renewals and forecasted life of tour licensed technology. Business Combinations and Goodwill 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. 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. When conducting the annual goodwill impairment assessment, we first assess qualitative factors, to determine whether it is necessary to perform the two-step goodwill impairment test. If determined to be necessary, the two-step impairment test shall be used to identify potential goodwill impairment and measure the amount of a goodwill impairment loss to be recognized, if any Share-Based Payments We recognize share-based payment expense beginning in the period of grant based on the fair value of the award at the grant date, net of estimated forfeitures, over the requisite service period, which is generally the vesting period of the respective award. The estimation of share awards that will ultimately vest requires judgement, especially awards with non-market performance conditions. Share-based payment expense is recorded based on awards that are 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. Determining the fair value of share-based awards at the grant date requires judgment. We use the Black-Scholes option-pricing model to determine the fair value of share options, employee warrants (BSPCE) and warrant (BSA). The determination of the grant date fair value of options using an option-pricing model is affected by our estimated ordinary share fair value as well as assumptions regarding a number of other complex and subjective variables. These variables include the expected term of the options, our expected share price volatility, risk-free interest rates and expected dividends, which are estimated as follows: Expected term. We determine the expected term based on the average period the share awards are expected to remain outstanding. Expected volatility. We consider historical volatility of our share price since the initial public offering and also consider the historical volatility of similar entities following a comparable period in their lives. Risk-free rate. The risk-free interest rate represents the implied yield currently available on zero-coupon government issued securities over the expected term of the award. Dividend yield. We have never declared or paid any cash dividends and do not presently plan to pay cash dividends in the foreseeable future. Consequently, we use an expected dividend yield of zero. Accounting standards issued not yet adopted In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842), which requires the recognition of lease assets and lease liabilities on the balance sheet by lessees for those leases currently classified as operating leases under ASC Topic 840 Leases. The guidance is effective for our fiscal year beginning January 1, 2019. Early adoption is permitted. We will adopt the new standard in the first quarter of fiscal 2019. Upon adoption, we will recognize right-of-use assets and operating lease liabilities on our consolidated balance sheets, which will increase our total assets and total liabilities. We are assessing the final impact of ASU 2016-02 on our consolidated financial statements but we expect that the adoption will result in recognition of approximately $41.0 million (before discounting impact) right-of-use asset and a roughly equal amount of operating lease liability as a result of substantially all operating leases existing as of the adoption date being capitalized along with the associated obligations. The $41.0 million represents the total undiscounted future lease obligations at December 31, 2018 and the final impact will be discounted. Results of Operations The following table sets forth our results of operations for the periods indicated. The period-to-period comparison of financial results is not necessarily indicative of financial results to be achieved in future periods. (1)Amounts include share-based payment and amortization of acquired intangibles expense, as follows: The following table sets forth our results of operations data for each of the periods indicated as a percentage of total revenue. Years Ended December 31, 2017 and 2018 Revenue Total revenue increased $55.7 million, or 38%, in the year ended December 31, 2018 compared to the year ended December 31, 2017. Growth in total revenue was attributable to increased demand for our products from both new and existing customers. The growth in total revenue was attributable primarily to the sale of subscriptions and to a lesser extent the growth of professional services revenue. Subscription revenue increased $49.0 million, or 39%, for the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase in subscription revenue was primarily attributable to strong demand for Talend Cloud and Talend Big Data Integration. Revenue from Talend Cloud grew by over 100% in the year ended December 31, 2018 compared to the prior period. The adoption of ASC 606 contributed to the increase in subscription revenue of approximately $4.5 million, as we recognized the license element of our subscription arrangements upfront, upon delivery of the license key. Professional services revenue grew by $6.7 million, or 30% for the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase in professional services revenue was mainly due to increased demand from North American customers. Subscription revenues by geography were as follows for the years ended December 31, 2017 and 2018: Cost of Revenue Total cost of revenue increased $15.3 million, or 45%, in the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase in total cost of revenue was driven by an increase in the cost of subscription revenue of $6.7 million, or 41%, in the year ended December 31, 2018 compared to the prior period. We increased our headcount during the period to meet the higher demand for support from our customers, resulting in increased compensation expense for employees and contractors of $5.2 million. Between December 31, 2017 and December 31, 2018, the support team headcount increased by 32% to 123 employees. The increase in the cost of subscription revenue was also driven by an increase in third-party licensing fees and hosting costs for our Talend Cloud for a total of $0.3 million. Cost of professional services revenue increased $8.6 million, or 48%, as we increased our team size and the use of contractors to support increased demand for our professional services. Between December 31, 2017 and December 31, 2018, the professional services team headcount increased by 51% to 128 employees, resulting in increased employee compensation and related expenses of $5.2 million for the year ended December 31, 2018. Additionally, cost of professional services was driven by an increase in sub-contractor expenses and travel and entertainment costs of $2.9 million for the year ended December 31, 2018. Sales and Marketing Sales and marketing expenses increased $26.8 million, or 31%, in the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase was primarily due to a $21.0 million increase in employee compensation expenses, related to increased headcount. Between December 31, 2017 and December 31, 2018, our sales and marketing headcount increased by 26% to 459 employees. In addition, to support our continued growth, spending on marketing programs increased by $2.0 million in the year ended December 31, 2018 compared to the year ended December 31, 2017. Sales and marketing expense was also driven by an increase of $1.9 million in travel and entertainment costs. These expenses were partially offset by a benefit of $4.4 million in capitalized commission expenses due to the adoption of ASC 606 in 2018. Research and Development Research and development expenses increased $15.5 million, or 58%, in the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase was primarily due to a $11.7 million increase in employee compensation expenses, related to increased headcount. Between December 31, 2017 and December 31, 2018, our research and development headcount increased by 16% to 277 employees. In addition, research and development expenses increased by $1.5 million related additional amortization expense from our November 2017 acquisition of Restlet S.A. and our November 2018 acquisition of Stitch Inc. General and Administrative General and administrative expenses increased $10.9 million, or 37%, in the year ended December 31, 2018, compared to the year ended December 31, 2017. The increase was primarily due to an increase of $8.5 million in employee compensation expenses. Between December 31, 2017 and December 31, 2018, our general and administrative headcount increased by 29% to 133 employees as we added personnel to support our growth. In addition, our professional and outside consulting services increased by $1.5 million related to our follow-on offering and acquisition of Stitch Inc. Between December 31, 2017 and December 31, 2018, our amortization of intangible assets increased by $0.4 million. Years Ended December 31, 2016 and 2017 Revenue Total revenue increased $42.6 million, or 40%, in the year ended December 31, 2017 compared to the year ended December 31, 2016. Growth in total revenue was attributable to increased demand for our products from both new and existing customers. The growth in total revenue was attributable primarily to the sale of subscriptions and to a lesser extent the growth of professional services revenue. Subscription revenue increased $37.3 million, or 42%, for the year ended December 31, 2017 compared to the year ended December 31, 2016. The increase in subscription revenue was primarily attributable to strong demand for Talend Cloud and Talend Big Data Integration, which combined grew by 100% in the year ended December 31, 2017 compared to the prior period. The increase in revenue was further driven by strong demand from North America where we have invested in greater sales capacity and Asia Pacific where we continued to scale out this expanding territory. Professional services revenue grew by $5.3 million, or 31% for the year ended December 31, 2017 compared to the year ended December 31, 2016. The increase in professional services revenue was mainly due to increased demand from North American customers. Subscription revenues by geography were as follows for the years ended December 31, 2016 and 2017: Cost of Revenue Total cost of revenue increased $8.6 million, or 34%, in the year ended December 31, 2017 compared to the year ended December 31, 2016. The increase in total cost of revenue was driven by an increase in the cost of subscription revenue of $4.1 million, or 33%, in the year ended December 31, 2017 compared to the prior period. We increased our headcount during the period to meet the higher demand for support from our customers, resulting in increased compensation expense for employees and contractors of $3.0 million. Between December 31, 2016 and December 31, 2017, the support team headcount increased by 34% to 95 employees. The increase in the cost of subscription revenue was also driven by an increase in third-party licensing fees and hosting costs for our Talend Cloud for a total of $0.6 million. Cost of professional services revenue increased $4.5 million, or 34%, as we increased our team size and the use of contractors to support increased demand for our professional services, particularly in North America. Between December 31, 2016 and December 31, 2017, the professional services team headcount increased by 35% to 85 employees. Sales and Marketing Sales and marketing expenses increased $19.3 million, or 29%, in the year ended December 31, 2017 compared to the year ended December 31, 2016. The increase was primarily due to $13.0 million increase in employee compensation expenses, related to increased headcount. Between December 31, 2016 and December 31, 2017, our sales and marketing headcount increased by 33% to 365 employees. In addition, to support our continued growth, spending on marketing programs increased by $3.0 million in the year ended December 31, 2017 compared to the year ended December 31, 2016. Sales and marketing expense was also driven by an increase of $1.3 million in travel and entertainment costs. Research and Development Research and development expenses increased $7.6 million, or 39%, in the year ended December 31, 2017 compared to the year ended December 31, 2016. The increase was primarily due to a $6.5 million increase in employee compensation expenses, related to increased headcount. Between December 31, 2016 and December 31, 2017, our research and development headcount increased by 27% to 238 employees including 16 new employees from our acquisition of Restlet SAS. General and Administrative General and administrative expenses increased $9.9 million, or 50%, in the year ended December 31, 2017, compared to the year ended December 31, 2016. The increase was primarily due to an increase of $4.3 million in employee compensation expenses. Between December 31, 2016 and December 31, 2017, our general and administrative headcount increased by 23% to 103 employees as we added personnel to support our growth and the additional requirements of being a public reporting company. Between December 31, 2016 and December 31, 2017, our professional and outside services increased by $4.0 million, of which $1.4 million were expenses related to our follow-on offering and filing of a registration statement on Form and $0.3 million in costs related to our acquisition of Restlet SAS. Quarterly Results of Operations The following unaudited quarterly results of operations data for each of the eight quarters ended December 31, 2018 have been prepared on a basis consistent with our audited consolidated annual financial statements and include, in management’s opinion, all normal recurring adjustments necessary for the presentation of the results of operations data for these periods, in accordance with GAAP. Our quarterly results of operations will vary in the future. These quarterly results of operations are not necessarily indicative of our results of operations for a full year or any future period. The following quarterly financial data should be read in conjunction with our consolidated financial statements, related notes and other financial information included elsewhere in this Annual Report. (1) Includes share-based payment and amortization of acquired intangibles expense as follows: The following table sets forth our results of operations data for each of the periods indicated as a percentage of total revenue. Quarterly Revenue Trends Our quarterly subscription revenue increased in each period presented due to increased sales to new and existing customers. Our professional services revenue fluctuates from quarter to quarter based on a number of factors, including complexity and length of new customer engagements and the decision of our customers to work with independent third-party systems integrators. Our overall strategy is to focus on growing our subscription revenue while working more closely with systems integrators. Our total gross margin has remained relatively consistent over all periods presented, with the fluctuations primarily due to the mix of subscription and professional services revenues in our total revenue. Our cost of subscription revenue increased slightly as a percentage of revenue in the fourth quarter of 2018 due to growth in our cloud operations. Research and development, sales and marketing, and general and administrative expenses generally increased, in absolute dollars, sequentially over the periods as we increased our headcount to support continued investment in our products. The increase in personnel costs was related to increases in headcount, along with higher share-based payment expense. Research and development expenses grew as a percentage of revenue as we expanded our engineering team to further support the development of our cloud offerings. Sales and marketing expenses generally are higher in the quarters ending December 31 as it is the quarter where we seasonally sell the most and thereby have higher commission expenses. Our general and administrative expenses generally increased sequentially in fiscal 2018 due to increased headcount as a result of continued overall growth. Liquidity and Capital Resources Through December 31, 2018, we have financed our operations primarily through cash received from customers for subscriptions of our software and professional services, as well as equity financings. As of December 31, 2018, we had $33.7 million of cash and cash equivalents. We believe that our current cash and cash equivalents will be sufficient to meet our working capital and capital expenditure requirements for at least the next 12 months. Also, subsequent to fiscal year-end 2018, we have entered into a revolving credit facility with Square 1 Bank, see the Subsequent Event footnote, Note 19 . Our future capital requirements will depend on many factors, including our growth rate, the timing and extent of our spending to support our operating expenses. In the event that additional financing is required from outside sources, we may not be able to raise such financing on terms acceptable to us or at all. If we are unable to raise additional capital when desired, our business, results of operations and financial condition would be adversely affected. Operating Activities During the year ended December 31, 2018, operating activities provided $3.2 million in cash as a result of a net loss of $40.4 million, adjusted by non-cash charges of $24.9 million and a $18.7 million favorable impact from changes in working capital. The net increase in our working capital was primarily the result of $26.0 million increase in deferred revenue as a result of increased sales of subscriptions, a $11.6 million increase in accounts payable and accrued expenses mainly due to increased accruals for paid time off and commissions and bonuses during the year. In addition to the net increase in our operating liabilities, there was a $12.4 million increase in accounts receivable in the year ended December 31, 2018 due to increased sales of our product offerings. During the year ended December 31, 2017, operating activities used $2.3 million in cash as a result of a net loss of $31.2 million, adjusted by non-cash charges of $10.1 million and a $18.4 million favorable impact from changes in working capital. The net decrease in our working capital was primarily the result of $29.1 million increase in deferred revenue as a result of increased sales of subscriptions, a $7.6 million increase in accounts payable and accrued expenses mainly due to increased accruals for paid time off and commissions and bonuses during the year. In addition to the net increase in our operating liabilities, there was a $16.5 million increase in accounts receivable in the year ended December 31, 2017 due to increased sales of our product offerings. During the year ended December 31, 2016, operating activities provided $3.4 million in cash as a result of a net loss of $24.2 million, adjusted by non-cash charges of $2.1 million and a $25.6 million favorable impact from changes in working capital. The net decrease in our working capital was primarily the result of $32.8 million increase in deferred revenue as a result of increased sales of subscriptions, a $6.6 million increase in trade and other payables mainly due to increased accruals for commissions and bonuses during the year. In addition to the net increase in our operating liabilities, there was a $14.1 million increase in trade and other receivables in the year ended December 31, 2016 due to increased sales of our product offerings. Investing Activities Cash used in investing activities during the years ended December 31, 2016, 2017 and 2018 was $1.4 million, $11.4 million, and $64.5 million, respectively. Investing activities for the year ended December 31, 2016 consist primarily of capital expenditures to purchase furniture and equipment to support additional office space as well as miscellaneous IT equipment for our employees. Investing activities for the year ended December 31, 2017 consists primarily of cash consideration paid for our acquisition of Restlet SAS. Investing activities for the year ended December 31, 2018 consists primarily of cash consideration paid for our acquisition of Stitch, Inc. Financing Activities Cash from financing activities for the years ended December 31, 2016, 2017, and 2018 was $82.3 million, $6.5 million, and $8.6 million, respectively. Financing proceeds for the year ended December 31, 2016 consisted primarily from $91.3 million of net proceeds from our initial public offering received in the third quarter of 2016. Financing proceeds for the year ended December 31, 2017 was driven by $6.7 million of proceeds from the exercise of employee stock awards. Financing proceeds for the year ended December 31, 2018 was driven by $8.9 million of proceeds from the exercise of employee stock awards and cash received from the employee stock purchase plan. Deferred revenue and backlog Our deferred revenue, which consists of billed but unrecognized revenue, was $140.2 million and $150.1 million as of December 31, 2017 and 2018, respectively. Our total backlog, which we define as including both cancelable and non-cancelable portions of our support subscription customer agreements that we have not yet billed, was $20.3 million and $32.1 million as of December 31, 2017 and 2018, respectively. Of the December 31, 2018 backlog, we expect to recognize revenue of $9.0 million in 2019 and $23.1 million thereafter. Research and Development, Patents and Licenses, etc. We invest substantial resources in research and development to enhance our data integration, data processing and data governance solutions. Our research and development team is globally distributed in France, Germany and China. We expect to continue to expand the capabilities of our Talend Data Fabric platform in the future and to invest significantly in continued research and development efforts. In the years ended December 31, 2016, 2017 and 2018, our research and development expenses were $19.3 million, $26.8 million and $42.4 million, respectively. As of December 31, 2018, we had two pending patent applications and no issued patents. Off-balance Sheet Arrangements During the periods presented, we did not have 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. Tabular Disclosure of Contractual Obligations Our contractual obligations consist of leases for office space. The leases have varying terms, escalation clauses and renewal rights. On renewal, the terms of the leases are renegotiated. As of December 31, 2018, the future undiscounted non-cancelable minimum lease payments under these obligations were as follows:
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-0.034824
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<s>[INST] Overview Our mission is to enable every organization to realize the power of their data with trust and speed. We are a key enabler of the datadriven enterprise where data is a strategic asset powering business. Talend Data Fabric allows customers in any industry to improve business performance by using their data to create new insights and to automate business processes. Our customers rely on our software to better understand their customers, offer new apps and services, and improve operations with predictive maintenance. Our employee base has grown from 679 employees as of December 31, 2016 to 886 employees as of December 31, 2017, and 1,136 employees as of December 31, 2018. We plan to continue to expand our nonU.S. presence to address the needs of our global customers as well as to acquire customers in new geographies. We also plan to continue to invest in new product development. Our open source approach is a key component of our gotomarket strategy. We have been able to rapidly expand awareness and usage of our products through our free open source versions. This enables developers and users to download and try the free version of our products, creating sales leads for our more featurerich commercial solutions. Users of our open source products often catalyze adoption of our commercial solutions by their organizations, primarily to benefit from enterprisegrade features that include the scaling out of our offering to a larger set of users, among others. Following an initial deployment of our paid subscription products, organizations often purchase more subscriptions or expand usage to additional products from our fully integrated suite after realizing the benefits of additional features or scale. We sell our product offerings as subscriptions based primarily on the number of users of our platform. We generate the majority of our revenue from subscriptions of our commercial solutions. We primarily sell annual contracts billed in advance. Our subscription offering includes enterprisegrade features and capabilities to scale our solutions across production environments and customer infrastructures. These product features and capabilities include scheduling, management and monitoring of data integration flows, collaboration across a team of users and technical support. We also provide professional services to implement our solutions. Our subscription revenue represents a significant portion of our revenue, growing from 84% of our total revenue in the year ended December 31, 2016, to 85% in the year ended December 31, 2017, to 86% in the year ended December 31, 2018. Our financial results include: Total revenue increased from $106.0 million for 2016 to $148.6 million for 2017 to $204.3 million for 2018; Subscription revenue increased from $88.6 million for 2016 to $125.9 million for 2017 to $174.9 million for 2018; Subscription revenue grew 39% yearoveryear for 2018; and Net loss was $24.2 million for 2016, $31.2 million for 2017 and $40.4 million for 2018. We intend to generate profits based on increased sales of our solutions to new and existing customers, including by the continued conversion of free open source users to paid users. We currently anticipate that at some point in the future we will be able to increase revenues at a greater rate than increases in our operating expenses. However, there can be no assurance that we will achieve or maintain profitability on a consistent basis, that we will increase our sales to new and existing customers, or that our operating expenses will increase at a lower rate than our revenue may grow. Key Factors Affecting Our Performance Expansion within Existing Customers. Our business model relies on rapidly and efficiently landing new customers and expanding our relationship with these customers over time. We have designed our apps for easeofuse and with strong integrations between apps to encourage broad adoption within organizations. As customers gain awareness of our solutions and as their data integration and integrity requirements evolve, they may recognize additional use cases for our software and expand their use of our solutions accordingly, and our growth strategy is dependent on our ability to demonstrate the value of these additional apps to our customers. We believe this provides us with substantial operating leverage because the costs of additional sales within existing customers are significantly less than costs of sales to new [/INST] Negative. </s>
2,019
8,366
1,668,105
Talend S.A.
2020-03-17
2019-12-31
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements, related notes and other financial information included elsewhere in this Annual Report. The following discussion contains forward-looking statements, including, without limitation, our expectations and statements regarding our outlook and future revenue, expenses, results of operations, liquidity, plans, strategies and objectives of management and any assumptions underlying any of the foregoing. Our actual results could differ materially from those discussed in the forward-looking statements. Our forward-looking statements and factors that might cause future actual results to differ materially from our recent results or those projected in the forward-looking statements include, but are not limited to, those discussed in “Special Note Regarding Forward-Looking Statements” and “Item 1A. Risk Factors”. Overview Our mission is to provide data intelligence for all users by delivering trusted data when and where is it needed. We are a key enabler of the data-driven enterprise where data is a strategic asset powering business. Talend Data Fabric allows customers in any industry to improve business performance by using their data to create new insights and to automate business processes. Our customers rely on our software to better understand their customers, offer new applications and services, and improve operations. We had 1,219 employees as of December 31, 2019 and we plan to continue to expand our non-U.S. presence to address the needs of our global customers as well as to acquire customers in new geographies. We also plan to continue to invest in new product development. Our business model combines our open source approach with self-service trials of our commercial software and direct sales. We have been able to rapidly expand awareness and usage of our products through our free open source versions and self-service trials. This enables developers and users to download and try the free and paid version of our products, creating sales leads for our more feature-rich commercial solutions. Users of our open source products often catalyze adoption of our commercial solutions by their organizations, primarily to benefit from enterprise-grade features that include the scaling out of our offering to a larger set of users, among others. Following an initial deployment of our paid subscription products, organizations often purchase more subscriptions or expand usage to additional products from our fully integrated suite after realizing the benefits of additional features or scale. We sell our product offerings as subscriptions based primarily on the number of users of our platform. We generate the majority of our revenue from subscriptions of our commercial solution Talend Data Fabric. We primarily sell annual contracts billed in advance. Our subscription offering includes enterprise-grade features and capabilities to scale our solutions across production environments and customer infrastructures. These product features and capabilities include scheduling, management and monitoring of data integration flows, collaboration across a team of users and technical support. We also provide professional services to implement our solutions. Our subscription revenue represents a significant portion of our revenue, growing from 85% of our total revenue in the year ended December 31, 2017, to 86% in the year ended December 31, 2018, and 88% in the year ended December 31, 2019. Our financial results include: ● Total revenue increased from $148.6 million for 2017 to $205.8 million for 2018 to $247.9 million for 2019; ● Subscription revenue increased from $125.9 million for 2017 to $176.4 million for 2018 to $217.0 million for 2019; ● Subscription revenue grew 23% year-over-year for 2019; and ● Net loss was $61.5 million for 2019, $39.0 million for 2018 and $31.2 million for 2017. We intend to generate profits based on increased sales of our solutions to new and existing customers, including by the continued conversion of free trials into paid users. We currently anticipate that at some point in the future we will be able to increase revenues at a greater rate than increases in our operating expenses. However, there can be no assurance that we will achieve or maintain profitability on a consistent basis, that we will increase our sales to new and existing customers, or that our operating expenses will increase at a lower rate than our revenue may grow. Key Factors Affecting Our Performance Expansion within Existing Customers. Our business model relies on rapidly and efficiently landing new customers and expanding our relationship with these customers over time. We have designed our apps for ease-of-use and with strong integrations between apps to encourage broad adoption within organizations. As customers gain awareness of our solutions and as their data integration and integrity requirements evolve, they may recognize additional use cases for our software and expand their use of our solutions accordingly, and our growth strategy is dependent on our ability to demonstrate the value of these additional apps to our customers. We believe this provides us with substantial operating leverage because the costs of additional sales within existing customers are significantly less than costs of sales to new customers. Our future revenue growth and profitability rely on customers continuing to expand user and app adoption within their organizations. Adoption of Modern Data Technologies. We believe our cloud and big data integration capabilities are a key competitive differentiator and driver of new customer adoptions. We expect that as organizations adopt and scale out deployments of modern data technologies such as cloud data warehouses, machine learning, and big data processing, they will continue to use Talend to facilitate the integration of these big data technologies within their IT environments. The continued shift to cloud is driving rapid growth in cloud integration. The adoption and usage of Talend Cloud and Talend Stitch Data Loader drives demand for other Talend Data Fabric apps. The continued adoption of big data technologies, and our ability to differentiate between our app offerings and those of our competitors, in both functionality and pricing, is critical to our continued revenue growth. Average Subscription Contract Duration. We primarily sell annual contracts, although we have some contracts that extend for multiple years. The average contract duration impacts our cash flows because we bill and collect payment for the full term in advance. For the twelve-month periods ended December 31, 2019 and 2018, subscription sales, excluding monthly contracts, each had an average pre-billed duration of 1.1 years. Open Source Strategy. Our open source strategy consists of fostering a community of users and developers and selling commercial versions of our solutions. Our open source developer community helps lower our research and development costs by contributing components and connectors, testing beta versions of our apps, identifying enhancements and providing free advice to other community members. To evaluate our open source strategy, we periodically review data points such as the volume of downloads of our open source apps, the number of open source users that are members of our open source community and the approximate number of leads that are generated from users of our open source apps. Given that our open source users register with us voluntarily, we do not use a conversion rate to evaluate our strategy. We believe the continued adoption of open source software by organizations as well as the vitality of our open source community is a critical part of our performance. Investment in Sales and Marketing. We continue to focus on long-term growth and expect to continue to invest aggressively in sales and marketing to grow our customer base and expand within existing customers. We also expect to increase investments in sales and marketing in markets outside of France and the United States. As we continue to focus on new customer acquisition, we will need to devote additional time and effort to the new customer sales cycle, which requires more time, education and effort than expanding our relationship with existing customers. Any investments that we make in sales and marketing will occur in advance of our experiencing benefits from such investments, as new sales hires take time to fully ramp. The success of these efforts will also be affected by our ability to hire and retain sales personnel, and attrition of these employees may slow our efforts. As a result, it may be difficult for us to determine if we are efficiently allocating our resources in these areas. Increasing new customer bookings, particularly among small and medium businesses and large enterprise customers, is key to our growth strategy, and we also anticipate continuing to invest in expanding our international operations and increasing sales of Talend Big Data. Integration and Talend Cloud. Sales to large enterprise customers have reflected larger deal sizes and have been one of the principal drivers of our revenue growth. However, sales to large enterprise customers involve risks that may not be present with sales to smaller customers, including increased competition from companies that traditionally target larger enterprise customers and a longer sales cycle. These factors result in less visibility and create difficulties in assessing deal cyclicality for these customers. Foreign Currency Exchange Risk. A portion of our subscription revenue, professional services revenue and operating expenses are incurred outside the United States and denominated in foreign currencies and are subject to fluctuations due to changes in foreign currency exchange rates, particularly changes in the euro. Because our reporting currency is the U.S. dollar, the impact of foreign currency exchange on our business is primarily material to our financial reporting, and less to the ongoing operations of our business, as our cash inflows generally exceed our expenses in a given currency, creating a partial hedge. We believe that as the portion of U.S. business increases relative to our global business, the impact of foreign currency exchange on our financial reporting will be reduced. As our international operations grow, we will continue to reassess our approach to managing the risks relating to fluctuations in currency rates. Key Business Metrics We review a number of metrics to evaluate our business, measure our performance, identify trends affecting our business, formulate business plans and make strategic decisions. These key business metrics include the following: Annual Recurring Revenue We believe disclosing Annual Recurring Revenue (“ARR”) provides greater clarity into our results given it is not affected by the shift from premise to cloud, accounting changes, or contract duration. ARR represents the annualized recurring value of all active contracts at the end of a reporting period. ARR includes subscriptions for use of premise-based products and SaaS offerings and excludes original equipment manufacturer ("OEM") sales. Both multi-year contracts and contracts with terms less than one year are annualized by dividing the total committed contract value by the number of months in the subscription term and then multiplied by twelve. Due to the significant portion of our customers who are invoiced in non-U.S. Dollar denominated currencies, we also calculate our ARR growth rate on a constant currency basis, thereby removing the effect of currency fluctuation. The following table summarizes ARR and its year over year growth rate on both an actual and constant currency basis as of the end of each reporting period since December 31, 2018. We calculate ARR growth rate on a constant currency basis by applying the spot currency rate from the last day of the comparative period to the corresponding day in the current period. The year over year growth rate for each quarter was calculated against the corresponding quarter in the prior year. The growth rate as of December 31, 2019 is driven by strong demand for our cloud-based solutions. Cloud Annual Recurring Revenue We believe disclosing Cloud Annual Recurring Revenue (“Cloud ARR”) provides greater clarity into the company’s results given it is not affected by accounting changes, or contract duration. Furthermore, the majority of new ARR comes from cloud and providing the metric will enable management and investors to better understand the our progress in our shift to cloud. Cloud ARR represents the annualized recurring value of all active cloud-based subscription contracts at the end of a reporting period. Cloud ARR includes subscriptions for use of SaaS offerings and excludes OEM sales. Both multi-year contracts and contracts with terms less than one year are annualized by dividing the total committed contract value by the number of months in the subscription term and then multiplied by twelve. Due to the significant portion of our customers who are invoiced in non-U.S. Dollar denominated currencies, we also calculate our Cloud ARR growth rate on a constant currency basis, thereby removing the effect of currency fluctuation. The following table summarizes Cloud ARR and its year over year growth rate on both an actual and constant currency basis as of the end of each reporting period since December 31, 2018. We calculate Cloud ARR growth rate on a constant currency basis by applying the spot currency rate from the last day of the comparative period to the corresponding day in the current period. ARR does not have any standardized definition and is therefore unlikely to be comparable to similarly titled measures presented by other companies. ARR should be viewed independently of revenue and deferred revenue and is not intended to be combined with or to replace either of those items. ARR is not a forecast and the active contracts at the end of a reporting period used in calculating ARR may or may not be extended or renewed by our customers. Subscription Revenue Growth Rate Subscription revenue is primarily derived from the sale of subscription-based license agreements to our customers. The growth of our subscription revenue reflects our ability to renew subscriptions with our existing customers, expand the sales of existing and new products within our existing customer base and sell our products to new customers. We believe subscription revenue growth is an important performance metric because it reflects the adoption of our software. Due to the significant portion of our customers who are invoiced in non-U.S. Dollar denominated currencies, we also calculate our subscription revenue growth rate on a constant currency basis, thereby removing the effect of currency fluctuation on our results of operations. The table below shows our subscription revenue growth rate on both an actual and constant currency basis for each quarter in the years ended December 31, 2019 and December 31, 2018, calculated against the corresponding quarter in the prior year, as well as the years ended December 31, 2019, 2018 and 2017. We calculate revenue on a constant currency basis by applying the average monthly currency rate for each month in the comparative period to the corresponding month in the current period. (1) The percentages previously disclosed for each of the quarters of the years ended December 31, 2019 and 2018 have been revised to reflect the correction of an immaterial error. See Note 3, Revision of prior period financial statements, for more details. Number of Customers Above a Certain ARR Threshold We believe our ability to increase the number of customers above a certain threshold is an indicator of our ability to penetrate large enterprise customers. We track and disclose the number of customers that, as of the end of the relevant period, have ARR of $0.1 million or more. Historically, we had tracked our performance in this area by measuring the number of customers that generate an annualized subscription revenue of $0.1 million or more, calculated by multiplying the total subscription revenue from a customer in the given quarter by four. However, we believe the ARR-based measure is more useful to management and investors because it is not affected by accounting changes or contract duration and better reflects the state of our customer base on the last day of the reporting period. Therefore, we no longer track or disclose the revenue-based metric and will only present the ARR-based metric. The following table summarizes the number of customers with ARR above $0.1 million as of the end of each reporting period since December 31, 2018: As we continue to expand the sales of existing and new products within our existing customer base, over time we expect more of our existing customers will cross the $0.1 million threshold, driven particularly by cloud customers as we increasingly focus our resources on our cloud offerings and the overall market shifts to cloud. However, this increase may not materialize if we do not successfully renew subscriptions with our existing customers, particularly if our on-premise subscription business growth falls below our expectations. Dollar-Based Net Expansion Rate Our ability to generate and increase revenue is dependent on our ability to maintain and grow our relationships with our existing customers. We believe our ability to retain customers and expand their subscription revenue over time is an indicator of the stability of our revenue base and the long-term value of our customer relationships. We track our performance in this area by measuring our dollar-based net expansion rate. Our dollar-based net expansion rate increases when customers expand their number of subscribed users or use additional Talend Data Fabric components. Our dollar-based net expansion rate is reduced when customers reduce their number of subscribed users, use fewer Talend Data Fabric components, or cease to be customers. We calculate our dollar-based net expansion rate by dividing our recurring customer revenue by our base revenue. We define base revenue as the subscription revenue we recognized from all customers during the four quarters ended one year prior to the date of measurement. We define our recurring customer revenue as the subscription revenue we recognized during the four quarters ended on the date of measurement from the same customer base included in our measure of base revenue, including revenue resulting from additional sales to those customers. This analysis excludes revenue derived from our OEM sales. We expect our dollar-based net expansion rate to potentially decline as we scale our business, particularly as we continue to focus on increasing sales of our cloud-based solutions to new customers and market demand for on-premise solutions continues to slow. Due to the significant portion of our customers who are invoiced in non-U.S. Dollar denominated currencies, we also calculate our dollar-base net expanstion rate on a constant currency basis, thereby removing the effect of currency fluctuation. The following table summarizes our quarterly dollar-based net expansion rate since January 1, 2018 on both an actual and constant currency basis. We calculate dollar-based net expansion rate on a constant currency basis by applying the average monthly currency rate for each month in the comparative period to the corresponding month in the current period. (1) The numbers previously disclosed for each of the quarters of the years ended December 31, 2019 and 2018 have been revised to reflect the correction of an immaterial error. See Note 3, Revision of prior period financial statements, for more details. Free Cash Flow To provide additional information regarding our financial results, we use free cash flow, a financial measure not calculated in accordance with GAAP, within this Annual Report. We define free cash flow as net cash (used in) from operating activities less net cash used in investing activities for purchases of property and equipment and intangible assets, except for those acquired as part of a business combination. We have included free cash flow in this Annual Report because it is a key measure used by our management and board of directors to understand and evaluate our core operating performance and trends, to prepare and approve our annual budget and to develop short- and long-term operational plans. We believe that free cash flow provides useful information to investors in understanding and evaluating our results of operations in the same manner as our management and board of directors. Although free cash flow measures are frequently used by investors and securities analysts in their evaluation of companies, free cash flow measures each have limitations as an analytical tool, and you should not consider them in isolation or as a substitute for analysis of our cash flows as reported under GAAP. Free cash flow as defined by us may not be comparable to similar measures used by other companies. The table below shows our free cash flow for each of the years ended December 31, 2019, 2018 and 2017, and a reconciliation to the most directly comparable GAAP measure for such period. Key Components of Results of Operations Revenue We primarily derive our revenue from the sale of subscriptions and professional services engagements. Subscription revenue. Subscription revenue consists of fees earned from arrangements to provide customers with the right to use our commercial software either in a cloud-based infrastructure that we provide or installed within the customer’s own environment. Our subscriptions include unspecified future updates, upgrades and enhancements and technical product support. Subscription fees are based primarily on the number of users of our software and to a lesser extent the processing power required to operate the software. Our subscription-based arrangements generally have a minimum contractual term of one year and are invoiced in advance for the full subscription term. Subscription fees are generally non-refundable regardless of the actual use of the service. Professional services revenue. Professional services revenue consists of fees earned for consulting engagements related to the deployment and configuration of our product offering, training customers and associated expenses. These engagements are generally provided by our own team of specialized consultants or by third-party consultants to whom we contract on a periodic basis. Consulting engagements consist of time-based arrangements for which the revenue is recognized using a time and material basis. Training revenue results from contracts to provide educational services to customers and partners regarding the use of our technologies and is recognized as delivered. We expect our professional services revenue growth will slow, and may decline, as we work with more systems integrators, who assist our customers with the implementation of our solutions, and as our cloud-based offerings increase because cloud customers typically demand fewer professional services. Cost of Revenue Cost of subscription revenue. Cost of subscription revenue consists primarily of employee-related costs, including salaries and bonuses, share-based payment expenses and employee benefit costs associated with our customer support organization. It also includes expenses related to hosting and operating our cloud infrastructure, licensing of third-party intellectual property and related overhead. We use third-party cloud platform providers to provide our cloud solution. We allocate overhead such as information technology infrastructure, rent and occupancy charges in each expense category based on headcount in that category. As such, general overhead expenses are reflected in cost of subscription revenue and operating expense categories. We intend to continue to invest additional resources in our cloud-based offering and services. We expect that the cost of hosting fees to provide our cloud-based offering will increase over time as we sell more of our cloud integration products. The timing of these expenses will affect our cost of subscription revenue in the affected periods. Cost of professional services revenue. Cost of professional services revenue consists primarily of personnel costs for employees including salaries and bonuses, share-based payment expenses and employee benefit costs and fees to external consultants associated with our professional service contracts, travel costs and allocated shared costs. We allocate overhead such as information technology infrastructure, rent and occupancy charges in each expense category based on headcount in that category. As such, general overhead expenses are reflected in the cost of professional services revenue and operating expense categories. Gross Profit and Gross Margin Gross profit is total revenue less total cost of revenue. Gross margin is gross profit expressed as a percentage of total revenue. We expect that our gross margin may fluctuate from period to period as a result of changes in the mix of our subscription and professional services revenue. Over time, we expect revenue from our cloud integration business to grow as a percentage of our total revenue. As a result, the cost of hosting fees to third-party cloud infrastructure providers, as a percentage of revenue, will increase, which may affect our gross margin. Operating Expenses Our operating expenses are classified as sales and marketing, research and development and general and administrative. For each functional category, the largest component is employee and labor-related expenses, which include salaries and bonuses, sales commissions, share-based payment expense, employee benefit costs and contractor costs. We allocate overhead such as information technology infrastructure, rent and occupancy charges in each expense category based on headcount in that category. Sales and marketing. Sales and marketing expenses consist primarily of salaries, sales commissions and related expenses, including share-based payment expense, for our sales and marketing employees, marketing programs and related overhead. Our sales and marketing employees include quota carrying headcount, sales administration, sales engineering, marketing and management. Marketing programs consist of advertising, promotional events, corporate communications, brand building, product marketing activities such as online lead generation, and developing sales strategies that emphasize particular products or services. We plan to continue to invest in sales and marketing by expanding our global promotional activities, building brand awareness, attracting new customers and sponsoring additional marketing events. The timing of these events, such as our annual sales kickoff, will affect our sales and marketing costs in a particular quarter. We also plan to invest in training and retention of our sales team. Research and development. Research and development expenses consist primarily of salaries and related expenses, including share-based payment expense, contractor software development costs and related overhead, as well as amortization of acquired developed technology, less any research and development subsidies. We continue to focus our research and development efforts on building new products, adding new features and services, increasing functionality and enhancing our integration cloud infrastructure. We expect that research and development expenses will increase in absolute dollars as we invest in building the necessary employee and system infrastructure required to enhance existing and support development of new, technologies and the integration of acquired businesses and technologies. General and administrative. General and administrative expenses consist of salaries and related expenses, including share-based payment expense for finance, legal, human resources and management information systems personnel, as well as external legal, accounting and other professional fees, other corporate expenses and related overhead. We will continue to incur additional expenses associated with being a publicly traded company, including higher legal, corporate insurance and accounting costs as well as costs of achieving and maintaining compliance with other public company regulations. We expect that general and administrative expenses will increase as we invest in our infrastructure and we incur additional employee related costs and professional fees related to the growth of our business. Results of Operations The following tables summarize our consolidated statements of operations for the fiscal years ended December 31, 2019, 2018 and 2017 (in thousands), and as a percentage of our revenue for those periods. The period-to-period comparison of financial results is not necessarily indicative of financial results to be achieved in future periods. (1) Amounts include share-based payment and amortization of acquired intangibles expense, as follows (in thousands): Revenue Revenue - 2019 compared to 2018 Total revenue increased $42.1 million, or 20%, in the year ended December 31, 2019 compared to the year ended December 31, 2018. Growth in total revenue was attributable to increased demand for our products from both new and existing customers. The growth in total revenue was attributable primarily to the sale of subscriptions and to a lesser extent the growth of professional services revenue. Subscription revenue increased $40.7 million, or 23%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase in subscription revenue was primarily attributable to greater demand for Talend Cloud and to a lesser extent the acquisition of Stitch. In the near term, we expect our subscription revenue growth to be negatively impacted by overall economic conditions in Europe, which contributed to a slower sequential increase in ARR as of December 31, 2019 compared to prior periods. Professional services revenue grew by $1.4 million, or 5% for the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase in professional services revenue was mainly due to increased demand from North American customers. Revenue - 2018 compared to 2017 Total revenue increased $57.2 million, or 38%, in the year ended December 31, 2018 compared to the year ended December 31, 2017. Growth in total revenue was attributable to increased demand for our products from both new and existing customers. The growth in total revenue was attributable primarily to the sale of subscriptions and to a lesser extent the growth of professional services revenue. Subscription revenue increased $50.5 million, or 40%, for the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase in subscription revenue was primarily attributable to strong demand for Talend Cloud and Talend Big Data Integration. Revenue from Talend Cloud grew by over 100% in the year ended December 31, 2018 compared to the prior period. The adoption of ASC 606 contributed to the increase in subscription revenue of approximately $6.0 million, as we recognized the license element of our subscription arrangements upfront, upon delivery of the license key. Professional services revenue grew by $6.7 million, or 30% for the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase in professional services revenue was mainly due to increased demand from North American customers. Subscription revenues by geography were as follows for the years ended December 31, 2019, 2018 and 2017:: Cost of Revenue Cost of Revenue - 2019 compared to 2018 Total cost of revenue increased $11.4 million, or 23%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase was primarily as a result of increased cost of subscription revenue and to a lesser extent an increase in cost of professional service revenue. Cost of subscription revenue increased $9.2 million, or 40%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase was primarily due to an increase in employee-related cost of $4.9 million resulting from an increase in headcount to support revenue growth, and an increase in IT costs, office costs and other operational costs of $2.2 million. Talend Cloud hosting support costs also increased $1.9 million due to an increase in our Talend Cloud bookings. Cost of professional services revenue increased $2.2 million, or 8%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase was primarily due to an increase in employee-related cost of $2.8 million resulting from an increase in headcount and share-based compensation expense, and an increase of $1.3 million in allocated shared costs, travel and IT costs. These increases were partially offset by a decrease in consulting fees paid to outside parties of $1.8 million. Cost of Revenue - 2018 compared to 2017 Total cost of revenue increased $15.3 million, or 45%, for the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase was primarily as a result of increased cost of subscription revenue and to a lesser extent an increase in cost of professional service revenue. Cost of subscription revenue increased $6.7 million, or 41%, for the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase was primarily due to an increase in employee-related cost of $5.2 million resulting from an increase in headcount to meet the higher demand for support from our cusomters. The increase in the cost of subscription revenue was also driven by an increase in third-party licensing fees and hosting costs for our Talend Cloud for a total of $0.3 million. Cost of professional services revenue increased $8.6 million, or 48%, for the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase was primarily due to an increase in employee-related cost of $5.8 million resulting from an increase in headcount, and an increase of $2.9 million in consulting fees paid to outside parties and travel and entertainment costs. Sales and Marketing Sales and Marketing - 2019 compared to 2018 Sales and marketing expenses increased $24.2 million, or 21%, in the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase was primarily due to a $17.5 million increase in employee compensation expenses resulting from an increase in headcount and increase in share-based compensation expense related to an adjustment to the estimated forfeiture rate during the period. Allocated shared costs, marketing costs, office and other operational costs also increased $5.7 million. Sales and Marketing - 2018 compared to 2017 Sales and marketing expenses increased $26.9 million, or 31%, in the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase was primarily due to a $21.2 million increase in employee compensation expenses, related to increased headcount. In addition, to support our continued growth, spending on marketing programs increased by $2.0 million in the year ended December 31, 2018 compared to the year ended December 31, 2017. Sales and marketing expense was also driven by an increase of $1.9 million in travel and entertainment costs. These expenses were partially offset by a benefit of $4.3 million in capitalized commission expenses due to the adoption of ASC 606 in 2018. Research and Development Research and Development - 2019 compared to 2018 Research and development expenses increased $20.7 million, or 49%, in the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase was primarily due to a $13.9 million increase in employee compensation expenses resulting from an increase in headcount and increase in share-based compensation expense related to an adjustment to the estimated forfeiture rate during the period. In addition, allocated shared costs increased $3.4 million and amortization expense increased $1.8 million due to the acquisition of Stitch, which happened in November 2018. Research and Development - 2018 compared to 2017 Research and development expenses increased $15.5 million, or 58%, in the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase was primarily due to a $11.7 million increase in employee compensation expenses, related to increased headcount. In addition, research and development expenses increased by $1.5 million related additional amortization expense from our November 2017 acquisition of Restlet S.A. and our November 2018 acquisition of Stitch Inc. General and Administrative General and Administrative - 2019 compared to 2018 General and administrative expenses increased $4.1 million, or 10%, in the year ended December 31, 2019, compared to the year ended December 31, 2018. The increase was primarily due to an increase of $6.8 million in employee compensation expenses resulting from an increase in headcount and increase in share-based compensation expense related to an adjustment to the estimated forfeiture rate during the period. Amortization expense, professional fees, insurance costs and office costs also increased $3.4 million. These increases were partially offset by a decrease in allocated shared costs of $6.1 million. General and Administrative - 2018 compared to 2017 General and administrative expenses increased $10.9 million, or 37%, in the year ended December 31, 2018, compared to the year ended December 31, 2017. The increase was primarily due to an increase of $8.5 million in employee compensation expenses. In addition, our professional and outside consulting services increased by $1.5 million related to our follow-on offering and acquisition of Stitch Inc. Between December 31, 2017 and December 31, 2018, our amortization of intangible assets increased by $0.4 million. Interest income (expense), net Interest income (expense), net - 2019 compared to 2018 Interest income (expense), net changed unfavorably by $3.2 million in the year ended December 31, 2019, compared to the year ended December 31, 2018. The change was primarily due to $2.3 million of amortization of debt discount and issuance cost and coupon expense from the issuance of our 1.75% Convertible Senior Notes due September 1, 2024, or our 2024 Notes. Interest income (expense), net - 2018 compared to 2017 Interest income (expense), net changed favorably by $0.2 million in the year ended December 31, 2018, compared to the year ended December 31, 2017. The change was primarily due to an increase in interest income from our investments in money market securities. Other income (expense), net Other income (expense), net - 2019 compared to 2018 Other income (expense), net changed unfavorably by $0.5 million in the year ended December 31, 2019, compared to the year ended December 31, 2018. The change is primarily due to fluctuations in foreign exchange rates, which impact our foreign currency denominated monetary assets and lliabilities. Other income (expense), net - 2018 compared to 2017 Other income (expense), net changed favorably by $2.8 million in the year ended December 31, 2018, compared to the year ended December 31, 2017. The change is primarily due to fluctuations in foreign exchange rates, which impact our foreign currency denominated monetary assets and lliabilities. Liquidity and Capital Resources Through December 31, 2019, we have financed our operations primarily through cash received from customers for subscriptions of our software and professional services, as well as equity and equity-linked financings. In September 2019, we received net proceeds, after deducting discounts and commission to the initial purchasers and issuance expenses, of $147.5 million from the issuance of our 2024 Notes. In connection with the issuance of our 2024 Notes, we terminated our secured revolving credit facility. As of December 31, 2019, we had $177.1 million of cash and cash equivalents. We believe that our current cash and cash equivalents will be sufficient to meet our working capital and capital expenditure requirements for at least the next 12 months. Our future capital requirements will depend on many factors, including our growth rate, the timing and extent of our spending to support our operating expenses. In the event that additional financing is required from outside sources, we may not be able to raise such financing on terms acceptable to us or at all. If we are unable to raise additional capital when desired, our business, results of operations and financial condition would be adversely affected. Operating Activities During the year ended December 31, 2019, operating activities used $14.5 million in cash as a result of a net loss of $61.5 million, offset by non-cash charges of $45.0 million and a $2.0 million favorable impact from changes in working capital. The net increase in our working capital was primarily the result of $19.7 million increase as a result of increased sales of subscriptions which generates increases in deferred revenue and a $4.5 million net increase in accounts payable and accrued expenses. In addition to the net increase in our operating liabilities, there was a $13.6 million increase in accounts receivable in the year ended December 31, 2019 due to increased sales of our product offerings and a $8.5 million increase in other assets. During the year ended December 31, 2018, operating activities provided $3.4 million in cash as a result of a net loss of $39.0 million, offset by non-cash charges of $25.0 million and a $17.6 million favorable impact from changes in working capital. The net increase in our working capital was primarily the result of $24.8 million increase in deferred revenue as a result of increased sales of subscriptions, a $11.6 million increase in accounts payable and accrued expenses mainly due to increased accruals for paid time off and commissions and bonuses during the year. In addition to the net increase in our operating liabilities, there was a $12.4 million increase in accounts receivable in the year ended December 31, 2018 due to increased sales of our product offerings and a $6.4 million increase in other assets. During the year ended December 31, 2017, operating activities used $2.3 million in cash as a result of a net loss of $31.2 million, adjusted by non-cash charges of $10.1 million and a $18.4 million favorable impact from changes in working capital. The net decrease in our working capital was primarily the result of $29.1 million increase in deferred revenue as a result of increased sales of subscriptions, a $7.6 million increase in accounts payable and accrued expenses mainly due to increased accruals for paid time off and commissions and bonuses during the year. In addition to the net increase in our operating liabilities, there was a $16.5 million increase in accounts receivable in the year ended December 31, 2017 due to increased sales of our product offerings. Investing Activities Cash used in investing activities during the year ended December 31, 2019 was $2.2 million. Investing activities consisted primarily of capital expenditures to purchase furniture and equipment to support additional office space as well as miscellaneous information technology equipment for our employees. Cash used in investing activities during the year ended December 31, 2018 was $64.5 million. Investing activities consisted primarily of cash consideration paid for our acquisition of Stitch Inc. Cash used in investing activities during the year ended December 31, 2017 was $11.4 million. Investing activities consisted primarily of cash consideration paid for our acquisition of Restlet SAS. Financing Activities Cash from financing activities during the year ended December 31, 2019 was $157.8 million. Financing proceeds for the year ended December 31, 2019 was primarily driven by $147.5 million of net proceeds from the issuance of the 2024 Notes, $5.8 million of proceeds from the exercise of employee stock awards and $4.7 million of proceeds received from employees as part of the Company’s employee stock purchase plan. Cash from financing activities during the year ended December 31, 2018 was $8.6 million. . Financing proceeds for the year ended December 31, 2018 was driven by $8.9 million of proceeds from the exercise of employee stock awards and cash received from the employee stock purchase plan. Cash from financing activities during the year ended December 31, 2018 was $6.5 million. Financing proceeds for the year ended December 31, 2017 was driven by $6.7 million of proceeds from the exercise of employee stock awards. Off-balance Sheet Arrangements During the periods presented, we did not have 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. Tabular Disclosure of Contractual Obligations Our contractual obligations primarily consist of obligations under our 2024 Notes, operating leases for office space and purchase obligations for IT-related services. We believe that we will be able to fund these obligations through cash generated from operations and from our existing balances of cash and cash equivalents. As of December 31, 2019, our non-cancelable contractual obligations were as follows: (1) Debt obligations include the principal balance of the 2024 Notes, reflected in the payment period in the table above based on the contractual maturity assuming no conversion. Debt obligations also include the principal payments of debt assumed by the Company from the Restlet SAS acquisition. (2) These amounts represent the estimated aggregate interest obligations for our outstanding 2024 Notes that are payable in cash. (3) These amounts represent the future undiscounted non-cancelable minimum lease payments under operating leases for our offices. (4) These amounts represent the future minimum payments under non-cancelable purchase commitments of IT-related services. Critical Accounting Policies and Estimates We prepare our financial statements in conformity with generally accepted accounting principles in the United States of America, or GAAP. The preparation of the consolidated financial statements in accordance with GAAP requires us to make judgments, estimates and assumptions that affect the reported amounts of assets, liabilities, contingent liabilities, revenues and expenses. We base our judgments and estimates on historical experience and various other factors we believe to be reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. Actual results may differ from these estimates under different assumptions and conditions and may materially affect the financial results or the financial position reported in future periods. While our significant accounting policies are more fully described in the notes to the consolidated financial statements, the following accounting policies involve a greater degree of judgment and complexity. Accordingly, these are the accounting policies we believe are the most critical to aid in fully understanding and evaluating our financial condition and results of operations. Revenue Recognition We primarily derive revenue from two sources: subscription revenue which is comprised of direct or indirect sales of subscription-based license agreements for Talend technologies; and related professional services revenue. Subscription revenue Subscriptions for our on-premise licenses include both a right to use the underlying software and a right to receive post-contract customer support during the subscription term. Post-contract customer support comprises maintenance services (including updates and updgrades to the software on a when and if available basis) and support services (including technical product support such as diagnosis and resolution of implementation and customer success services such as case reviews, integration job design and operational performance metrics). We have concluded that the rights to use the software, which is recognized at the outset of the arrangement, and to receive technical support and software fixes and updates, which is recognized over the term of the arrangement, are two separately identifiable performance obligations. We estimate the stand-alone selling price for each performance obligation using the “expected cost plus a margin” approach, as it maximizes the use of observable datapoints including the estimated useful life of the intellectual property and appropriate margins. Based on this approach, the Company generally allocated 16% of the transaction value to the intellecutal property performance obligation and generally allocated 84% of the transaction value to the post-contract customer support performance obligation during each of the twelve months periods ended December 31, 2019 and 2018. Subscriptions for our cloud-based offerings represent the right of access to our software as a service for which revenue is recognized ratably over the term of the arrangement. Subscription agreements typically have a contractual term of one to three years and are generally billed annually in advance and non-cancelable. We sell subscriptions to customers either directly through our internal sales force or indirectly through non-exclusive value-added channel partners and resellers (collectively, “resellers”). Resellers market, sell and provide our products and support services to end-users and we do not have the ability or the contractual right to establish pricing between resellers and end users. Professional services revenue We offer professional services which include consulting and training and associated expenses. Consulting services include implementation support to our customers during subscription setup and consist of time-based arrangements for which the revenue is recognized as the services are rendered. Training revenue results from contracts to provide educational services to customers and partners regarding the use of our technologies and is recognized as training is delivered. Contracts with multiple performance obligations We may enter into transactions that contain multiple performance obligations where a subscription and consulting and training services are sold together. 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 are able to determine reliably the standalone selling price of a consulting or training service component based on historical pricing for the component or a similar component that has been sold on a standalone basis. The transaction price allocated to each performance obligation is recognized as revenue when each performance obligation is satisfied. Contract acquisition costs Contract acquisition costs consist of sales commissions earned by our sales force to initially obtain a contract, and upon renewal of such contracts. Sales commissions to initially obtain are contract are considered incremental and recoverable costs and are deferred and then amortized on a straight-line basis over the period of benefit determined to be to be five years. The period of benefit includes the contractual and expected renewal periods and is based on historical patterns of renewals and forecasted life of the Group’s licensed technology. Sales commissions paid upon renewal are not commensurate with and substantially lower than the commissions paid to initially obtain the contract, even though the economic benefits we expect to receive upon renewal are similar to those expected from the initial contract. The commissions paid on renewals are expensed in the period the contract is renewed. The majority of customer contracts are annual in nature and as a result these renewals commissions are paid on an annual basis. Business Combinations and Goodwill 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. 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. When conducting the annual goodwill impairment assessment, we first assess qualitative factors, to determine whether it is necessary to perform the two-step goodwill impairment test. If determined to be necessary, the two-step impairment test is used to identify potential goodwill impairment and measure the amount of a goodwill impairment loss to be recognized, if any. Intangible Assets Intangible assets include acquired customer relationships and acquired developed technology. Intangibles acquired through a business combination are recognized separately from goodwill, initially at fair value on the acquisition date. Subsequent to initial recognition, intangible assets acquired in a business combination are reported at cost less accumulated amortization and accumulated impairment losses, on the same basis as intangible assets acquired separately. Intangible assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. Share-Based Payments We recognize share-based payment expense beginning in the period of grant based on the fair value of the award at the grant date, net of estimated forfeitures, over the requisite service period, which is generally the vesting period of the respective award. The estimation of share awards that will ultimately vest requires judgement, especially awards with non-market performance conditions. Share-based payment expense is recorded based on awards that are ultimately expected to vest, and such expense is reduced for estimated forfeitures. When estimating forfeitures, we considered voluntary termination behaviors as well as trends of the actual forfeitures of share-awards. Determining the fair value of share-based awards at the grant date requires judgment. We use the Black-Scholes option-pricing model to determine the fair value of share options, employee warrants (BSPCE) and warrants (BSA). The determination of the grant date fair value of options using an option-pricing model is affected by our estimated ordinary share fair value as well as assumptions regarding a number of other complex and subjective variables. These variables include the expected term of the options, our expected share price volatility of our shares, risk-free interest rates and expected dividends. These variables are estimated as follows: ● Expected term. We determine the expected term based on the average period the share awards are expected to remain outstanding. ● Expected volatility. We consider historical volatility of our share price since the initial public offering and also consider the historical volatility of similar entities following a comparable period in their lives. ● Risk-free rate. The risk-free interest rate represents the implied yield currently available on zero-coupon government issued securities over the expected term of the award. ● Dividend yield. We have never declared or paid any cash dividends and do not presently plan to pay cash dividends in the foreseeable future. Consequently, we use an expected dividend yield of zero. Convertible Notes We account for the issued 1.75% Convertible Senior Notes due September 1, 2024 (the “2024 Notes”) as separate liability and equity components in accordance with ASC 470, Debt. The carrying amount of the liability component was calculated by measuring the fair value of a similar debt instrument that does not have an associated conversion feature. The carrying amount of the equity component representing the conversion option was determined by deducting the fair value of the liability component from the par value of the convertible notes as a whole. This difference represents a debt discount that is amortized to interest expense over the term of the 2024 Notes using the effective interest rate method. The equity component is not remeasured as long as it continues to meet the conditions for equity classification. We allocated issuance costs incurred to the liability and equity components. Issuance costs attributable to the liability component are being amortized to expense over the respective term of the 2024 Notes and issuance costs attributable to the equity component were netted with the respective equity component in Additional paid-in capital. Recent Accounting Pronouncements See Note 2, Summary of significant accounting polices, in the Notes to our Consolidated Financial Statements included elsewhere in this Annual Report for analysis of recent accounting pronouncements that are applicable to our business.
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0
<s>[INST] Overview Our mission is to provide data intelligence for all users by delivering trusted data when and where is it needed. We are a key enabler of the datadriven enterprise where data is a strategic asset powering business. Talend Data Fabric allows customers in any industry to improve business performance by using their data to create new insights and to automate business processes. Our customers rely on our software to better understand their customers, offer new applications and services, and improve operations. We had 1,219 employees as of December 31, 2019 and we plan to continue to expand our nonU.S. presence to address the needs of our global customers as well as to acquire customers in new geographies. We also plan to continue to invest in new product development. Our business model combines our open source approach with selfservice trials of our commercial software and direct sales. We have been able to rapidly expand awareness and usage of our products through our free open source versions and selfservice trials. This enables developers and users to download and try the free and paid version of our products, creating sales leads for our more featurerich commercial solutions. Users of our open source products often catalyze adoption of our commercial solutions by their organizations, primarily to benefit from enterprisegrade features that include the scaling out of our offering to a larger set of users, among others. Following an initial deployment of our paid subscription products, organizations often purchase more subscriptions or expand usage to additional products from our fully integrated suite after realizing the benefits of additional features or scale. We sell our product offerings as subscriptions based primarily on the number of users of our platform. We generate the majority of our revenue from subscriptions of our commercial solution Talend Data Fabric. We primarily sell annual contracts billed in advance. Our subscription offering includes enterprisegrade features and capabilities to scale our solutions across production environments and customer infrastructures. These product features and capabilities include scheduling, management and monitoring of data integration flows, collaboration across a team of users and technical support. We also provide professional services to implement our solutions. Our subscription revenue represents a significant portion of our revenue, growing from 85% of our total revenue in the year ended December 31, 2017, to 86% in the year ended December 31, 2018, and 88% in the year ended December 31, 2019. Our financial results include: Total revenue increased from $148.6 million for 2017 to $205.8 million for 2018 to $247.9 million for 2019; Subscription revenue increased from $125.9 million for 2017 to $176.4 million for 2018 to $217.0 million for 2019; Subscription revenue grew 23% yearoveryear for 2019; and Net loss was $61.5 million for 2019, $39.0 million for 2018 and $31.2 million for 2017. We intend to generate profits based on increased sales of our solutions to new and existing customers, including by the continued conversion of free trials into paid users. We currently anticipate that at some point in the future we will be able to increase revenues at a greater rate than increases in our operating expenses. However, there can be no assurance that we will achieve or maintain profitability on a consistent basis, that we will increase our sales to new and existing customers, or that our operating expenses will increase at a lower rate than our revenue may grow. Key Factors Affecting Our Performance Expansion within Existing Customers. Our business model relies on rapidly and efficiently landing new customers and expanding our relationship with these customers over time. We have designed our apps for easeofuse and with strong integrations between apps to encourage broad adoption within organizations. As customers gain awareness of our solutions and as their data integration and integrity requirements evolve, they may recognize additional use cases for our software and expand their use of our solutions accordingly, and our growth strategy is dependent on our ability to demonstrate the value of these additional apps to our customers. We believe this provides us with substantial operating leverage because the costs of additional sales within existing customers are significantly less than costs of sales to new customers. Our future revenue growth and profitability rely on customers continuing to expand user and app adoption within their organizations. Adoption of Modern Data Technologies [/INST] Negative. </s>
2,020
8,883
1,735,438
MeiraGTx Holdings plc
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 and analysis of financial condition and operating results our financial statements and the related notes appearing at the end of this Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. As a result of many factors, such as those set forth in the section of this Form 10-K captioned “Item 1A. Risk Factors” and elsewhere in this Form 10-K, our actual results may differ materially from those anticipated in these forward-looking statements. For convenience of presentation some of the numbers have been rounded in the text below. Overview We are a vertically integrated, clinical stage gene therapy company with five programs in clinical development and a broad pipeline of preclinical and research programs. We have core capabilities in viral vector design and optimization, gene therapy manufacturing as well as a potentially transformative gene regulation technology. Led by an experienced management team, we have taken a portfolio approach by licensing, acquiring and developing technologies that give us depth across both product candidates and indications. Though initially focusing on the eye, salivary gland and central nervous system, we intend to expand our focus in the future to develop additional gene therapy treatments for patients suffering from a range of serious diseases. We are an exempted company incorporated under the laws of the Cayman Islands in 2018, and prior to that, we commenced operations as MeiraGTx Limited, a private limited company incorporated under the laws of England and Wales in 2015. Our discussion of our financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States. Since our formation, we have devoted substantially all of our resources to developing our technology platform, establishing our viral vector manufacturing facility and developing manufacturing processes, advancing the product candidates in our ophthalmology, salivary gland and neurodegenerative disease programs, building our intellectual property portfolio, organizing and staffing our company, business planning, raising capital, and providing general and administrative support for these operations. In 2016, we completed the acquisition of assets held by BRI-Alzan, Inc., a Delaware corporation, including a worldwide license agreement to develop certain preclinical technology for the treatment of ALS. In October 2018, we acquired Vector Neurosciences, Inc., a Delaware corporation. In connection with that acquisition, we acquired its AAV-GAD gene therapy program which had completed a randomized, sham-controlled Phase 2 study for treatment of Parkinson’s disease. To date, we have financed our operations primarily with cash on hand and proceeds from the sales of our Series A ordinary shares, Convertible Preferred C Shares and ordinary shares. Through December 31, 2018, we received gross proceeds of approximately $203.7 million from sales of our ordinary shares, Series A ordinary shares and Convertible Preferred C Shares. As of December 31, 2018, we had cash and cash equivalents of $68.1million. We are a clinical stage company and have not generated any product revenues to date. We have five clinical programs and a pipeline of preclinical programs. Since inception, we have incurred significant operating losses. Our net losses for the years ended December 31, 2018 and 2017 were $82.9 million and $31.1 million, respectively. As of December 31, 2018, we had an accumulated deficit of $148.3 million. While we do not expect to generate revenue from sales of any products for several years, if at all, in January 2019, we entered into the Collaboration Agreement, which provides for Janssen to pay us an $100 million upfront payment and provide us with research funding, and we are eligible to receive potential milestone payments and royalties. Our total operating expenses were $78.1 million and $31.7 million for the years ended December 31, 2018 and 2017, respectively. While we expect our operating expenses to increase substantially in connection with our ongoing development activities related to our product candidates, we believe that these increases may be partially offset by the research funding in connection with a collaboration, option and license agreement we entered into in January 2019. We anticipate that our expenses will increase due to costs associated with our clinical development program targeting in achromatopsia due to mutations in the CNGB3 or CNGA3 gene, inherited retinal dystrophy caused by mutations in RPE65, or RPE65-deficiency, and X-Linked retinitis pigmentosa, or XLRP. In addition, we expect to continue incurring increasing costs associated with our clinical activities for hAQP1 for the treatment of radiation-induced xerostomia and xerostomia associated with Sjogren’s syndrome. We are currently evaluating potential next steps for clinical development of AAV-GAD, which remains pending future discussions with regulatory agencies. We also expect to incur expenses related to research activities in additional therapeutic areas to expand our pipeline, hiring additional personnel in manufacturing, research, clinical trials, quality and other functional areas, and associated cash and share-based compensation expense, as well as the further development of internal manufacturing capabilities and capacity and other associated costs including the management of our intellectual property portfolio. As a result of these anticipated expenditures, we will require additional capital, which we may raise through equity offerings, debt financings, marketing and distribution arrangements and other collaborations, strategic alliances and licensing arrangements or other sources to enable us to complete the development and potential commercialization of our product candidates. Furthermore, we expect to continue incurring costs associated with being a public company. Adequate additional financing may not be available to us on acceptable terms, or at all. Our failure to raise capital as and when needed would have a negative effect on our financial condition and our ability to pursue our business strategy. In addition, attempting to secure additional financing may divert the time and attention of our management from day-to-day activities and harm our product candidate development efforts. If we are unable to raise capital when needed or on acceptable terms, we would be forced to delay, reduce or eliminate certain of our research and development programs. Based on our cash and cash equivalents at December 31, 2018 and after receiving an additional $77.4 million from a private placement of ordinary shares during the first quarter of 2019 and our receipt of the $100 million payment under the terms of the Collaboration Agreement, we estimate that such funds will be sufficient to enable us to fund our operating expenses and capital expenditure requirements into 2022. We have based these estimates on assumptions that may prove to be wrong, and we may use our available capital resources sooner than we currently expect. See “-Liquidity and Capital Resources.” Because of the numerous risks and uncertainties associated with the development of our product candidates, any future product candidates, our platform and technology and because the extent to which we may enter into collaborations with third parties for development of any of our product candidates is unknown, we are unable to estimate the amounts of increased capital outlays and operating expenses associated with completing the research and development of our product candidates. Our future capital requirements will depend on many factors, including: • the initiation, progress, timing, costs and results of our planned clinical trials for our product candidates; • the outcome, timing and cost of meeting regulatory requirements established by the FDA, EMA and other regulatory authorities; • 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 any of our product candidates; • the effect of competing technological and market developments; • the costs and timing of further developing our manufacturing facilities in the United Kingdom; • the costs of operating as a public company. • the extent to which we in-license or acquire other products and technologies; • the cost of establishing sales, marketing and distribution capabilities for our product candidates in regions where we choose to commercialize our products; and • the initiation, progress, timing and results of our commercialization of our product candidates, if approved for commercial sale. 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 securities, your ownership interest will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect your 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 your ownership interests. If we raise additional funds through 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 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 programs or any future commercialization efforts or grant rights to develop and market product candidates that we would otherwise prefer to develop and market ourselves. Because of the numerous risks and uncertainties associated with drug development, we are unable to predict the timing or amount of increased expenses or when or if we will be able to achieve or maintain profitability. Even if we are able to generate revenue from product sales, we may not become profitable. If we fail to become profitable or are unable to sustain profitability on a continuing basis, then we may be unable to continue our operations at planned levels and be forced to reduce or terminate our operations. Highlights and Recent Development On October 5, 2018, we acquired Vector Neurosciences Inc. (“Vector”) and acquired Vector’s rights to the clinical stage gene therapy product candidate adeno-associated virus encoding glutamic acid decarboxylase (“AAV-GAD”), an investigational gene therapy medicine ready for continued Phase 2 clinical development for Parkinson’s disease. We issued an aggregate of 225,000 of our ordinary shares as initial merger consideration, consisting of 202,500 shares which were issued at the closing of the merger and an additional 22,500 shares to be issued 18 months following the closing. On December 14, 2018, we acquired from Moorfields Eye Hospital NHS Foundation Trust of Moorfields Eye Hospital a long leasehold interest (the “Head Lease”) in the site of our manufacturing facility, 92 Britannia Walk, London N1 7LU, for a purchase price of approximately $6,615,000. As a result of this transaction, we are now the tenant under the Head Lease, which has a remaining term of 108 years, with no facility rent due. In January and February, 2019, we amended and restated the following agreements: (i) the License Agreement, dated February 4, 2015, as amended, between Athena Vision Ltd. and UCLB; (ii) the License Agreement, dated July 28, 2017, as amended, between MeiraGTx UK II Limited and UCLB; and (iii) the License Agreement, dated March 15, 2018, among MeiraGTx Limited, MeiraGTx UK II Limited and UCLB to establish new stand-alone license agreements for our inherited retinal disease (“IRD”) programs. In connection with the stand-alone agreement related to CNGB3, we agreed to make an upfront payment to UCLB of £1,500,000 and issue £1,500,000 of our ordinary shares. On January 30, 2019, we entered into a strategic collaboration with Janssen to develop and commercialize gene therapies for the treatment of inherited retinal diseases (IRDs). This Collaboration Agreement provides for Janssen to pay us an $100 million upfront payment and provide us with research funding, and we are eligible to receive potential milestone payments and royalties. We will collaborate with Janssen to develop our current clinical programs in Retinitis Pigmentosa and two genetic forms of Achromatopsia and Janssen has the exclusive right to commercialize these products globally. We will manufacture these products for commercial supply. Janssen will pay 100% of the clinical and commercialization costs of the products and we are eligible to receive untiered 20 percent royalties on net sales of products and additional development and commercialization milestones of up to $340 million. In addition, we will enter a research collaboration with Janssen in the area of IRDs, with Janssen paying for the majority of the research costs. Janssen has the right to exclusively license any product coming out of the collaboration at the time of an IND. Janssen will then pay 100% of the clinical and commercialization costs for these products and we will receive an untiered royalty in the high teens on net sales as well as development milestones. In addition, we have entered into a manufacturing research collaboration with Janssen to further develop processes for manufacturing AAV viral vectors in which the costs of the research will be shared. On March 1, 2019, we consummated a private placement with various investors, including one of our existing shareholders Perceptive Life Sciences Master Fund Ltd., pursuant to which we issued and sold an aggregate of 5,797,102 ordinary shares for gross proceeds of approximately $80.0 million. The financing was led by JJDC, the investment arm of Johnson & Johnson, which made a $40.0 million equity investment in the Company and received 2,898,550 ordinary shares. Components of Our Results of Operations Operating Expenses Our operating expenses since inception have consisted primarily of general and administrative costs and research and development costs. General and Administrative Expenses General and administrative expenses consist primarily of salaries and other related costs, including share-based compensation, for personnel in our executive, finance, business development and administrative functions. General and administrative expenses also include legal fees relating to intellectual property and corporate matters; professional fees for accounting, auditing, tax and consulting services; insurance costs; travel expenses; and office facility-related expenses, which include direct depreciation costs. We expect that our general and administrative expenses will increase in the future as we increase our personnel headcount to support increased research and development activities. We have also incurred and expect to continue to incur increased expenses associated with being a public company, including costs of accounting, audit, legal, regulatory and tax-related services associated with maintaining compliance with Nasdaq and SEC requirements; director and officer insurance costs; and investor and public relations costs. Research and Development Expenses Research and development expenses consist primarily of costs incurred for our research activities, including our discovery efforts, and the development of our product candidates, and include: • employee-related expenses, including salaries, benefits and travel of our research and development personnel; • expenses incurred in connection with third-party vendors that conduct clinical and preclinical studies and manufacture the drug product for the clinical trials and preclinical activities; • acquisition of in-process research and development; • costs associated with clinical and preclinical activities including costs related to facilities, supplies, rent, insurance, certain legal fees, share-based compensation, and depreciation; and • expenses incurred with the development and operation of our manufacturing facility. We expense research and development costs as incurred. We typically use our employee and infrastructure resources across our development programs. We track outsourced development costs by product candidate or development program, but we do not allocate personnel costs, license payments made under our licensing arrangements or other internal costs to specific development programs or product candidates. These costs are included in other research and development expenses in the table below. The following table summarizes our research and development expenses: Research and development activities are central to our business model. We expect that our research and development expenses will continue to increase substantially for the foreseeable future as we initiate additional preclinical and clinical trials of our existing product candidates and continue to discover and develop additional product candidates. This increase in research and development costs may be partially offset by the research funding provided in connection with the Collaboration Agreement we entered into in January 2019 We cannot determine with certainty the duration and costs of future clinical trials of our product candidates or any other product candidate we may develop or if, when, or to what extent we will generate revenue from the commercialization and sale of any product candidate for which we obtain marketing approval. We may never succeed in obtaining marketing approval for any product candidate. The duration, costs and timing of clinical trials and development of our existing product candidates or any other product candidate we may develop will depend on a variety of factors, including: • the scope, rate of progress, expense and results of clinical trials of our existing product candidates, as well as of any future clinical trials of other product candidates and other research and development activities that we may conduct; • uncertainties in clinical trial design and patient enrollment rates; • the actual probability of success for our product candidates, including the safety and efficacy, early clinical data, competition, manufacturing capability and commercial viability; • significant and changing government regulation and regulatory guidance; • the timing and receipt of any marketing approvals; and • the expense of filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights. A change in the outcome of any of these variables with respect to the development of a product candidate could mean a significant change in the costs and timing associated with the development of that product candidate. For example, if the FDA or another U.S. or foreign regulatory authority were to require us to conduct clinical trials beyond those that we anticipate will be required for the completion of clinical development of a product candidate, or if we experience significant delays in our clinical trials due to patient enrollment or other reasons, we would be required to expend significant additional financial resources and time on the completion of clinical development. Other non-operating income (expense) Other non-operating income (expense) includes the following: Foreign currency (loss)gain Our consolidated financial statements are presented in U.S. dollars, which is our reporting currency. The financial position and results of operations of our subsidiaries MeiraGTx UK II and MeiraGTx B.V. are measured using the foreign subsidiaries’ local currency as the functional currency. MeiraGTx UK II cash accounts holding U.S. dollars are remeasured based upon the exchange rate at the date of remeasurement with the resulting gain or loss included in the consolidated statement of operations and comprehensive loss. Expenses of such subsidiaries have been translated into U.S. dollars at average exchange rates prevailing during the period. Assets and liabilities have been translated at the rates of exchange on the consolidated balance sheet date. The resulting translation gain and loss adjustments are recorded directly as a separate component of shareholders’ equity and as other comprehensive loss on the consolidated statement of operations and comprehensive loss. Convertible note inducement expense Convertible note inducement expense consists of the issuance of a warrant to a convertible note holder as an inducement to convert the note payable into Series C preferred shares. Change in fair value of warrant liability We have determined that our warrants are classified as liabilities on our balance sheet because the Preferred Shares underlying the warrants have a redemption feature in the event of a change of control of the Company. The fair values of the warrants are estimated using the Black-Scholes valuation model with certain assumptions regarding risk free interest rate, expected volatility, expected divided yield and expected life. The Black-Scholes value of the warrants was recorded as a warrant liability and is remeasured quarterly. Any changes in the quarterly valuation of the warrants is charged to operations. Income Taxes The 2018 income tax provision consisted of current tax expense of $0 and a deferred tax benefit of $474,391. The 2018 deferred tax benefit includes a $474,391 benefit recorded due to the required intraperiod tax allocation resulting from the loss from continuing operations and other comprehensive income. Critical Accounting Policies and Use of Estimates Our management’s discussion and analysis of financial condition and results of operations is based on our financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States. The preparation of our financial statements and related disclosures requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, costs and expenses and the disclosure of contingent assets and liabilities in our financial statements. We base our estimates on historical experience, known trends and events and various other factors that we believe are 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. We evaluate our estimates and assumptions on an ongoing basis. Our 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 in this 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 financial statements. Consolidation The accompanying consolidated financial statements include the accounts of Meira Holdings and its wholly owned subsidiaries: MeiraGTx Limited, a limited company under the laws of England and Wales (“Meira Limited); MeiraGTx, LLC, a Delaware corporation (“Meira LLC”); BRI-Alzan, Inc., a Delaware corporation (“BRI-Alzan”); MeiraGTx B.V., a Netherlands corporation (“Meira BV”); MeiraGTx Neurosciences, Inc. a Delaware corporation (“Meira Neuro”); MeiraGTx UK II Limited, (“Meira UK II”), a limited company under the laws of England and Wales; and MeiraGTx UK Limited (“Meira UK”), a limited company under the laws of England and Wales. All intercompany balances and transactions between the consolidated companies have been eliminated in consolidation. Foreign Currencies Our consolidated financial statements are presented in U.S. dollars, our reporting currency. The financial position and results of operations of MeiraGTx UK II and MeiraGTx UK II cash accounts holding U.S. dollars are remeasuring based upon the exchange rate at the date of remeasurement with the resulting gain or loss included in the consolidated statement of operations and comprehensive loss. Expenses of such subsidiaries have been translated into U.S. dollars at average exchange rates prevailing during the period. Assets and liabilities have been translated at the rates of exchange on the consolidated balance sheet dates. The resulting translation gain and loss adjustments are recording directly as a separate component of shareholders’ equity and as other comprehensive loss on the consolidated statements of operations and comprehensive loss. Income Taxes Since we have recurring losses and a valuation allowance against deferred tax assets, there was no tax expense (benefit) through December 31, 2017. For the year ended December 31, 2018, we recognized a tax benefit of $(474,391). As of December 31, 2018, we had federal and state net operating loss (“NOL”) carryforwards in the United States of approximately $14.2 million and $14.2 million respectively, and in the U.K. of approximately $94.1 million, which are available to reduce future taxable income. The U.S. federal and state NOL carryforwards incurred prior to January 1, 2018 in the amount of approximately $6.8 million and $6.7 million, respectively, will begin to expire in 2036. The U.S. NOL incurred after December 31, 2017 and the U.K. NOL will be indefinitely carried forward. As of December 31, 2018, we also had orphan drug and research and development credits in the U.S. in the amount of $1.1 million, which will begin to expire 2036. Research and Development Research and development costs are charged to expense as incurred. These costs include, but are not limited to, employee-related expenses, including salaries, benefits and travel of our research and development personnel; expenses incurred under agreements with contract research organizations and investigative sites that conduct clinical and preclinical studies and manufacture the drug product for the clinical studies and preclinical activities; acquisition of in-process research and development; facilities; supplies; rent, insurance, certain legal fees, stock-based compensation, depreciation and other costs associated with clinical and preclinical activities and regulatory operations. Refundable research and development tax credits received are recorded as an offset to these costs. Costs for certain development activities, such as outside research programs funded by us, are recognized based on an evaluation of the progress to completion of specific tasks with respect to their actual costs incurred. Payments for these activities are based on the terms of the individual arrangements, which may differ from the pattern of costs incurred, and are reflected in the financial statements as prepaid or accrued research and development expense, as the case may be. Share-Based Compensation Options We grant share options to employees, non-employee members of our board of directors and non-employee consultants as compensation for services performed. Employee and non-employee members of the board of directors’ awards of share-based compensation are accounted for in accordance with ASC 718, Compensation-Stock Compensation, or ASC 718. ASC 718 requires all share-based payments to employees and non-employee directors, including grants of share options, to be recognized in the statement of operations and comprehensive loss based on their grant date fair values. The grant date fair value of share options is estimated using the Black-Scholes option valuation model. Using this model, fair value is calculated based on assumptions with respect to (i) the fair value our ordinary shares on the grant date; (ii) expected volatility of our ordinary share price, (iii) the periods of time over which employees and members of our board of directors are expected to hold their options prior to exercise (expected term), (iv) expected dividend yield on our ordinary shares, and (v) risk-free interest rates. Our ordinary shares were not traded on a public exchange prior to our IPO in June 2018. Therefore, we believe that our future volatility will differ materially during the expected term from the volatility that would be calculated from our historical share prices to date. Consequently, expected volatility is based on an analysis of guideline companies in accordance with ASC 718. The expected dividend yield is zero as we have never paid dividends and do not currently anticipate paying any in the foreseeable future. Risk-free interest rates are based on quoted U.S. Treasury rates for securities with maturities approximating the option’s expected term. As of January 1, 2016, we early adopted ASU 2016-09, Improvements to Employee Share-Based Payment Accounting, and accounts for forfeitures as they occur from that date. Additionally, excess tax benefits and deficiencies will be recognized as income tax expense or benefit in the income statement. There was no cumulative effect adjustment as we did not issue any options prior to January 1, 2016. We had accounted for options granted to non-employee consultants under ASC 505-50, Equity-Based Payments to Non-Employees. As such, we estimate the fair value of each such option using the Black-Scholes model, with the expected term of share options granted to non-employees initially equal to the options’ maximum contractual life of ten years, at issuance. On each subsequent reporting date until performance is complete, we revalue all outstanding options granted to non-employee consultants during the vesting period of each tranche. Under ASC 505-50, upon re-measurement of each award, income or expense is recognized during its vesting term. Compensation cost relating to awards with service-based graded vesting schedules is recognized as general and administrative and research and development expenses in the consolidated statement of operations and comprehensive loss using the straight-line method. On July 1, 2018, we early adopted ASU 2018-07, Improvements to Nonemployee Share-Based Payment Accounting, which simplifies the accounting for share-based payments granted to nonemployees for goods and services. The adoption did not have a material effect on the consolidated financial statements. Restricted Shares In connection with certain service agreements and research agreements, we have granted restricted ordinary shares as compensation. The shares are recognized in the statement of operations and comprehensive loss based on their grant date fair values. Compensation cost relating to share grants with service-based graded vesting schedules is recognized based on the vesting schedule. Results of Operations The following table summarizes our results of operations for the years ended December 31, 2018 and 2017, respectively General and Administrative Expenses General and administrative expenses were $44.5 million for the year ended December 31, 2018, compared to $9.3 million for the year ended December 31, 2017. The increase of $35.2 million was primarily due to increases of $19.7 million in payroll, $14.0 million in share-based compensation, $1.1 million in legal, $0.7 million in insurance $0.5 million in accounting, $0.4 million in travel, and $0.3 million in investor relations, which was partially offset by a decrease of $1.5 million in rent. Research and Development Expenses Research and development expenses for the year ended December 31, 2018 were $33.6 million, compared to $22.4 million for the year ended December 31, 2017. The increase of $11.2 million was primarily due to an increase in costs of $3.0 million for clinical trial costs related to our ophthalmology programs, $3.0 million for acquired neurology research and development, $2.3 million related costs of payroll and consultants, $1.6 million of depreciation, $1.3 million related to the preparation for production of our manufacturing facility, $1.0 million in share-based compensation, and $0.7 million in rent, which was partially offset an increase of $1.7 million in the research and development credit in the United Kingdom in 2018. Foreign Currency (Loss) Gain Foreign currency loss was $3.8 million for the year ended December 31, 2018 compared to a gain of $1.7 million for the year ended December 31, 2017. The change of $5.5 million was primarily due to a strengthening of the U.S. dollar against the pound sterling in 2018. Convertible Note Inducement Expense We recorded a $0.5 million convertible note inducement expense for the year ended December 31, 2017 primarily due to the issuance of a warrant to purchase 231,898 Convertible Preferred C Shares in 2017 to a convertible noteholder as an inducement to convert the note into Convertible Preferred C Shares. Change in Fair Market Value of Warrant Liability We recorded $1.5 million change in fair value of a warrant liability for the year ended December 31, 2018, compared to $0.5 million for the year ended December 31, 2017. The increase of $1.0 million was primarily due to the revaluation of certain warrants, which were issued to certain investors in September and November 2017, using the Black-Scholes valuation model at June 7, 2018, when the warrants were exercised and December 31, 2017. Income Taxes The 2018 income tax provision consisted of current tax expense of $0 and a deferred tax benefit of $474,391. The 2018 deferred tax benefit includes a $474,391 benefit recorded due to the required intraperiod tax allocation resulting from the loss from continuing operations and other comprehensive income. Liquidity and Capital Resources Since our inception, we have incurred significant operating losses. We have not generated positive cash flows from operations, and there are no assurances that we will be successful in obtaining an adequate level of financing for the development and commercialization of our product candidates. We expect to incur significant expenses and operating losses for the foreseeable future as we advance the preclinical and clinical development of our product candidates. We expect that our research and development and general and administrative costs will increase in connection with conducting preclinical studies and clinical trials for our product candidates, building out internal capacity to have product manufactured to support preclinical studies and clinical trials, expanding our intellectual property portfolio, and providing general and administrative support for our operations. As a result, we will need additional capital to fund our operations, which we may obtain from additional equity or debt financings, collaborations, licensing arrangements, or other sources. We are required to maintain a stand-by letter of credit as a security deposit under a certain lease with ARE, an entity that is under common control with an entity that is a minority shareholder of the Company and whose executive chairman and founder is on our board of directors. Our bank requires us to maintain restricted cash balances to serve as collateral for the letter of credit issued to the landlord by the bank. As of December 31, 2018, the restricted cash balances for the ARE lease was invested in a commercial money market account. The restricted cash balance for the ARE lease remains at $123,376 through the end of the lease term in December 2021, plus three months. We had $123,376 of restricted cash included in long-term assets as of December 31, 2018. We do not currently have any approved products and have never generated any revenue from product sales. We have historically financed our operations primarily through the sale of our ordinary shares and Convertible Preferred C Shares. In January 2019, we entered into the Collaboration Agreement, which provides for Janssen to pay us an $100 million upfront payment and provide us with research funding, and we are eligible to receive potential milestone payments and royalties. Cash Flows We had $68.1 million and $8.5 million of cash and cash equivalents as of December 31, 2018 and 2017, respectively. The following table summarizes our sources and uses of cash for the period presented: Operating Activities During the year ended December 31, 2018, our cash used in operating activities of $58.9 million was primarily due to our net loss of $82.9 million as we incurred expenses associated with research activities on our clinical programs and research activities for our other product candidates and incurred general and administrative expenses. The loss included non-cash charges of $27.9 million, which consisted of $18.1 million of share-based compensation, issuance of shares for acquired research and development in the amount of $3.0 million, change in fair value of warrant liability in the amount of $1.5 million, depreciation of $2.1 million, and a foreign currency loss of $3.9 million, which was partially offset by an income tax benefit of $0.5 million. Additionally, current assets, consisting of prepaid expenses, other current assets and security deposits increased by $3.9 million. Current liabilities, consisting of accounts payable, accrued expenses, deferred rent, due to affiliate and other liabilities, decreased by $0.1 million During the year ended December 31, 2017, our cash used in operating activities of $18.1 million was primarily due to our net loss of $31.0 million as we incurred expenses associated with research activities on our clinical programs and research activities for our other product candidates and incurred general and administrative expenses. The loss included non-cash charges of $3.0 million, which consisted of $3.0 million of share-based compensation, change in fair value of warrant liability in the amount of $0.5 million, convertible note inducement expense of $0.5 million and depreciation of $0.7 million, which was partially offset by a foreign currency gain of $1.7 million. Additionally, current liabilities, consisting of accounts payable, accrued expenses deferred rent, and due to affiliate, increased by $11.1 million. Current assets, consisting of prepaid expenses and other current assets, decreased by $1.2 million. Investing Activities Net cash used in investing activities for the years ended December 31, 2018 and December 31, 2017 of $11.3 million and $10.5 million, respectively, consisted of purchase of property plant and equipment, primarily for our manufacturing facility. Financing Activities Net cash provided by financing activities was $130.0 million for the year ended December 31, 2018, represented proceeds of $65.6 million from the issuance of Ordinary Shares in connection with our initial public offering, $56.1 million from the issuance of Convertible Preferred C Shares and $9.7 million from the exercise of warrants, which was partially offset by the repayment of a note payable in the amount of $1.4 million. Net cash provided by financing activities was $19.3 million for the year ended December 31, 2017, represented proceeds of $16.8 million from the issuance of Convertible Preferred C Shares and $2.5 million from the issuance of a note payable Funding Requirements Our operating expenses increased substantially in 2018 and 2017 and are expected to increase substantially in the future in connection with our ongoing activities, particularly as we advance our clinical activities including scale-up of manufacturing processes and additional clinical trials. In addition, we expect to continue to incur additional costs associated with operating as a public company. Specifically, our expenses will increase as we: • pursue the preclinical and clinical development of our product candidates; • scale up our manufacturing processes and capabilities to support our preclinical studies and clinical trials of our product candidates; • in-license or acquire the rights to other products, product candidates or technologies; • maintain, expand and protect our intellectual property portfolio; • hire additional personnel in research, manufacturing and regulatory and clinical development as well as management personnel; and • continue to expand our operational, financial and management systems and increase personnel, including personnel to support our operations as a public company. Based on our planned use of the net proceeds of the IPO, our current cash and cash equivalents, the proceeds from a private placement of ordinary shares in March 2019 and the proceeds we are to receive pursuant to the terms of the Collaboration Agreement, we estimate that such funds will be sufficient to enable us to fund our operating expenses and capital expenditure requirements. We have based these estimates on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we expect. Because of the numerous risks and uncertainties associated with research, development and commercialization of gene therapies, it is difficult to estimate with certainty the amount of our working capital requirements. Our future funding requirements will depend on many factors, including: • the progress, costs and results of our preclinical development and initial clinical trials for our gene therapy programs; • the progress, costs and results of our additional clinical, research and preclinical development programs in gene therapy; • the costs and timing of process development and manufacturing scale-up activities associated with our clinical programs; • our ability to establish and maintain strategic collaborations, licensing or other agreements and the financial terms of such agreements; • the scope, progress, results and costs of any product candidates that we may derive from our platform technology or any other product candidates that we may develop; • the extent to which we in-license or acquire rights to other products, product candidates or technologies; and • the costs and timing of preparing, filing and prosecuting patent applications, maintaining and protecting our intellectual property rights and defending against any intellectual property-related claims. Until such time, if ever, that we can generate product revenue sufficient to achieve profitability, we expect to finance our cash needs through a combination of equity offerings, debt financings, collaboration agreements, other third-party funding, strategic alliances, licensing arrangements and marketing and distribution 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 these securities may include liquidation or other preferences that adversely affect your rights as a holder of ordinary shares. Debt financing and preferred 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 additional funds through other third-party funding, collaboration agreements, strategic alliances, licensing arrangements or marketing and distribution arrangements, 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. 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 products or product candidates that we would otherwise prefer to develop and market ourselves. Contractual Obligations and Commitments The following is a summary of our significant contractual obligations as of December 31, 2018. (1) Represents the leases for office, laboratory, and manufacturing space in London, United Kingdom and New York, New York under non-cancelable operating leases that expire between December 2021 and May 2027 and December 2021. (2) Represents future payments under capitalized leases for office equipment. The contractual obligations table does not include any potential future payments we may be required to make under (1) our license agreements with UCLB, Brandeis and other entities or (2) our sponsored research agreements with universities and commercial research organizations. These agreements may be terminated upon 30-90 days written notice and, therefore, the amounts to be paid by us are not fixed or determinable at this time. Off-Balance Sheet Arrangements We have not entered into any off-balance sheet arrangements under applicable SEC rules and do not have any holdings in variable interest entities.
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-0.032777
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<s>[INST] Overview We are a vertically integrated, clinical stage gene therapy company with five programs in clinical development and a broad pipeline of preclinical and research programs. We have core capabilities in viral vector design and optimization, gene therapy manufacturing as well as a potentially transformative gene regulation technology. Led by an experienced management team, we have taken a portfolio approach by licensing, acquiring and developing technologies that give us depth across both product candidates and indications. Though initially focusing on the eye, salivary gland and central nervous system, we intend to expand our focus in the future to develop additional gene therapy treatments for patients suffering from a range of serious diseases. We are an exempted company incorporated under the laws of the Cayman Islands in 2018, and prior to that, we commenced operations as MeiraGTx Limited, a private limited company incorporated under the laws of England and Wales in 2015. Our discussion of our financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States. Since our formation, we have devoted substantially all of our resources to developing our technology platform, establishing our viral vector manufacturing facility and developing manufacturing processes, advancing the product candidates in our ophthalmology, salivary gland and neurodegenerative disease programs, building our intellectual property portfolio, organizing and staffing our company, business planning, raising capital, and providing general and administrative support for these operations. In 2016, we completed the acquisition of assets held by BRIAlzan, Inc., a Delaware corporation, including a worldwide license agreement to develop certain preclinical technology for the treatment of ALS. In October 2018, we acquired Vector Neurosciences, Inc., a Delaware corporation. In connection with that acquisition, we acquired its AAVGAD gene therapy program which had completed a randomized, shamcontrolled Phase 2 study for treatment of Parkinson’s disease. To date, we have financed our operations primarily with cash on hand and proceeds from the sales of our Series A ordinary shares, Convertible Preferred C Shares and ordinary shares. Through December 31, 2018, we received gross proceeds of approximately $203.7 million from sales of our ordinary shares, Series A ordinary shares and Convertible Preferred C Shares. As of December 31, 2018, we had cash and cash equivalents of $68.1million. We are a clinical stage company and have not generated any product revenues to date. We have five clinical programs and a pipeline of preclinical programs. Since inception, we have incurred significant operating losses. Our net losses for the years ended December 31, 2018 and 2017 were $82.9 million and $31.1 million, respectively. As of December 31, 2018, we had an accumulated deficit of $148.3 million. While we do not expect to generate revenue from sales of any products for several years, if at all, in January 2019, we entered into the Collaboration Agreement, which provides for Janssen to pay us an $100 million upfront payment and provide us with research funding, and we are eligible to receive potential milestone payments and royalties. Our total operating expenses were $78.1 million and $31.7 million for the years ended December 31, 2018 and 2017, respectively. While we expect our operating expenses to increase substantially in connection with our ongoing development activities related to our product candidates, we believe that these increases may be partially offset by the research funding in connection with a collaboration, option and license agreement we entered into in January 2019. We anticipate that our expenses will increase due to costs associated with our clinical development program targeting in achromatopsia due to mutations in the CNGB3 or CNGA3 gene, inherited retinal dystrophy caused by mutations in RPE65, or RPE65deficiency, and XLinked retinitis pigmentosa, or XLRP. In addition, we expect to continue incurring increasing costs associated with our clinical activities for hAQP1 for the treatment of radiationinduced xerostomia and xerostom [/INST] Negative. </s>
2,019
6,768
1,735,438
MeiraGTx Holdings plc
2020-03-11
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 financial condition and operating results together with our financial statements and the related notes appearing in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report, including information with respect to our plans and strategy for our business and related financing, includes forward-looking statements that involve risks and uncertainties. As a result of many important factors, including those set forth in the section of this Form 10-K captioned “Item 1A. Risk Factors” and elsewhere in this Form 10-K, our actual results could differ materially from the results described in, or implied by, the forward-looking statements contained in the following discussion and analysis. For convenience of presentation some of the numbers have been rounded in the text below. Overview We are a vertically integrated, clinical stage gene therapy company with six programs in clinical development and a broad pipeline of preclinical and research programs. We have core capabilities in viral vector design and optimization, gene therapy manufacturing as well as a potentially transformative gene regulation technology. Led by an experienced management team, we have taken a portfolio approach by licensing, acquiring and developing technologies that give us depth across both product candidates and indications. Though initially focusing on ophthalmology, salivary gland and neurodegenerative disease programs, we intend to expand our focus in the future to develop additional gene therapy treatments for patients suffering from a range of serious diseases. We are an exempted company incorporated under the laws of the Cayman Islands in 2018, and prior to that, we commenced operations as MeiraGTx Limited, a private limited company incorporated under the laws of England and Wales in 2015. Our discussion of our financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States (“GAAP”). Since our formation, we have devoted substantially all of our resources to developing our technology platform, establishing our viral vector manufacturing facilities and developing manufacturing processes, advancing the product candidates in our ophthalmology, salivary gland and neurodegenerative disease programs, building our intellectual property portfolio, organizing and staffing our company, developing our business plan, raising capital, and providing general and administrative support for these operations. In 2016, we completed the acquisition of assets held by BRI-Alzan, Inc., a Delaware corporation, including a worldwide license agreement to develop certain preclinical technology for the treatment of amyotrophic lateral sclerosis (“ALS”). In October 2018, we acquired Vector Neurosciences, Inc., a Delaware corporation. In connection with that acquisition, we acquired its rights to the clinical stage gene therapy product candidate adeno-associated virus encoding glutamic acid decarboxylase (“AAV-GAD”) gene therapy program which had completed a randomized, sham-controlled Phase 2 study for treatment of Parkinson’s disease. In October 2019, we acquired Arthrogen, B.V., a Netherlands corporation. To date, we have financed our operations primarily with cash on hand and proceeds from the sales of our Series A ordinary shares, Convertible Preferred C Shares and ordinary shares. Through December 31, 2019, we received gross proceeds of approximately $358.7 million from sales of our ordinary shares, Series A ordinary shares and convertible preferred C shares and $100.0 million from the collaboration, option and license agreement with Janssen Pharmaceuticals, Inc. (“Janssen”), one of the Janssen Pharmaceuticals Companies of Johnson & Johnson (the “Collaboration and License Agreement”). As of December 31, 2019, we had cash and cash equivalents of $227.2 million. We are a clinical stage company and have not generated any product revenues to date. We have six clinical programs and a pipeline of preclinical programs. Since inception, we have incurred significant operating losses. Our net losses for the years ended December 31, 2019 and 2018 were $54.8 million and $82.9 million, respectively. As of December 31, 2019, we had an accumulated deficit of $203.0 million. We do not expect to generate revenue from sales of any products for several years, if at all. In March 2019, we received an upfront payment in the amount of $100.0 million from the Collaboration and License Agreement. Additionally, pursuant to the Collaboration and License Agreement, we are eligible to receive research and development funding and potential milestone payments and royalties. Our total operating expenses were $71.6 million and $78.1 million for the years ended December 31, 2019 and 2018, respectively. While we expect our operating expenses to increase substantially in connection with our ongoing development activities related to our product candidates, we believe that these increases will be partially offset by the research funding in connection with the Collaboration and License Agreement. We anticipate that our expenses will increase due to costs associated with our clinical development program targeting achromatopsia due to mutations in the CNGB3 or CNGA3 gene, inherited retinal dystrophy caused by mutations in RPE65, and X-Linked retinitis pigmentosa, or XLRP. In addition, we expect to continue incurring increasing costs associated with our clinical activities for AAV-AQP1 for the treatment of radiation-induced xerostomia and xerostomia associated with Sjogren’s syndrome. We are currently working with regulatory agencies to determine the path forward for clinical development of AAV-GAD. We also expect to incur expenses related to research activities in additional therapeutic areas to expand our pipeline, hiring additional personnel in manufacturing, research, clinical operations, quality and other functional areas, and associated cash and share-based compensation expense, as well as the further development of internal manufacturing capabilities and capacity and other associated costs including the management of our intellectual property portfolio. As a result of these anticipated expenditures, we will require additional capital, which we may raise through equity offerings, debt financings, marketing and distribution arrangements and other collaborations, strategic alliances and licensing arrangements or other sources to enable us to complete the development and potential commercialization of our product candidates. Furthermore, we expect to continue incurring costs associated with being a public company. Adequate additional financing may not be available to us on acceptable terms, or at all. Our failure to raise capital as and when needed would have a negative effect on our financial condition and our ability to pursue our business strategy. In addition, attempting to secure additional financing may divert the time and attention of our management from day-to-day activities and harm our product candidate development efforts. If we are unable to raise capital when needed or on acceptable terms, we would be forced to delay, reduce or eliminate certain of our research and development programs. Based on our cash and cash equivalents at December 31, 2019, we estimate that such funds will be sufficient to enable us to fund our operating expenses and capital expenditure requirements into 2022. We have based these estimates on assumptions that may prove to be wrong, and we may use our available capital resources sooner than we currently expect. See “Liquidity and Capital Resources.” Because of the numerous risks and uncertainties associated with the development of our product candidates, any future product candidates, our platform and technology and because the extent to which we may enter into collaborations with third parties for development of any of our product candidates is unknown, we are unable to estimate the amounts of increased capital outlays and operating expenses associated with completing the research and development of our product candidates. Our future capital requirements will depend on many factors, including: · the initiation, progress, timing, costs and results of our planned clinical trials for our product candidates; · the outcome, timing and cost of meeting regulatory requirements established by the FDA, EMA and other regulatory authorities; · 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 any of our product candidates; · the effect of competing technological and market developments; · the costs and timing of further developing and scaling our manufacturing facilities and processes; · the costs of operating as a public company; · the extent to which we in-license or acquire rights to other products, product candidates and technologies; · the cost of establishing sales, marketing and distribution capabilities for our product candidates in regions where we choose to commercialize our products; and · the initiation, progress, timing and results of our commercialization of our product candidates, if approved for commercial sale. 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 securities, your ownership interest will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect your 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 your ownership interests. If we raise additional funds through 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 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 programs or any future commercialization efforts or grant rights to develop and market product candidates that we would otherwise prefer to develop and market ourselves. Because of the numerous risks and uncertainties associated with drug development, we are unable to predict the timing or amount of increased expenses or when or if we will be able to achieve or maintain profitability. Even if we are able to generate revenue from product sales, we may not become profitable. If we fail to become profitable or are unable to sustain profitability on a continuing basis, then we may be unable to continue our operations at planned levels and be forced to reduce or terminate our operations. Highlights and Recent Developments Recent Clinical Development Highlights AAV-AQP1 for the treatment of Grade 2/3 Radiation-Induced Xerostomia: · We continue to activate clinical trial sites in our recently initiated Phase 1/2 AQUAx study, with patients now being enrolled at three of five expected study sites. Dosing in the first cohort was completed in the first quarter of 2020. · The single center Phase 1 dose-finding study of AAV-AQP1 also continues to enroll patients at the National Institutes of Health (NIH). Enrollement in the fourth dose escalation cohort is now ongoing. · We expect to report preliminary data from the AQUAx clinical trial in the second half of 2020. Janssen-partnered investigational gene therapies for the treatment of inherited retinal diseases: · In the first quarter of 2020, the EMA granted PRIME and ATMP designations to AAV-RPGR. PRIME designation was granted based on clinical data from the ongoing Phase 1/2 trial. To be awarded PRIME, a medicine must demonstrate potential to benefit patients with unmet medical needs based on early clinical data. We expect to engage with global regulatory authorities in 2020 with the goal of optimizing and accelerating the development of AAV-RPGR. · We expect to report data from the ongoing clinical trial of AAV-RPGR in 2020. · We continue to advance the ongoing phase 1/2 studies of AAV-CNGB3 and AAV-CNGA3 for the treatment of achromatopsia (ACHM) associated with mutations in the CNGB3 and CNGA3 genes. AAV-GAD for the treatment of Parkinson’s Disease: · We anticipate that we will file an Investigational New Drug application (IND) in the second half of 2020. AAV-RPE65 for the treatment of RPE65-Associated Retinal Dystrophy: · In 2019, we presented data from a Phase 1/2 clinical trial which demonstrated that, in addition to meeting its primary endpoint of safety, AAV-RPE65 demonstrated statistically significant improvement across several assesments of visual function. We expect to meet with global regulatory authorities in 2020 to determine the regulatory pathway for AAV-RPE65. Recent Corporate Development Highlights Second Viral Vector Manufacturing Facility and Plasmid Production Facility · We have completed feasibility studies for a second cGMP viral vector manufacturing facility and a cGMP plasmid production facility. · We anticipate that our plasmid production facility will be operational by the end of 2020 and expect to initiate construction of our viral vector facility in mid-2020. Expanding Clinical, Regulatory, Manufacturing, MSAT and Preclinical Development Teams · We continue to substantially increase key personnel across functional areas to support our broad pipeline of optimized investigational gene therapies. As of December 31, 2019, we had 157 employees. Components of Our Results of Operations License Revenue Our license revenue consisted of the amortization of the upfront payment we received in connection with the Collaboration and License Agreement. Operating Expenses Our operating expenses since inception have consisted primarily of general and administrative costs and research and development costs. General and Administrative Expenses General and administrative expenses consist primarily of salaries and other related costs, including share-based compensation, for personnel in our executive, finance, legal, business development and administrative functions. General and administrative expenses also include legal fees relating to intellectual property and corporate matters; professional fees for accounting, auditing, tax and consulting services; insurance costs; travel expenses; and office facility-related expenses, which include direct depreciation costs. We expect that our general and administrative expenses will increase in the future as we increase our personnel headcount to support increased research and development activities. We have also incurred and expect to continue to incur increased expenses associated with being a public company, including costs of accounting, audit, legal, regulatory and tax-related services associated with maintaining compliance with Nasdaq and SEC requirements; director and officer insurance costs; and investor and public relations costs. Research and Development Expenses Research and development expenses consist primarily of costs incurred for our research activities, including our discovery efforts, and the development of our product candidates, and include: · employee-related expenses, including salaries, benefits and travel of our research and development personnel; · expenses incurred in connection with third-party vendors that conduct clinical and preclinical studies and manufacture the drug product for the clinical trials and preclinical activities; · acquisition of in-process research and development; · costs associated with clinical and preclinical activities including costs related to facilities, supplies, rent, insurance, certain legal fees, share-based compensation, and depreciation; and · expenses incurred with the development and operation of our manufacturing facility. We expense research and development costs as incurred. We typically use our employee and infrastructure resources across our development programs. We track outsourced development costs by product candidate or development program, but we do not allocate personnel costs, license payments made under our licensing arrangements or other internal costs to specific development programs or product candidates. These costs are included in other research and development expenses in the table below. The following table summarizes our research and development expenses: Research and development activities are central to our business model. We expect that our research and development expenses will continue to increase substantially for the foreseeable future as we initiate additional preclinical and clinical trials of our existing product candidates and continue to discover and develop additional product candidates. These increases in research and development costs may be partially offset by the research funding provided in connection with the Collaboration and License Agreement we entered into in January 2019. We cannot determine with certainty the duration and costs of future clinical trials of our product candidates or any other product candidate we may develop or if, when, or to what extent we will generate revenue from the commercialization and sale of any product candidate for which we obtain marketing approval. We may never succeed in obtaining marketing approval for any product candidate. The duration, costs and timing of clinical trials and development of our existing product candidates or any other product candidate we may develop will depend on a variety of factors, including: · the scope, rate of progress, expense and results of clinical trials of our existing product candidates, as well as of any future clinical trials of other product candidates and other research and development activities that we may conduct; · uncertainties in clinical trial design and patient enrollment rates; · the actual probability of success for our product candidates, including the safety and efficacy, early clinical data, competition, manufacturing capability and commercial viability; · significant and changing government regulation and regulatory guidance; · the timing and receipt of any marketing approvals; and · the expense of filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights. A change in the outcome of any of these variables with respect to the development of a product candidate could mean a significant change in the costs and timing associated with the development of that product candidate. For example, if the FDA or another U.S. or foreign regulatory authority were to require us to conduct clinical trials beyond those that we anticipate will be required for the completion of clinical development of a product candidate, or if we experience significant delays in our clinical trials due to patient enrollment or other reasons, we would be required to expend significant additional financial resources and time on the completion of clinical development. Other non-operating income (expense) Other non-operating income (expense) includes the following: Foreign currency (loss) gain Our consolidated financial statements are presented in U.S. dollars, which is our reporting currency. The financial position and results of operations of our subsidiaries MeiraGTx UK II Limited, Arthrogen B.V. and MeiraGTx B.V. are measured using the foreign subsidiaries’ local currency as the functional currency. MeiraGTx UK II Limited’s cash accounts holding U.S. dollars are remeasured based upon the exchange rate at the date of remeasurement with the resulting gain or loss included in the consolidated statement of operations and comprehensive loss. Expenses of such subsidiaries have been translated into U.S. dollars at average exchange rates prevailing during the period. Assets and liabilities have been translated at the rates of exchange on the consolidated balance sheet date. The resulting translation gain and loss adjustments are recorded directly as a separate component of shareholders’ equity and as other comprehensive loss on the consolidated statement of operations and comprehensive loss. Income Taxes The 2018 income tax provision consisted of current tax expense of $0 and a deferred tax benefit of $474,391. The 2018 deferred tax benefit was recorded due to the required intraperiod tax allocation resulting from the loss from continuing operations and other comprehensive income. An intraperiod tax allocation was not required for 2019. Critical Accounting Policies and Use of 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 the accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires us to make estimates and judgements that affect the reporting amounts of assets, liabilities and expenses and the disclosure of contingent assets and liabilities in our consolidated financial statements. On an ongoing basis, we evaluate our estimates and judgements, including those related to license and collaboration revenue, warrant liabilities, share-based compensation 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 judgements about the carrying value of assets and liabilities that are not readily apparent from our sources. Actual results may differ from these estimates under different assumptions. While our significant accounting policies are described in more detail in the notes to our financial statements appearing in this 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 financial statements. Consolidation The accompanying consolidated financial statements include the accounts of Meira Holdings and its wholly owned subsidiaries: MeiraGTx Limited, a limited company under the laws of England and Wales (“Meira Limited); MeiraGTx, LLC, a Delaware corporation (“Meira LLC”); MeiraGTx UK II Limited, (“Meira UK II”), a limited company under the laws of England and Wales; Arthrogen, B.V., a Netherlands corporation (“Arthrogen”) BRI-Alzan, Inc., a Delaware corporation (“BRI-Alzan”); MeiraGTx B.V., a Netherlands corporation (“Meira BV”); MeiraGTx Neurosciences, Inc. a Delaware corporation (“Meira Neuro”); and MeiraGTx UK Limited (“Meira UK”), a limited company under the laws of England and Wales. All intercompany balances and transactions between the consolidated companies have been eliminated in consolidation. Collaboration Arrangements We evaluate our collaborative arrangements pursuant to Accounting Standards Codification (“ASC”) 808, Collaborative Arrangements (“ASC 808”) and ASC 606, Revenue from Contracts with Customers (“ASC 606”). We consider the nature and contractual terms of collaborative arrangements and assess whether the arrangement involves a joint operating activity pursuant to which we are an active participant and are exposed to significant risks and rewards with respect to the arrangement. If we are an active participant and exposed to significant risks and rewards with respect to the arrangement, we account for the arrangement as a collaboration under ASC 808. To date, we have entered into two separate collaboration agreements, both of which are with Janssen, which were determined to be within the scope of ASC 808. ASC 808 does not address recognition or measurement matters related to collaborative arrangements. Payments between participants pursuant to a collaborative arrangement that are within the scope of other authoritative accounting literature on income statement classification are accounted for using the relevant provisions of that literature. If the payments are not within the scope of other authoritative accounting literature, the income statement classification for the payments is based on an analogy to authoritative accounting literature or if there is no appropriate analogy, a reasonable, rational and consistently applied accounting policy election. Payments received from a collaboration partner to which this policy applies may include upfront payments in respect of a license of intellectual property, development and commercialization-based milestones, and royalties. Revenue Recognition Arrangements with collaborators may include licenses to intellectual property, research and development services, manufacturing services for clinical and commercial supply, and participation on joint steering committees. We evaluate the promised goods or services to determine which promises, or group of promises, represent performance obligations. In contemplation of whether a promised good or service meets the criteria required of a performance obligation, we consider the stage of development of the underlying intellectual property, the capabilities and expertise of the customer relative to the underlying intellectual property, and whether the promised goods or services are integral to or dependent on other promises in the contract. When accounting for an arrangement that contains multiple performance obligations, we must develop judgmental assumptions, which may include market conditions, reimbursement rates for personnel costs, development timelines and probabilities of regulatory success to determine the stand-alone selling price for each performance obligation identified in the contract. When we conclude that a contract should be accounted for as a combined performance obligation and recognized over time, we must then determine the period over which revenue should be recognized and the method by which to measure revenue. We generally recognize revenue using a cost-based input method. The Collaboration and License Agreement is accounted for under ASC 808, however, as ASC 808 does not address recognition or measurement matters such as determining the appropriate unit of accounting or when the recognition criteria are met, we account for the consideration received from Janssen in accordance with ASC 606. In accordance with ASC 606, we recognize revenue when the customer or collaborator obtains control of promised goods or services, in an amount that reflects the consideration which we expect to receive in exchange for those goods or services. To determine revenue recognition for arrangements that we determine are within the scope of ASC 606, we perform 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 within the contract; and v.recognize revenue when (or as) the entity satisfies a performance obligation. We only apply the five-step model to contracts when we determine that it is probable we will collect the consideration we are entitled to in exchange for the goods or services we transfers to the customer. At contract inception, once the contract is determined to be by analogy within the scope of ASC 606, we assess the goods or services promised within the contract to determine whether each promised good or service is a performance obligation. The promised goods or services for our arrangements typically consist of a license to our intellectual property and research, development and manufacturing services. We may provide options to additional items in such arrangements, which are accounted for as separate contracts when the customer elects to exercise such options, unless the option provides a material right to the customer. Performance obligations are promises in a contract to transfer a distinct good or service to the customer that (i) the customer can benefit from on its own or together with other readily available resources, and (ii) is separately identifiable from other promises in the contract. Goods or services that are not individually distinct performance obligations are combined with other promised goods or services until such combined group of promises meet the requirements of a performance obligation. We determine transaction prices based on the amount of consideration we expect to receive for transferring the promised goods or services in the contract. Consideration may be fixed, variable, or a combination of both. At contract inception for arrangements that include variable consideration, we estimate the probability and extent of consideration we expect to receive under the contract utilizing either the most likely amount method or expected amount method, whichever best estimates the amount expected to be received. We then consider any constraints on the variable consideration and include in the transaction price variable consideration to the extent it is deemed probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved. We then allocate the transaction price to each performance obligation based on the relative standalone selling price and recognize as revenue the amount of the transaction price that is allocated to the respective performance obligation when (or as) control is transferred to the customer and the performance obligation is satisfied. For performance obligations which consist of licenses and other promises, we utilize judgment to assess the nature of the combined performance obligation to determine whether the combined performance obligation is satisfied over time or at a point in time and, if over time, the appropriate method of measuring progress. We evaluate the measure of progress each reporting period and, if necessary, adjust the measure of performance and related revenue recognition. We record amounts as accounts receivable when the right to consideration is deemed unconditional. When consideration is received, or such consideration is unconditionally due, from a customer prior to transferring goods or services to the customer under the terms of a contract, a contract liability is recorded as deferred revenue. Amounts received prior to satisfying the revenue recognition criteria are recognized as deferred revenue in our consolidated balance sheet. Amounts expected to be recognized as revenue within the 12 months following the balance sheet date are classified as deferred revenue - related party, current. Amounts not expected to be recognized as revenue within the 12 months following the balance sheet date are classified as deferred revenue - related party. Income Taxes Since we have recurring losses and a valuation allowance against deferred tax assets, there was no tax expense (benefit) for the year ended December 31, 2019. For the year ended December 31, 2018, we recognized a tax benefit of $(474,391). As of December 31, 2019, we had federal and state net operating loss (“NOL”) carryforwards in the United States of approximately $27.5 million and $27.6 million, respectively, in the UK of approximately $107.3 million and in the Netherlands of approximately $22.8, which are available to reduce future taxable income. The U.S. federal and state NOL carryforwards incurred prior to January 1, 2018 in the amount of approximately $6.8 million and $6.7 million, respectively, will begin to expire in 2036. The U.S. NOL incurred after December 31, 2017 and the UK NOL will be indefinitely carried forward. The Netherlands NOL’s expire after nine years from the date of inception. As of December 31, 2019, we also had orphan drug and research and development credits in the U.S. in the amount of $2.4 million, which will begin to expire 2036. Leases We account for leases in accordance with ASC 842. We determine if an arrangement is a lease at contract inception. A lease exists when a contract conveys the right to control the use of identified property, plant, or equipment for a period of time in exchange for consideration. The definition of a lease embodies two conditions: (1) there is an identified asset in the contract that is land or a depreciable asset (i.e., property, plant, and equipment), and (2) we have the right to control the use of the identified asset. We account for the lease and non-lease components as a single lease component. From time to time we enter into direct financing lease arrangements that include a lessee obligation to purchase the leased asset at the end of the lease term, a bargain purchase option, or provides for minimum lease payments with a present value of 90% or more of the fair value of the leased asset at the date of lease inception. Operating leases where we are the lessee are included in right-of-use (“ROU”) assets and lease obligations are included on our consolidated balance sheets. The lease obligations are initially and subsequently measured at the present value of the unpaid lease payments at the lease commencement date and subsequent reporting periods. Finance leases where we are the lessee are included in ROU assets and lease obligations on our consolidated balance sheets. The lease obligations are initially measured in the same manner as for operating leases and are subsequently measured at amortized cost using the effective interest method. Key estimates and judgments include how we determined (1) the discount rate we use to discount the unpaid lease payments to present value, (2) lease term and (3) lease payments. ASC 842 requires a lessee to discount its unpaid lease payments using the interest rate implicit in the lease or, if that rate cannot be readily determined, its incremental borrowing rate. As most of our leases where we are the lessee do not provide an implicit rate, we use our incremental borrowing rate based on the information available at commencement date in determining the present value of lease payments. Our incremental borrowing rate for a lease is the rate of interest we would have to pay on a collateralized basis to borrow an amount equal to the lease payments under similar terms. We use the implicit rate when readily determinable. The lease term for all of our leases includes the non-cancellable period of the lease plus any additional periods covered by either a lessee option to extend (or not to terminate) the lease that is reasonably certain to be exercised, or an option to extend (or not to terminate) the lease controlled by the lessor. The ROU asset is initially measured at cost, which comprises the initial amount of the lease liability adjusted for lease payments made at or before the lease commencement date less any lease incentives received. For operating leases, the ROU asset is subsequently measured throughout the lease term at the carrying amount of the lease liability, minus any accrued lease payments, less the unamortized balance of lease incentives received. Lease expense for lease payments is recognized on a straight-line basis over the lease term. For finance leases, the ROU asset is subsequently amortized using the straight-line method from the lease commencement date to the earlier of the end of its useful life or the end of the lease term unless the lease transfers ownership of the underlying asset to us, or we are reasonably certain to exercise an option to purchase the underlying asset. In those cases, the ROU asset is amortized over the useful life of the underlying asset. Amortization of the ROU asset is recognized and presented separately from interest expense on the lease liability. We have elected not to recognize ROU assets and lease liabilities for all short-term leases that have a lease term of 12 months or less at lease commencement. We recognize the lease payments associated with our short-term leases as an expense on a straight-line basis over the lease term. We adopted ASU 2016-02 using a modified retrospective transition approach as of the effective date as permitted by the amendments in ASU 2018-11, which provides an alternative modified retrospective transition method. As a result, we were not required to adjust our comparative period financial information for effects of the standard or make the new required lease disclosures for periods before the date of adoption (i.e. January 1, 2019). We have elected to adopt the package of transition practical expedients and, therefore, have not reassessed (1) whether existing or expired contracts contain a lease, (2) lease classification for existing or expired leases or (3) the accounting for initial direct costs that were previously capitalized. We did not elect the practical expedient to use hindsight for leases existing at the adoption date. Further, we do not expect the amendments in ASU 2018-01: Land Easement Practical Expedient to have an effect on us because we do not enter into land easement arrangements. Research and Development Research and development costs are charged to expense as incurred. These costs include, but are not limited to, employee-related expenses, including salaries, benefits and travel of our research and development personnel; expenses incurred under agreements with contract research organizations and investigative sites that conduct clinical and preclinical studies and manufacture the drug product for the clinical studies and preclinical activities; acquisition of in-process research and development; facilities; supplies; rent, insurance, certain legal fees, stock-based compensation, depreciation and other costs associated with clinical and preclinical activities and regulatory operations. Research funding under collaboration agreements and refundable research and development credits / tax credits received are recorded as an offset to these costs. Costs for certain development activities, such as outside research programs funded by us, are recognized based on an evaluation of the progress to completion of specific tasks with respect to their actual costs incurred. Payments for these activities are based on the terms of the individual arrangements, which may differ from the pattern of costs incurred, and are reflected in the financial statements as prepaid or accrued research and development expense, as the case may be. Share-Based Compensation Options We grant share options to employees, non-employee members of our board of directors and non-employee consultants as compensation for services performed. Employee and non-employee members of the board of directors’ awards of share-based compensation are accounted for in accordance with ASC 718, Compensation-Stock Compensation, or ASC 718. ASC 718 requires all share-based payments to employees and non-employee directors, including grants of share options, to be recognized in the statement of operations and comprehensive loss based on their grant date fair values. The grant date fair value of share options is estimated using the Black-Scholes option valuation model. Using this model, fair value is calculated based on assumptions with respect to (i) the fair value of our ordinary shares on the grant date; (ii) expected volatility of our ordinary share price, (iii) the periods of time over which employees and members of our board of directors are expected to hold their options prior to exercise (expected term), (iv) expected dividend yield on our ordinary shares, and (v) risk-free interest rates. Our ordinary shares were not traded on a public exchange prior to our IPO in June 2018. Therefore, we believe that our future volatility will differ materially during the expected term from the volatility that would be calculated from our historical share prices to date. Consequently, expected volatility is based on an analysis of guideline companies in accordance with ASC 718. The expected dividend yield is zero as we have never paid dividends and do not currently anticipate paying any in the foreseeable future. Risk-free interest rates are based on quoted U.S. Treasury rates for securities with maturities approximating the option’s expected term. As of January 1, 2016, we early adopted ASU 2016-09, Improvements to Employee Share-Based Payment Accounting, and account for forfeitures as they occur from that date. Additionally, excess tax benefits and deficiencies will be recognized as income tax expense or benefit in the income statement. There was no cumulative effect adjustment as we did not issue any options prior to January 1, 2016. We had accounted for options granted to non-employee consultants under ASC 505-50, Equity-Based Payments to Non-Employees. As such, we estimate the fair value of each such option using the Black-Scholes model, with the expected term of share options granted to non-employees initially equal to the options’ maximum contractual life of ten years, at issuance. On each subsequent reporting date until performance is complete, we revalue all outstanding options granted to non-employee consultants during the vesting period of each tranche. Under ASC 505-50, upon re-measurement of each award, income or expense is recognized during its vesting term. Compensation cost relating to awards with service-based graded vesting schedules is recognized as general and administrative and research and development expenses in the consolidated statement of operations and comprehensive loss using the straight-line method. On July 1, 2018, we early adopted ASU 2018-07, Improvements to Nonemployee Share-Based Payment Accounting, which simplifies the accounting for share-based payments granted to nonemployees for goods and services. The adoption did not have a material effect on the consolidated financial statements. Restricted Shares In connection with certain service agreements and research agreements, we have granted restricted ordinary shares as compensation. The shares are recognized in the statement of operations and comprehensive loss based on their grant date fair values. Compensation cost relating to share grants with service-based graded vesting schedules is recognized based on the vesting schedule. Results of Operations The following table summarizes our results of operations for the years ended December 31, 2019 and 2018, respectively License Revenue License revenue in the amount of $13.3 million for the year ended December 31, 2019 represents amortization of the $100.0 million upfront payment received in connection with the Collaboration and License Agreement entered into in January 2019. General and Administrative Expenses General and administrative expenses were $46.7 million for the year ended December 31, 2019, compared to $44.5 million for the year ended December 31, 2018. The increase of $2.2 million was primarily due to increases of $1.9 million in legal fees, $1.2 million in rent, $1.4 million in insurance, $0.6 million in consulting fees, $0.6 million in travel expenses, $0.3 million in director fees and $0.5 million in other general and administrative expenses, which was partially offset by a decreases of $3.7 million in share-based compensation and $0.6 million in payroll. Research and Development Expenses Research and development expenses for the year ended December 31, 2019 were $24.9 million, compared to $33.6 million for the year ended December 31, 2018. The decrease of $8.7 million was primarily due to research funding provided to us under the Janssen collaboration agreements in the amount of $27.9 million and an increase in the refundable research and development credit in the United Kingdom of $8.6 million. These were partially offset by increases in costs of $9.2 million for clinical trial costs related to our ophthalmology and salivary gland programs, $7.5 million related to the manufacturing of our clinical trial materials, $4.5 million due to the restructuring of certain licenses, $4.3 million in payroll related costs, $1.7 million in share-based compensation, and $0.7 million in rent. Foreign Currency Gain (Loss) Foreign currency gain was $3.2 million for the year ended December 31, 2019 compared to a loss of $3.8 million for the year ended December 31, 2018. The change of $7.0 million was primarily due to a strengthening of the pound sterling against the U.S. dollar in 2019. Change in Fair Market Value of Warrant Liability We recorded $1.5 million change in fair value of a warrant liability for the year ended December 31, 2018, due to the revaluation of warrants, which were issued to certain investors in September and November 2017, using the Black-Scholes valuation model at June 7, 2018, when the warrants were exercised. Income Taxes The 2018 income tax provision consisted of current tax expense of $0 and a deferred tax benefit of $474,391. The 2018 deferred tax benefit was recorded due to the required intraperiod tax allocation resulting from the loss from continuing operations and other comprehensive income. An intraperiod tax allocation was not required for 2019. Liquidity and Capital Resources Since our inception, we have incurred significant operating losses. For the year ended December 31, 2019, we generated $20.0 million of positive cash flows from operations, primarily from the $100 million upfront payment received in connection with the Collaboration and License Agreement. However, prior to the year ended December 31, 2019, we did not generate positive cash flows from operations and there are no assurances that we will generate positive cash flows in the future. Additionally, there are no assurances that we will be successful in obtaining an adequate level of financing for the development and commercialization of our product candidates. We expect to incur significant expenses and operating losses for the foreseeable future as we advance the preclinical and clinical development of our product candidates. We expect that our research and development and general and administrative costs will increase in connection with conducting preclinical studies and clinical trials for our product candidates, building out internal capacity to have products manufactured to support preclinical studies and clinical trials, expanding our intellectual property portfolio, and providing general and administrative support for our operations. In addition, we expect to expand our manufacturing and supply chain capabilities in the coming months. As a result, we will need additional capital to fund our operations, which we may obtain from additional equity or debt financings, collaborations, licensing arrangements, or other sources. We do not currently have any approved products and have never generated any revenue from product sales. We have historically financed our operations primarily through cash on hand and proceeds from the sale of our ordinary shares, series A ordinary shares and convertible preferred C shares. In March 2019, we received $100.0 million in connection with the Collaboration and License Agreement, which also provides us with research funding, and we are eligible to receive potential milestone payments and royalties. Cash Flows We had $227.4 million and $68.2 million of cash and cash equivalents as of December 31, 2019 and 2018, respectively. The following table summarizes our sources and uses of cash for the period presented: Operating Activities During the year ended December 31, 2019, our cash provided by operating activities of $20.0 million was primarily due to our receipt of a $100.0 million upfront payment received from the Collaboration and License Agreement, which was partially offset by a net loss of $54.8 million as we incurred expenses associated with research activities on our clinical programs and research activities for our other product candidates and incurred general and administrative expenses. The net loss included non-cash charges of $4.8 million, which consisted of $16.0 million of share-based compensation, $2.0 million for shares issued in connection with license agreements, depreciation of $2.2 million and lease obligations of $1.1 million, which was partially offset by a foreign currency gain of $3.2 million. Additionally, operating assets, consisting of accounts receivable, prepaid expenses, tax incentive receivable, security deposits and other current assets, increased by $35.5 million and operating liabilities, consisting of accounts payable, accrued expenses, and deferred revenue, increased by $92.2 million. During the year ended December 31, 2018, our cash used in operating activities of $58.9 million was primarily due to our net loss of $82.9 million as we incurred expenses associated with research activities on our clinical programs and research activities for our other product candidates and incurred general and administrative expenses. The loss included non-cash charges of $27.9 million, which consisted of $17.9 million of share-based compensation, issuance of shares for acquired research and development in the amount of $3.0 million, change in fair value of warrant liability in the amount of $1.5 million, depreciation of $2.1 million, and a foreign currency loss of $3.9 million, which was partially offset by an income tax benefit of $0.5 million. Additionally, current assets, consisting of prepaid expenses, other current assets and security deposits increased by $3.9 million. Current liabilities, consisting of accounts payable, accrued expenses, deferred rent, due to affiliate and other liabilities, decreased by $0.1 million Investing Activities Net cash used in investing activities for the years ended December 31, 2019 and 2018 of $9.4 million and $11.3 million, respectively, consisted primarily of purchases of property and equipment for our manufacturing, laboratory and process development facilities and buildout costs of our new facilities. Financing Activities Net cash provided by financing activities was $148.2 million for the year ended December 31, 2019, which consisted primarily of gross proceeds of $155.2 million from a private placement and a public offering of our ordinary shares, which was offset by $7.5 million in offering costs. Net cash provided by financing activities was $130.0 million for the year ended December 31, 2018, represented proceeds of $65.6 million from the issuance of Ordinary Shares in connection with our initial public offering, $56.1 million from the issuance of Convertible Preferred C Shares and $9.7 million from the exercise of warrants, which was partially offset by the repayment of a note payable in the amount of $1.4 million. Off-Balance Sheet Arrangements We have not entered into any off-balance sheet arrangements under applicable SEC rules and do not have any holdings in variable interest entities. Emerging Growth Company Status The Jumpstart Our Business Startups Act of 2012, (the “JOBS Act”), permits an “emerging growth company,” which we are, 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 elected to take advantage of this extended transition period.
-0.067215
-0.066969
0
<s>[INST] Overview We are a vertically integrated, clinical stage gene therapy company with six programs in clinical development and a broad pipeline of preclinical and research programs. We have core capabilities in viral vector design and optimization, gene therapy manufacturing as well as a potentially transformative gene regulation technology. Led by an experienced management team, we have taken a portfolio approach by licensing, acquiring and developing technologies that give us depth across both product candidates and indications. Though initially focusing on ophthalmology, salivary gland and neurodegenerative disease programs, we intend to expand our focus in the future to develop additional gene therapy treatments for patients suffering from a range of serious diseases. We are an exempted company incorporated under the laws of the Cayman Islands in 2018, and prior to that, we commenced operations as MeiraGTx Limited, a private limited company incorporated under the laws of England and Wales in 2015. Our discussion of our financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States (“GAAP”). Since our formation, we have devoted substantially all of our resources to developing our technology platform, establishing our viral vector manufacturing facilities and developing manufacturing processes, advancing the product candidates in our ophthalmology, salivary gland and neurodegenerative disease programs, building our intellectual property portfolio, organizing and staffing our company, developing our business plan, raising capital, and providing general and administrative support for these operations. In 2016, we completed the acquisition of assets held by BRIAlzan, Inc., a Delaware corporation, including a worldwide license agreement to develop certain preclinical technology for the treatment of amyotrophic lateral sclerosis (“ALS”). In October 2018, we acquired Vector Neurosciences, Inc., a Delaware corporation. In connection with that acquisition, we acquired its rights to the clinical stage gene therapy product candidate adenoassociated virus encoding glutamic acid decarboxylase (“AAVGAD”) gene therapy program which had completed a randomized, shamcontrolled Phase 2 study for treatment of Parkinson’s disease. In October 2019, we acquired Arthrogen, B.V., a Netherlands corporation. To date, we have financed our operations primarily with cash on hand and proceeds from the sales of our Series A ordinary shares, Convertible Preferred C Shares and ordinary shares. Through December 31, 2019, we received gross proceeds of approximately $358.7 million from sales of our ordinary shares, Series A ordinary shares and convertible preferred C shares and $100.0 million from the collaboration, option and license agreement with Janssen Pharmaceuticals, Inc. (“Janssen”), one of the Janssen Pharmaceuticals Companies of Johnson & Johnson (the “Collaboration and License Agreement”). As of December 31, 2019, we had cash and cash equivalents of $227.2 million. We are a clinical stage company and have not generated any product revenues to date. We have six clinical programs and a pipeline of preclinical programs. Since inception, we have incurred significant operating losses. Our net losses for the years ended December 31, 2019 and 2018 were $54.8 million and $82.9 million, respectively. As of December 31, 2019, we had an accumulated deficit of $203.0 million. We do not expect to generate revenue from sales of any products for several years, if at all. In March 2019, we received an upfront payment in the amount of $100.0 million from the Collaboration and License Agreement. Additionally, pursuant to the Collaboration and License Agreement, we are eligible to receive research and development funding and potential milestone payments and royalties. Our total operating expenses were $71.6 million and $78.1 million for the years ended December 31, 2019 and 2018, respectively. While we expect our operating expenses to increase substantially in connection with our ongoing development activities related to our product candidates, we believe that these increases [/INST] Negative. </s>
2,020
7,761
1,651,944
Constellation Alpha Capital Corp.
2018-06-29
2018-03-31
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Overview We are a blank check company incorporated on July 31, 2015 in the British Virgin Islands and formed for the purpose of entering into a business combination with one or more target businesses. We intend to effectuate our business combination using cash from the proceeds of our initial public offering and the sale of Private Units that occurred simultaneously with the completion of our initial public offering, our securities, debt or a combination of cash, securities and debt. The issuance of additional ordinary shares or preferred stock: · may significantly dilute the equity interest of our investors who would not have pre-emption rights in respect of any such issuance; · may subordinate the rights of holders of ordinary shares if we issue preferred shares with rights senior to those afforded to our ordinary shares; · could cause a change in control if a substantial number of ordinary shares 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 share 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, it could result in: · default and foreclosure on our assets if our operating revenues after our 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 any document governing such debt contains covenants restricting our ability to obtain such financing while the debt security is outstanding; · our inability to pay dividends on our ordinary shares; · 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 ordinary shares 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 acquisition plans. We cannot assure you that our plans to complete a business combination or to raise capital will be successful. Results of Operations We have neither engaged in any operations nor generated any revenues to date. Our only activities prior to March 31, 2018 were organizational activities, those necessary to consummate our 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 and marketable securities we hold as a result of the initial public offering. There has been no material adverse change has occurred since the date of our audited financial statements included in our registration statement for 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 in pursuit of our acquisition plans. For the year ended March 31, 2018, we had net income of $856,407, consisting of interest income on marketable securities held in our trust account of $1,208,066, offset by operating costs of $306,243 and an unrealized loss on marketable securities held in our trust account of $45,416. For the year ended March 31, 2017, we had a net loss $60, consisting of operating costs. For the period from July 31, 2015 (inception) through March 31, 2016, we had a net loss of $2,733, consisting of formation and operating costs. Liquidity and Capital Resources On June 23, 2017, we consummated our initial public offering of 14,375,000 Units, at a price of $10.00 per Unit, which includes the full exercise by the underwriters of their over-allotment option in the amount of 1,875,000 Units at $10.00 per Unit, generating gross proceeds of $143,750,000. Simultaneously with the closing of our initial public offering, we consummated the sale of 561,250 Private Units at a price of $10.00 per Unit, of which of which 425,000 Private Units were purchased by the Sponsor and 136,250 Private Units were purchased by Cowen Investments, generating gross proceeds of $5,612,500. Following the initial public offering and the exercise of the over-allotment option, a total of $145,187,500 was placed in the trust account. We incurred $8,420,717 in initial public offering related costs, including $2,875,000 of underwriting fees, $5,031,250 of deferred underwriting fees and $514,467 of initial public offering costs. As of March 31, 2018, we had marketable securities held in the trust account of $146,350,150, substantially all of which is invested in U.S. treasury bills with a maturity of 180 days or less. Interest income earned on the balance in the trust account may be available to us to pay our income tax obligations. Since inception, we have not withdrawn any interest from the trust account. As of March 31, 2018, we had cash of $449,942 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 March 31, 2018, we had accounts payable and accrued expenses of $30,853. For the year ended March 31, 2018, cash used in operating activities amounted to $373,391. Net income of $856,407 was impacted by interest earned on marketable securities held in the trust account of $1,208,066 and an unrealized loss on marketable securities held in the trust account of $45,416. Changes in our operating assets and liabilities used cash of $67,148. For the year ended March 31, 2017, cash provided by operating activities amounted to $2,194. Net loss of $60 was offset by changes in our operating assets and liabilities, which provided $2,254 of cash. For the period from July 31, 2015 (inception) through March 31, 2016, cash used in operating activities amounted to $489. Net loss of $2,733 was offset by changes in our operating assets and liabilities, which provided $2,244 of cash. We intend to use substantially all of the net proceeds of our initial public offering and the sale of the private units, including the funds held in the trust account (excluding deferred underwriting commissions and taxes payable on interest earned on the trust account), to acquire a target business or businesses and to pay our expenses relating thereto. To the extent that our shares are 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. 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 finance transaction costs in connection with a 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 a business combination, we would repay such loaned amounts 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 the working capital held outside the trust account to repay such loaned amounts but no proceeds from our trust account would be used to repay such loaned amounts. Up to $1,500,000 of such loans may be converted into private units of the post business combination entity at a price of $10.00 per private unit at the option of the lender. The terms of such loans, if any, have not been determined and no written agreements exist with respect to such loans. 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 the costs of identifying a target business, undertaking in-depth due diligence and negotiating a business combination are less than the actual amounts 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 consummate our business combination or because we become obligated to redeem a significant number of our public shares upon consummation of our 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 complete such financing simultaneously with the completion of our business combination, in which case we may issue additional securities or incur debt in connection with such business combination. We cannot provide any assurance that financing will be available to us on commercially acceptable terms, if at all. 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. Off-balance sheet financing arrangements We have no obligations, assets or liabilities which would be considered off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K. 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 office space, utilities and administrative support provided to the Company. We began incurring these fees on June 20, 2017 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 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 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 March 31, 2018, ordinary shares subject to possible redemption are presented at redemption value as temporary equity, outside of the shareholders’ equity section of our balance sheet.
-0.005781
-0.005633
0
<s>[INST] We are a blank check company incorporated on July 31, 2015 in the British Virgin Islands and formed for the purpose of entering into a business combination with one or more target businesses. We intend to effectuate our business combination using cash from the proceeds of our initial public offering and the sale of Private Units that occurred simultaneously with the completion of our initial public offering, our securities, debt or a combination of cash, securities and debt. The issuance of additional ordinary shares or preferred stock: · may significantly dilute the equity interest of our investors who would not have preemption rights in respect of any such issuance; · may subordinate the rights of holders of ordinary shares if we issue preferred shares with rights senior to those afforded to our ordinary shares; · could cause a change in control if a substantial number of ordinary shares 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 share 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, it could result in: · default and foreclosure on our assets if our operating revenues after our 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 any document governing such debt contains covenants restricting our ability to obtain such financing while the debt security is outstanding; · our inability to pay dividends on our ordinary shares; · 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 ordinary shares 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 acquisition plans. We cannot assure you that our plans to complete a business combination or to raise capital will be successful. Results of Operations We have neither engaged in any operations nor generated any revenues to date. Our only activities prior to March 31, 2018 were organizational activities, those necessary to consummate our 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 nonoperating income in the form of interest income on cash and marketable securities we hold as a result of the initial public offering. There has been no material adverse change has occurred since the date of our audited financial statements included in our registration statement for 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 in pursuit of our acquisition plans. For the year ended March 31, 2018, we had net income of $856,407, consisting of interest income on marketable securities held in our trust account of $1,208,066, offset by operating costs of $306,243 and an unrealized loss on marketable securities held in our trust account of $45,416. For the year ended March 31, 2017, we had a net loss $60, consisting of operating costs. [/INST] Negative. </s>
2,018
2,199
1,651,944
Constellation Alpha Capital Corp.
2019-06-14
2019-03-31
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations References to the “Company,” “our,” “us” or “we” refer to Constellation Alpha Capital 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. 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 filings with the SEC. Overview We are a blank check company incorporated on July 31, 2015 in the British Virgin Islands and formed for the purpose of entering into a business combination with one or more target businesses. On June 23, 2017, we consummated our initial public offering of 14,375,000 units (including 1,875,000 units sold pursuant to the underwriters exercising their over-allotment option), with each unit consisting of one ordinary share, one warrant, each warrant entitling the holder to purchase one-half of one ordinary share at a price of $11.50 per whole share and one right to receive one-tenth of one ordinary share upon the consummation of an initial business combination. No fractional shares will be issued upon exercise of the warrants. Each warrant will become exercisable on the completion of our business combination. The warrants will expire five years after the completion of our initial business combination or earlier upon redemption or liquidation. The units in our initial public offering were sold at an offering price of $10.00 per unit, generating total gross proceeds of $143,750,000. Cowen Investments acted as the sole book running manager and I-Bankers Securities, Inc. acted as co-manager of the offering. The securities sold in the offering were registered under the Securities Act on a registration statement on Form S-1 (No. 333-218093), or our registration statement. The SEC declared our registration statement effective on June 19, 2017. We paid a total of $2,875,000 in underwriting discounts and commissions and $514,467 for other costs and expenses related to our initial public offering. In addition, the underwriters agreed to defer $5,031,250 in underwriting discounts and commissions, and up to this amount will be payable upon consummation of the business combination. After deducting the underwriting discounts and commissions (excluding the deferred portion of $5,031,250 in underwriting discounts and commissions, which will be released from the trust account upon consummation of the business combination, if consummated) and the estimated offering expenses, the total net proceeds from our initial public offering and the private placement was $145,973,033, of which $145,187,500 (or $10.10 per unit sold in our initial public offering) was placed in the trust account. On March 21, 2019, at the Special Meeting, our shareholders approved our amended and restated memorandum and articles of association to extend the date by which we have to consummate a business combination (the “Extension”) to September 23, 2019 (the “Combination Period”). In connection with the Extension, an aggregate of 13,187,468 ordinary shares was redeemed for an aggregate payment of approximately $136.9 million out of the trust account. If we are unable to complete a Business Combination on or before the Combination Period, 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, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the trust account, including interest earned (net of taxes payable and less interest to pay dissolution expenses up to $50,000), 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), 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 the Company, subject in each case to our obligations to provide for claims of creditors and the requirements of applicable law. 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 or to raise capital will be successful. On August 2, 2018, we entered into an agreement (the “Share Purchase Agreement”) to purchase all of the issued and outstanding shares of capital stock of Medall Healthcare Private Limited, a company registered under the laws of India. On December 3, 2018, the Share Purchase Agreement was terminated automatically. On March 21, 2019, at the special meeting of shareholders, our shareholders approved an amended and restated memorandum and articles of association to extend the date by which we have to consummate a business combination to September 23, 2019. In connection with the extension, an aggregate of 13,187,468 ordinary shares was redeemed for an aggregate payment of approximately $136.9 million out of our trust account. On March 15, 2019, we announced that it has executed a non-binding letter of intent to merge with DermTech, Inc., a Delaware corporation and a leading moleculargenomics company, with an initial focus on skin cancer, that develops and markets novel non-invasive diagnostic tests. On May 22, 2019 and May 23, 2019, we entered into separate Subscription Agreements with new health care focused institutional investors as well as certain existing investors in DermTech, pursuant to which the Subscribers agreed to purchase an aggregate of 6,153,847 PIPE Shares for a purchase price of $3.25 per share, in a private placement in which we will raise an aggregate of approximately $20,000,000, less certain offering related expenses payable by us. The PIPE Shares are identical to the shares of common stock that will be held by our public stockholders at the time of the closing of the Merger. The closing of the sale of PIPE Shares will be contingent upon, among other things, the substantially concurrent consummation of the Merger. On May 29, 2019, we entered into the Merger Agreement with DermTech and Merger Sub, pursuant to which Merger Sub will merge with and into DermTech with DermTech surviving the Merger as a wholly owned subsidiary of the Company. Upon the closing of the Merger, all of DermTech’s outstanding common stock and preferred stock will be cancelled and converted automatically into the right to receive an aggregate of 16,000,000 shares of the Company less the total number of shares of our common stock that can be acquired or received pursuant to certain options, restricted stock units and warrants of DermTech, as set forth in the Merger Agreement. Notice of Delisting or Failure to Satisfy a Continued Listing Rule or Standard On February 22, 2019, the Notice from the Listing Qualifications Department of The Nasdaq Stock Market indicating that we are not in compliance with the Minimum Public Holders Rule, which requires us to have at least 300 public holders for continued listing on the NASDAQ Capital Market. The Notice is only a notification of deficiency, not of imminent delisting, and has no current effect on the listing or trading of our securities on the NASDAQ Capital Market. On April 8, 2019, the Company submitted a plan to regain compliance with the Minimum Public Holders Rule to Nasdaq providing that it expects to regain compliance with the Minimum Public Holders Rule upon the consummation of the proposed Transaction. Nasdaq subsequently provided us with an extension until August 21, 2019, to demonstrate compliance with Nasdaq’s initial listing requirements. Results of Operations We have neither engaged in any operations nor generated any revenues to date. Our only activities from inception through March 31, 2019 were organizational activities, those necessary to consummate our 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 and marketable securities we hold as a result of the initial public offering. There has been no material adverse change has occurred since the date of our audited consolidated financial statements included in our registration statement for 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 in pursuit of our acquisition plans. For the year ended March 31, 2019, we had net income of approximately $944,000, consisting of interest income of approximately $2.9 million, and unrealized gain on marketable securities held in our trust account of approximately $59,000, offset by operating costs of approximately $2.0 million. For the year ended March 31, 2018, we had net income of approximately $856,000, consisting of interest income on marketable securities held in our trust account of approximately $1.2 million, offset by unrealized loss on marketable securities held in our trust account of approximately $45,000, and operating costs of approximately $306,000. Liquidity and Capital Resources On June 23, 2017, we consummated our initial public offering of 14,375,000 Units, at a price of $10.00 per Unit, which includes the full exercise by the underwriters of their over-allotment option in the amount of 1,875,000 Units at $10.00 per Unit, generating gross proceeds of $143.75 million. Simultaneously with the closing of our initial public offering, we consummated the sale of 561,250 Private Units at a price of $10.00 per Unit, of which of which 425,000 Private Units were purchased by the Sponsor and 136,250 Private Units were purchased by Cowen Investments, generating gross proceeds of approximately $5.61 million. Following the initial public offering and the exercise of the over-allotment option, a total of approximately $145.2 million was placed in the trust account. We incurred approximately $8.4 million in initial public offering related costs, including $2.875 million of underwriting fees, approximately $5.03 million of deferred underwriting fees and approximately $514,000 of initial public offering costs. As of March 31, 2019, we had marketable securities held in the trust account of approximately $12.4 million, substantially all of which is invested in U.S. treasury bills with a maturity of 180 days or less. Interest income earned on the balance in the trust account may be available to us to pay our income tax obligations. As of March 31, 2019, we had cash of approximately $30,000 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 March 31, 2019, we had accounts payable and accrued expenses of approximately $1.5 million. For the year ended March 31, 2019, cash used in operating activities amounted to approximately $444,000. Net income of approximately $944,000 was impacted by interest earned on marketable securities held in the trust account of approximately $2.9 million and an unrealized gain on marketable securities held in the trust account of approximately $59,000. Changes in our operating assets and liabilities used cash of approximately $1.5 million. For the year ended March 31, 2018, cash used in operating activities amounted to approximately $373,000. Net income of approximately $856,000 was impacted by interest earned on marketable securities held in the trust account of approximately $1.2 million and an unrealized loss on marketable securities held in the trust account of approximately $45,000. Changes in our operating assets and liabilities used cash of approximately $67,000. We intend to use substantially all of the net proceeds of our initial public offering and the sale of the private units, including the funds held in the trust account (excluding deferred underwriting commissions and taxes payable on interest earned on the trust account), to acquire a target business or businesses and to pay our expenses relating thereto. To the extent that our shares are 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. 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 finance transaction costs in connection with a 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 a business combination, we would repay such loaned amounts 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 the working capital held outside the trust account to repay such loaned amounts but no proceeds from our trust account would be used to repay such loaned amounts. Up to $1,500,000 of such loans may be converted into private units of the post business combination entity at a price of $10.00 per private unit at the option of the lender. The terms of such loans, if any, have not been determined and no written agreements exist with respect to such loans. On April 17, 2019 and May 21, 2019, we entered into two promissory notes evidencing loans of $55,000 and $14,559 made to us by two related parties, respectively, for the sole purpose of paying our expenses. The principal balance of the notes shall be payable on the date that we consummate our initial business combination from the funds available to us in connection with the consummation of our initial business combination. We will need to obtain additional financing either to consummate our business combination or because we become obligated to redeem a significant number of our public shares upon consummation of our business combination, in which case we will issue additional securities or incur debt in connection with such business combination. Subject to compliance with applicable securities laws, we would only complete such financing simultaneously with the completion of our business combination, in which case we will issue additional securities or incur debt in connection with such business combination. We cannot provide any assurance that financing will be available to us on commercially acceptable terms, if at all. 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. 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 March 31, 2019, the Company had cash held outside the trust account of approximately $30,000, cash and marketable securities held in the trust account of approximately $12.4 million (including approximately $364,000 of interest income, net of unrealized losses), substantially all of which is invested in U.S. treasury bills with a maturity of 180 days or less, and a working capital deficit of approximately $1.5 million. Further, we have incurred and expect to continue to incur significant costs in pursuit of our acquisition plans. We intend to use substantially all of the net proceeds of our initial public offering and the sale of the private units, including the funds held in the trust account (excluding deferred underwriting commissions and taxes payable on interest earned on the trust account), to acquire a target business or businesses and to pay our expenses relating thereto. To the extent that our shares are 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. 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. In order to finance transaction costs in connection with a 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 a business combination, we would repay such loaned amounts 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 the working capital held outside the trust account to repay such loaned amounts but no proceeds from our trust account would be used to repay such loaned amounts. Up to $1,500,000 of such loans may be converted into private units of the post business combination entity at a price of $10.00 per private unit at the option of the lender. The terms of such loans, if any, have not been determined and no written agreements exist with respect to such loans. On April 17, 2019 and May 21, 2019, we entered into two promissory notes evidencing loans of $55,000 and $14,559 made to us by two related parties, respectively, for the sole purpose of paying our expenses. The principal balance of the notes shall be payable on the date that we consummate our initial business combination from the funds available to us in connection with the consummation of our initial business combination. Based on the foregoing, we have insufficient funds available to operate our business through the earlier of consummation of a business combination or September 23, 2019. Following the initial business combination, if cash on hand is insufficient, we may need to obtain additional financing in order to meet our obligations. We cannot be certain that additional funding will be available on acceptable terms, or at all. 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. Off-balance sheet financing arrangements We have no obligations, assets or liabilities which would be considered off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K. 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 office space, utilities and administrative support provided to the Company. We began incurring these fees on June 20, 2017 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 consolidated 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 consolidated 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 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 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 March 31, 2019 and 2018, ordinary shares subject to possible redemption are presented at redemption value as temporary equity, outside of the shareholders’ equity section of our consolidated balance sheet. Net income (loss) per ordinary share Net income (loss) per ordinary share is computed by dividing net income (loss) by the weighted average number of ordinary shares outstanding for the period. We apply the two-class method in calculating earnings per share. Ordinary shares subject to possible redemption at March 31, 2019 and 2018, which are not currently redeemable and are not redeemable at fair value, have been excluded from the calculation of basic loss per share since such shares, if redeemed, only participate in their pro rata share of the earnings from the assets held in the trust account. 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 consolidated financial statements.
-0.003708
-0.00332
0
<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 filings with the SEC. Overview We are a blank check company incorporated on July 31, 2015 in the British Virgin Islands and formed for the purpose of entering into a business combination with one or more target businesses. On June 23, 2017, we consummated our initial public offering of 14,375,000 units (including 1,875,000 units sold pursuant to the underwriters exercising their overallotment option), with each unit consisting of one ordinary share, one warrant, each warrant entitling the holder to purchase onehalf of one ordinary share at a price of $11.50 per whole share and one right to receive onetenth of one ordinary share upon the consummation of an initial business combination. No fractional shares will be issued upon exercise of the warrants. Each warrant will become exercisable on the completion of our business combination. The warrants will expire five years after the completion of our initial business combination or earlier upon redemption or liquidation. The units in our initial public offering were sold at an offering price of $10.00 per unit, generating total gross proceeds of $143,750,000. Cowen Investments acted as the sole book running manager and IBankers Securities, Inc. acted as comanager of the offering. The securities sold in the offering were registered under the Securities Act on a registration statement on Form S1 (No. 333218093), or our registration statement. The SEC declared our registration statement effective on June 19, 2017. We paid a total of $2,875,000 in underwriting discounts and commissions and $514,467 for other costs and expenses related to our initial public offering. In addition, the underwriters agreed to defer $5,031,250 in underwriting discounts and commissions, and up to this amount will be payable upon consummation of the business combination. After deducting the underwriting discounts and commissions (excluding the deferred portion of $5,031,250 in underwriting discounts and commissions, which will be released from the trust account upon consummation of the business combination, if consummated) and the estimated offering expenses, the total net proceeds from our initial public offering and the private placement was $145,973,033, of which $145,187,500 (or $10.10 per unit sold in our initial public offering) was placed in the trust account. On March 21, 2019, at the Special Meeting, our shareholders approved our amended and restated memorandum and articles of association to extend the date by which we have to consummate a business combination (the “Extension”) to September 23, 2019 (the “Combination Period”). In connection with the Extension, an aggregate of 13,187,468 ordinary shares was redeemed for an aggregate payment of approximately $136.9 million out of the trust account. If we are unable to complete a Business Combination on or before the Combination [/INST] Negative. </s>
2,019
3,859
1,651,944
DermTech, Inc.
2020-03-11
2019-12-31
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion of our financial condition and results of operations should be read in conjunction with the consolidated financial statements and the related notes thereto included elsewhere in this Annual Report on Form 10-K. Overview We are an emerging growth molecular diagnostic company developing and marketing novel non-invasive genomics tests that seek to transform the practice of dermatology and related fields. Our platform may change the diagnostic paradigm in dermatology from one that is subjective, invasive, less accurate and higher-cost, to one that is objective, non-invasive, more accurate and lower-cost. Our initial focus is skin cancer. We currently have two clinical commercial tests, with a third in development, that enhance the early detection of skin cancer and related conditions. Our scalable genomics platform has been designed to work with a proprietary adhesive patch sample collection kit that provides a skin sample collected non-invasively. We process our tests in a CLIA certified and College of American Pathologists accredited commercial laboratory located in La Jolla, California that is licensed by the State of California and all states requiring out-of-state licensure. We also provide our technology platform on a contract basis to large pharmaceutical companies who use the technology in their clinical trials to test for the existence of genetic targets of various diseases and to measure the response of new drugs under development. We have a history of net losses since our inception. Events, Trends and Uncertainties We filed an application for a technology assessment for our Pigmented Lesion Assay, or PLA, with MolDX (Medicare) in April of 2018, and the comment period for the accompanying Medicare Draft Local Coverage Decision, or Draft LCD, closed in August of 2018. In March 2019, a Draft LCD proposed favorable coverage for the PLA. In late October 2019, the AMA provided us with a Proprietary Laboratory Analyses Code, or PLA Code. Pricing of $760 for the PLA Code was published on December 24, 2019 as part of the CMS Laboratory Fee Schedule for 2020. The Medicare Final Coverage Decision, or Final LCD, first made available on December 26, 2019 expanded the coverage proposal in the Draft LCD from one to two tests per date of service and to allow clinicians to order our PLA if they have sufficient skill and experience to decide whether a pigmented lesion should be biopsied. PLA became eligible for Medicare reimbursement on February 10, 2020. With Medicare coverage granted, we have the opportunity to approach commercial payors and as a result, we believe that PLA may generate significant revenues in 2021 and 2022. Even following the grant of Medicare coverage for the PLA, uncertainty surrounds third-party payor reimbursement, including governmental and commercial payors, of any test incorporating new technology, including tests developed using our technologies. For example, technology assessments of new medical tests conducted by research centers and other entities may be disseminated to interested parties for informational purposes. Third-party payors and health care providers may use such technology assessments as grounds to deny coverage for a test or procedure. Because each payor generally determines for its own enrollees or insured patients whether to cover or otherwise establish a policy to reimburse our tests, seeking payor approvals is a time-consuming and costly process. We cannot be certain that coverage for our current tests and our planned future tests will be provided in the future by additional third-party payors or that existing policy decisions, or reimbursement levels will remain in place or be fulfilled under existing terms and provisions. If we cannot obtain or maintain coverage and reimbursement from private and governmental payors such as Medicare and Medicaid for our current tests, or new tests or test enhancements that we may develop in the future, our ability to generate revenues could be limited, which may have a material adverse effect on our business financial condition, results of operation, and cash flows. Financial Overview Revenue We generate revenue through laboratory services that are billed to private medical insurance companies and to pharmaceutical companies who order our laboratory services, which can include sample collection kits, assay development, gene expression analysis, data analysis and reporting. Our revenue is generated from two revenue streams, contract revenue and assay revenue. Assay revenue can be highly variable as it is based on payments received by private insurance payors that are not under contract and can vary based on patient insurance coverage, deductibles and co-pays. Contract revenue is ordered by customers on projects that may span over several years. Segments of these contracts may be increased, delayed or eliminated based on the success of each customers’ clinical trials or other factors. We account for revenue in accordance with Accounting Standards Codification, or ASC, Topic 606, Revenue from Contracts with Customers, or ASC 606. The core principle of ASC 606 is that the Company recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the Company expects to be entitled in exchange for those goods or services. The ASC 606 revenue recognition model consists of the following five steps: (1) identify the contracts 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) the entity satisfies a performance obligation. We adopted ASC 606 on January 1, 2019, using the modified retrospective method and elected to utilize Practical Expedient 1 to apply the modified retrospective method to only contracts which were open as of January 1, 2019. Operating Expenses Sales and Marketing Expenses Sales and marketing expenses are primarily related to our specialty field sales force, market research, reimbursement efforts, trade show attendance, public relations, and general marketing. Research and Development Expenses Our research and development, or R&D, expenses consist primarily of salaries and fringe benefits, clinical trials, consulting costs, facilities costs, laboratory costs, equipment expense, and depreciation. We also conduct clinical trials to validate the performance characteristics of our tests and to show medical cost benefit in support of our reimbursement efforts. We expect these expenses to increase significantly as we continue to develop new products and expand the use of our existing products. General and Administrative Expenses Our general and administrative expenses consist of senior management compensation, consulting, legal, billing and collections, human resources, information technology, accounting, insurance, and general business expenses. We expect our general and administrative expenses, especially insurance, accounting, and legal fees, to increase due to operating as a publicly traded company. Financing Activities Convertible Bridge Notes On May 23, 2019, DermTech Operations, Inc. (formerly known as DermTech, Inc.), or DermTech Operations, and various holders of its convertible bridge notes agreed to amend DermTech Operations’ then outstanding convertible notes that were issued prior to June 5, 2019. As part of the amendment, the maturity dates of the notes were extended to the earliest of (i) September 24, 2019; (ii) the occurrence of an Event of Default; (iii) the consummation of a liquidation or dissolution of DermTech Operations (iv) a Liquidation Transaction; or (v) the consummation of a merger with or into the Company or any of its subsidiaries. Between June 5, 2019 and June 10, 2019, DermTech Operations issued additional convertible bridge notes to its existing investors for aggregate gross proceeds of $2.6 million. These convertible bridge notes carried an interest rate of 10% and matured after the earliest to occur of: (i) September 25, 2019; (ii) the occurrence of an Event of Default; (iii) the consummation of a liquidation or dissolution of DermTech Operations; (iv) a Liquidation Transaction: or (v) the consummation of a merger of DermTech Operations with DT Merger Sub, Inc., a subsidiary of the Company, in accordance with the Merger Agreement (as defined below). On August 29, 2019, in connection with the completion of the Business Combination (as defined below), all of the outstanding convertible bridge notes of DermTech Operations converted into Company common stock, in accordance with their respective terms. Business Combination On August 29, 2019, the Company and DermTech Operations consummated the transactions contemplated by the Agreement and Plan of Merger, dated as of May 29, 2019, by and among the Company, DT Merger Sub, Inc., or Merger Sub, and DermTech Operations. We refer to this agreement, as amended by that certain First Amendment to Agreement and Plan of Merger dated as of August 1, 2019, as the Merger Agreement. Pursuant to the Merger Agreement, Merger Sub merged with and into DermTech Operations, with DermTech Operations surviving as a wholly-owned subsidiary of the Company. We refer to this transaction as the Business Combination. Immediately following the completion of the Business Combination, the Company changed its name from Constellation Alpha Capital Corp. to DermTech, Inc. and effected a one-for-two reverse stock split of its common stock. Prior to the closing of the Business Combination, the Company’s stock was listed on the Nasdaq Capital Market under the ticker symbol “CNAC.” On August 30, 2019, the Company’s common stock commenced trading on the Nasdaq Capital Market under the ticker symbol “DMTK.” 2019 PIPE Financing On August 29, 2019, immediately prior to the completion of the Business Combination, the Company issued, in a private placement transaction, or the 2019 PIPE Financing, an aggregate of 3,076,925 shares of common stock and 1,231 shares of Series A Convertible Preferred Stock, which are convertible into an aggregate of up to 615,385 shares of common stock, for an aggregate purchase price of $24.0 million, to certain accredited investors pursuant to the terms of separate Subscription Agreements and Amended and Restated Subscription Agreements, dated between May 22, 2019 and August 1, 2019, entered into by the Company and such investors. Results of Operations Fiscal Years Ended December 31, 2019 and 2018 Assay Revenue Assay revenues grew $0.1 million or 9% to $1.4 million for fiscal year 2019 compared to $1.3 million for fiscal year 2018. As much of our assay revenue is driven by the samples that are sent by physicians and physician assistants to our central lab for testing, a key performance measure for us is samples that are received and processed by our central lab successfully, also known as billable samples. Billable samples increased to 13,714 for fiscal year 2019 compared to 11,077 for fiscal year 2018. Sample volume is dependent on two major factors; the number of physicians or physician assistants who order an assay in any given quarter and the number of assays ordered by each physician during the period. The number of ordering physicians and the utilization per physician can vary based on a number of factors including the types of patients presenting skin cancer conditions, physician reimbursement, office workflow, market awareness, physician education and other factors. Contract Revenue Contract revenues with major pharmaceutical companies increased $0.8 million to $2.0 million for fiscal year 2019, or 69%, compared to $1.2 million for fiscal year 2018, due to accelerating activity with ongoing clinical trial contracts and new contracts. Contract revenue can be highly variable as it is dependent on the pharmaceutical customers’ clinical trial progress which can be difficult to forecast due to variability of patient enrollment, drug safety and efficacy and other factors. Many of our contracts with third parties are structured to contain milestone billing payments, which typically are advance payments on work yet to be performed. These advanced payments are structured to help fund operations and are included in deferred revenue as the work has not yet been performed. At December 31, 2019, the deferred revenue amount for these contracts, which is the advance payments minus the value of work performed, was $1.4 million. These advance payments will remain in deferred revenue until we process the laboratory portion of the contracts allowing us to recognize the revenue. Cost of Revenue Cost of revenues increased $0.7 million, or 26%, to $3.3 million for fiscal year 2019 compared to $2.6 million for fiscal year 2018. The increase was driven by the costs incurred by the growing volume of our assay and contract revenue activities, which lead to increase spending on laboratory supplies and shipping costs. In addition, we implemented a new laboratory information system during 2019, which led to additional incurred costs; however, we believe the new system will allow us to facilitate the automation of several processes in our central laboratory to increase efficiency and decrease costs in our sample analysis process over the next several years. Much of the cost of revenue expenses incurred primarily relate to salaries and benefits, laboratory supplies, shipping costs, equipment maintenance and calibration, utilities and depreciation. In the near- and long-term future, we remain committed to continuing the automation of our laboratory processes in order to become more cost efficient and productive. Operating Expenses Sales and Marketing Sales and marketing expenses increased $3.5 million, or 125%, to $6.3 million for fiscal year 2019 compared to $2.8 million for fiscal year 2018. The increase was largely due to a $1.9 million increase in higher compensation-related costs, including salaries, commissions and benefits, due to an increase in our sales force and establishment of our payor access team throughout fiscal year 2019. In connection with our expanded sales force, we incurred an increase of $0.4 million in meals, entertainment and travel expenses as well as a $0.2 million increase in recruiting expenses. In addition, we incurred a $0.7 million in higher consulting expenses in connection with our new marketing campaign and sales force strategy. We expect to significantly add to our specialty sales force and payor access teams in 2020 and this would significantly increase our sales and marketing expenses. Research and Development R&D expenses increased $0.4 million, or 22%, to $2.5 million for fiscal year 2019 compared to $2.1 million for fiscal year 2018. The increase was due to $0.2 million in higher compensation related costs associated with additional headcount, and a $0.1 million increase in laboratory supplies to help expand our research and development efforts. The primary expenses in R&D include salaries and benefits, clinical trials, facility and lab supplies. We expect these expenses to increase as we continue the development of our non-melanoma skin cancer assays and other new products. General and Administrative General and administrative expenses increased $5.4 million, or 152%, to $8.9 million for fiscal year 2019 compared to $3.5 million for fiscal year 2018. The increase was due to $2.3 million of additional legal fees, $1.2 million of additional accounting fees, $0.6 million in additional headcount-related costs and $0.4 million of additional insurance costs. The increase was primarily due to significant costs incurred in association with our Business Combination and costs required to operate as a publicly traded company. We expect to these expenses to continue to increase as we add additional infrastructure such as human resources, information technology and legal resources. Ongoing expenses include salaries and benefits, facility costs, billing and collections, auditing and legal expenses. Interest Expense, net Interest expense increased to approximately $2.7 million for fiscal year 2019 compared to approximately $1.1 million for fiscal year 2018. During 2018 through 2019, DermTech Operations issued $9.4 million in convertible promissory notes and the recorded interest expense includes both the stated interest on the notes as well as amortization of debt discount on the notes. As these convertible bridge notes were extinguished in connection with the Business Combination, we do not expect any additional significant interest expense during the next fiscal year. Other Expense Other expense of $0.4 million for fiscal year 2019 is related to the change in fair value of the derivative liability from the various reporting periods throughout 2019. As these convertible bridge notes were extinguished in connection with the Business Combination, we do not expect to incur significant other expense during the next fiscal year. Gain on Debt Extinguishment Gain on debt extinguishment of $0.9 million for fiscal year 2019 is related to the conversion of our convertible notes in connection with our Business Combination. The net carrying amounts of the convertible notes, including remaining unamortized debt discount and issuance costs, and the bifurcated embedded derivative liability were extinguished on the date of the Business Combination. A gain on debt extinguishment was recognized, which represented the unamortized debt discounts and issuance costs remaining at the time of the debt extinguishment. As these convertible bridge notes were extinguished in connection with the Business Combination, we do not expect to incur other gain during the next fiscal year. Liquidity and Capital Resources We have never been profitable and have historically incurred substantial net losses, including net losses of $10.0 million in 2018 and $19.7 million in 2019. As of December 31, 2019, our accumulated deficit was $91.1 million, and we had negative operating cash flow of $17.8 million. In connection with the Business Combination, we completed the 2019 PIPE financing that raised a total of $24.0 million in gross proceeds in addition to the $1.8 million in cash the Company had on hand at the close of the Business Combination. We have historically financed operations through private placement equity offerings and convertible debt offerings. We expect our losses to continue as a result of costs relating to ongoing R&D expenses and increased sales and marketing costs for existing and planned products. These losses have had, and will continue to have, an adverse effect on our working capital. Because of the numerous risks and uncertainties associated with our commercialization and development efforts, we are unable to predict when we will become profitable, and we may never become profitable. Our inability to achieve and then maintain profitability would negatively affect our business, financial condition, results of operation and cash flows. As of December 31, 2019, our cash and cash equivalents totaled approximately $15.4 million. On February 28, 2020, we entered into a securities purchase agreement with certain institutional investors for a private placement, which closed on March 4, 2020, of our equity securities for aggregate gross proceeds of approximately $65.0 million, and net proceeds to us of approximately $60.0 million, after deducting estimated offering expenses payable by us. Based on our current business operations and the additional financing completed in March 2020, we believe our current cash and cash equivalents will be sufficient to meet our anticipated cash requirements for at least the next twelve months. While we believe we have enough capital to fund anticipated operating costs for at least the next 12 months, we expect to incur significant additional operating losses over at least the next several years. We anticipate that we will raise additional capital through equity offerings, debt financings, collaborations or licensing arrangements and believe this will be sufficient to continue to support our planned operations and to continue developing and commercializing gene expression tests. We may also consider raising additional capital in the future to expand our business, to pursue strategic investments or to take advantage of financing opportunities. Our present and future funding requirements will depend on many factors, including: • our revenue growth rate and ability to generate cash flows from operating activities; • our sales and marketing and R&D activities; • effects of competing technological and market developments; • costs of and potential delays in product development; • changes in regulatory oversight applicable to our tests; and • timing of and costs related to future international expansion. There can be no assurances as to the availability of additional financing or the terms upon which additional financing may be available to us. If we are unable to obtain sufficient funding at acceptable terms, we may be forced to significantly curtail our operations, and the lack of sufficient funding may have a material adverse impact on our ability to continue as a going concern. Cash Flow Analysis Fiscal Year Ended December 31, 2019 Net cash used in operating activities for the twelve months ended December 31, 2019 totaled $17.8 million, primarily driven by the $19.7 million net loss offset by non-cash related items, including $2.0 million in amortization of the convertible bridge notes debt discount, $1.3 million in stock-based compensation and $0.4 million in the change in the convertible bridge notes derivative liability, offset by the gain on extinguishment of convertible notes of $0.9 million and a tax payment of $1.6 million related to the release of certain employees’ restricted stock units. In addition, we had $2.0 million of cash inflow through the increase of accounts payables and accrued compensation offset by the cash outflow of $1.0 million related to payments for prepaid insurance. Net cash used in investing activities totaled $0.2 million for the twelve months ended December 31, 2019, which related predominantly to the purchase of laboratory equipment. As we scale our sales force and the resulting expected increase to assay volume, additional laboratory equipment investment will be needed to install complex automation systems and other genomic testing equipment. Net cash provided by financing activities totaled $28.6 million for the twelve months ended December 31, 2019, which was predominantly driven by the $25.6 million in net proceeds raised from the Business Combination and related 2019 PIPE financing and issuing $2.6 million in convertible notes. In order to fund future operations, we completed a private placement in March 2020 with certain institutional investors for a private placement of our equity securities for aggregate gross proceeds of approximately $65.0 million, and net proceeds to the Company of approximately $60.0 million, after deducting estimated offering expenses payable by the Company. Fiscal Year Ended December 31, 2018 Net cash used in operating activities for the twelve months ended December 31, 2018 totaled $7.6 million primarily driven by a $10.0 million net loss offset by non-cash related items, including $1.0 million in amortization of the convertible bridge notes debt discount, $0.9 million in stock-based compensation and $0.4 million in the change in the convertible bridge notes derivative liability. Accounts receivable increased by $0.2 million leading to a cash outflow that was primarily attributable to significant billings of advance payments related to our contract revenue business that was partially offset by the resulting increase in deferred revenue. Net cash used in investing activities totaled $12,000 for the twelve months ended December 31, 2018, which related to the purchase of laboratory equipment. As we scale our sales force and the resulting expected increase to assay volume, additional laboratory equipment investment will be needed to install complex automation systems and other genomic testing equipment. Net cash provided by financing activities totaled $11.1 million, which included $4.5 million in Series C Preferred Stock sold by DermTech Operations through a private placement and $6.8 million in convertible bridge notes that were partially offset by $0.2 million in debt issuance costs. Off-Balance Sheet Arrangements As of December 31, 2019 and 2018, we did not have any off-balance sheet arrangements, as such term is defined under Item 303 of Regulation S-K, 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 that is material to investors. Critical Accounting Policies and Significant Judgments and Estimates The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles requires that management 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 and the amounts of revenues and expenses reported during the period. On an ongoing basis, management evaluates these estimates and judgments, including but not limited to those related to revenue, warrants, stock-based compensation, accounts receivable, expense accruals, convertible debt, the realization of deferred tax assets, and common and preferred stock valuations. Actual results may differ from those estimates. The SEC has defined a company’s critical accounting policies as the ones that are most important to the portrayal of the company’s financial condition and results of operations, and which require the company to make its most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. While our significant accounting policies are more fully described in Note 1 of our consolidated financial statements included in this report, we believe that the following accounting policies and judgments are most critical to aid in fully understanding and evaluating our reported financial results based upon the SEC’s defined criteria. Revenue Recognition Our revenue is generated from two revenue streams, contract revenue and assay revenue. We account for revenue in accordance with ASC 606. The core principle of ASC 606 is that we recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which we expect to be entitled in exchange for those goods or services. The ASC 606 revenue recognition model consists of the following five steps: (1) identify the contracts 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) the entity satisfies a performance obligation. We recognize revenue from our contract and assay goods and service in accordance with that core principle and key aspects considered by us include the following: (a) Contract Revenue Contract revenue is generated from the sale of laboratory services and adhesive sample collection kits to third party companies through contract research agreements. Laboratory revenues result from providing gene expression tests to facilitate the development of drugs designed to treat dermatologic conditions. The provision of gene expression services may include sample collection using our patented adhesive patch biopsy devices, assay development for research partners, ribonucleic acid, or RNA isolation, expression, amplification and detection, including data analysis and reporting. Performance obligations ASC 606 requires an entity to assess the goods or services promised in a contract and identify as a performance obligation each promise to transfer to the customer either a good or service (or a bundle of goods or services) that is distinct, or a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer. Based upon review of existing contracts, a majority of our contract revenue contracts contain three performance obligations: (1) Adhesive patch kits (2) RNA extractions and analysis (3) Certain project management fees Many of the contract revenue contracts contain promises such as start-up activities and quality system setup fees, which are activities that are performed to fulfill the contract and they do not transfer any good or service to the customer. These promises encompass the administrative tasks associated with beginning and initiating a new project or study with a pharmaceutical company. In accordance with ASC 606, an entity does not account for these activities as a promised good or service within the contract nor evaluate whether they are a performance obligation. Transaction price The transaction prices of all the performance obligations are listed in each contract on a per unit basis and are fixed based for the adhesive patch kits and RNA extractions and analysis. The project management fees are assessed based on a monthly service fee which range within the contracts depending on certain factors which include length of project and amount of kits or RNA extractions and analysis promised within the contract. The fixed and variable rates are materially consistent within all contracts. Therefore, we utilize the prices listed in each of our contracts as the transaction price for each performance obligation. Allocate the transaction price All contracts have a directly observable transaction price pertaining to each promised good or service. Those prices are consistent across all contracts for adhesive patch kits and RNA extractions and analysis, with the exception of project management fees, which encompass a sufficiently narrow range of prices that are dictated upon factors of each contract previously discussed above. Therefore, we rely on those transaction prices as the basis to allocate the stand-alone selling prices to the performance obligations of the contract. Recognize Revenue The adhesive patch kits are recognized as point in time when shipped to the customer. The RNA extraction and analysis are recognized at a point in time when the extraction process is complete, and the results are sent to the customer. We provide project management service over the life of the contract, providing equal benefit to the customer throughout the life of the project or study. Therefore, the revenue related to project management fees is recognized straight-line over the life of the contract. (b) Assay Revenue We generate revenues from our Pigmented Lesion Assay, or PLA, and Nevome services we provide to healthcare clinicians in various states throughout the United States to assist in a clinician’s diagnosis of melanoma. We provide prescribing clinicians with our adhesive sample collection kits to perform non-invasive skin biopsies of clinically ambiguous pigmented skin lesions on patients. Once the sample is collected by the healthcare clinician, it is returned to our CLIA laboratory for analysis. The patient RNA and deoxyribonucleic acid, or DNA, is extracted from the adhesive patch collection kit and analyzed using gene expression technology to determine if the pigmented skin lesion contains certain genomic features indicative of melanoma. Upon completion of the gene expression analysis, a final report is drafted and provided to the clinicians detailing the results of the pigmented skin lesion indicating whether the sample collected is indicative of melanoma or not. A detailed analysis of payments made to us by private health insurance payors for the assays over several quarters is used to estimate the ultimate receipt of funds for payment of billed amounts. These payments can vary widely from payor to payor and can be halted for routine audits or other reasons. Contracts Our customer is the patient. However, we do not enter into a formal reimbursement contract with a patient, as formal reimbursement contracts are more commonly established with insurance payors. Accordingly, we establish a contract with a patient in accordance with other customary business practices. Performance obligations A performance obligation is a promise in a contract to transfer a distinct good or service (or a bundle of goods or services) to the customer. The customer is able to order a PLA test. However, a Nevome test cannot be ordered separately from the PLA test and it is contingent on being run only when a PLA test comes back positive on a sample. The Nevome test would not qualify as a distinct service. Therefore, the PLA test is recognized as a single performance obligation and the Nevome test, if rendered, is bundled with the single PLA performance obligation. Transaction price The consideration derived from our contracts is deemed to be variable, though the variability is not explicitly stated in any contract. Rather, the implied variability is due to several factors, such as the amount of contractual adjustments, any patient co-payments, deductibles or patient compliance incentives, the existence of secondary payors and claim denials. We estimate the amount of variable consideration using the expected value method, which represents the sum of probability-weighted amounts in a range of possible consideration amounts. When estimating the amount of variable consideration, we consider several factors, such as historical collections experience, patient insurance eligibility and payor reimbursement contracts. We monitor our estimates of transaction price to depict conditions that exist at each reporting date. If we subsequently determine that we will collect more consideration than we originally estimated for a contract with a patient, we will account for the change as an increase in the estimate of the transaction price (i.e., an upward revenue adjustment) in the period identified. Similarly, if we subsequently determine that the amount we expect to collect from a patient is less than it originally estimated, we will generally account for the change as a decrease in the estimate of the transaction price (i.e., a downward revenue adjustment), provided that such downward adjustment does not result in a significant reversal of cumulative revenue recognized. Recognize revenue Our single performance obligation is satisfied at a point in time, and that point in time is defined as the date a patient’s successful test result is delivered to the patient’s ordering physician. We consider this date to be the time at which the patient obtains control of the final results of the promised test service. If a Nevome test service is ordered and completed in conjunction with our PLA service, then we will recognize revenue at a point in time upon the delivery of both the final reports to the physician. The delivery of our Nevome test results is commonly after our PLA results are delivered due to the circumstances of how we process the Nevome test. However, this length in time is determined to not materially impact the final overall revenue recognition timing. Stock-Based Compensation Compensation costs associated with stock option awards and other forms of equity compensation are measured at the grant-date fair value of the awards and recognized over the requisite service period of the awards on a straight-line basis. We grant stock options to purchase common stock to employees with exercise prices equal to the fair market value of the underlying stock, as determined by the board of directors, management, outside valuation experts and subsequent to the completion of the Business Combination, the closing stock price on the date of grant. The board of directors and outside valuation experts determine the fair value of the underlying stock by considering a number of factors, including historical and projected financial results, the risks we faced at the time, the preferences of our debt holders and preferred stockholders, and the lack of liquidity of our common stock that occurred prior to the Business Combination. The fair value of each stock option award is estimated using the Black-Scholes-Merton valuation model. Such value is recognized as expense over the requisite service period, net of estimated forfeitures, using the straight-line method. The expected term of options is based on the simplified method which defines the expected term as the average of the contractual term of the options and the weighted average vesting period for all option tranches. The expected volatility of stock options is based upon the historical volatility of a number of related publicly traded companies in similar stages of development. The risk-free interest rate is based on the average yield of U.S. Treasury securities with remaining terms similar to the expected term of the share-based awards. The assumed dividend yield was based on our expectation of not paying dividends in the foreseeable future. Restricted stock units, or RSUs, are considered restricted stock. The fair value of restricted stock is equal to the fair market value of the underlying stock, as determined by the board of directors, management, input from outside valuation experts and subsequent to the completion of the Business Combination, the closing stock price on the date of grant. We recognize stock-based compensation expense based on the fair value on a straight-line basis over the requisite service periods of the awards, taking into consideration estimated forfeitures. RSUs that are granted to employees have a requisite service period between two and four years. Recent accounting pronouncements See Note 1(r) of our consolidated financial statements for a discussion of the impact of new accounting pronouncements on our consolidated financial statements.
-0.047598
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0
<s>[INST] Overview We are an emerging growth molecular diagnostic company developing and marketing novel noninvasive genomics tests that seek to transform the practice of dermatology and related fields. Our platform may change the diagnostic paradigm in dermatology from one that is subjective, invasive, less accurate and highercost, to one that is objective, noninvasive, more accurate and lowercost. Our initial focus is skin cancer. We currently have two clinical commercial tests, with a third in development, that enhance the early detection of skin cancer and related conditions. Our scalable genomics platform has been designed to work with a proprietary adhesive patch sample collection kit that provides a skin sample collected noninvasively. We process our tests in a CLIA certified and College of American Pathologists accredited commercial laboratory located in La Jolla, California that is licensed by the State of California and all states requiring outofstate licensure. We also provide our technology platform on a contract basis to large pharmaceutical companies who use the technology in their clinical trials to test for the existence of genetic targets of various diseases and to measure the response of new drugs under development. We have a history of net losses since our inception. Events, Trends and Uncertainties We filed an application for a technology assessment for our Pigmented Lesion Assay, or PLA, with MolDX (Medicare) in April of 2018, and the comment period for the accompanying Medicare Draft Local Coverage Decision, or Draft LCD, closed in August of 2018. In March 2019, a Draft LCD proposed favorable coverage for the PLA. In late October 2019, the AMA provided us with a Proprietary Laboratory Analyses Code, or PLA Code. Pricing of $760 for the PLA Code was published on December 24, 2019 as part of the CMS Laboratory Fee Schedule for 2020. The Medicare Final Coverage Decision, or Final LCD, first made available on December 26, 2019 expanded the coverage proposal in the Draft LCD from one to two tests per date of service and to allow clinicians to order our PLA if they have sufficient skill and experience to decide whether a pigmented lesion should be biopsied. PLA became eligible for Medicare reimbursement on February 10, 2020. With Medicare coverage granted, we have the opportunity to approach commercial payors and as a result, we believe that PLA may generate significant revenues in 2021 and 2022. Even following the grant of Medicare coverage for the PLA, uncertainty surrounds thirdparty payor reimbursement, including governmental and commercial payors, of any test incorporating new technology, including tests developed using our technologies. For example, technology assessments of new medical tests conducted by research centers and other entities may be disseminated to interested parties for informational purposes. Thirdparty payors and health care providers may use such technology assessments as grounds to deny coverage for a test or procedure. Because each payor generally determines for its own enrollees or insured patients whether to cover or otherwise establish a policy to reimburse our tests, seeking payor approvals is a timeconsuming and costly process. We cannot be certain that coverage for our current tests and our planned future tests will be provided in the future by additional thirdparty payors or that existing policy decisions, or reimbursement levels will remain in place or be fulfilled under existing terms and provisions. If we cannot obtain or maintain coverage and reimbursement from private and governmental payors such as Medicare and Medicaid for our current tests, or new tests or test enhancements that we may develop in the future, our ability to generate revenues could be limited, which may have a material adverse effect on our business financial condition, results of operation, and cash flows. Financial Overview Revenue We generate revenue through laboratory services that are billed to private medical insurance companies and to pharmaceutical companies who order our laboratory services, which can include sample collection kits, assay development, gene expression analysis, data analysis and reporting. Our revenue is generated from two revenue streams, contract revenue and assay revenue. Assay revenue can be highly variable as it is based on payments received by private insurance payors [/INST] Negative. </s>
2,020
5,868
1,628,369
Cushman & Wakefield plc
2019-02-28
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 audited Consolidated Financial Statements and related notes included elsewhere in this Annual Report on Form 10-K. As discussed in “Cautionary Note Regarding Forward-Looking Statements,” the following discussion and analysis contains forward-looking statements that involve risks and uncertainties. Our actual results may materially differ from those discussed in such forward-looking statements. Factors that could cause or contribute to these differences include, but are not limited to, those identified below and those discussed in “Risk Factors” under Part I, Item 1A in this report. Our fiscal year ends December 31. With respect to presentation, all statements asserting an "increase" or "decrease" relate to changes from prior applicable periods of comparison. Overview Cushman & Wakefield is a leading global commercial real estate services firm, built on a trusted brand and backed by approximately 51,000 employees and serving the world's real estate owners and occupiers through a scalable platform. We operate from approximately 400 offices in 70 countries, managing over 3.6 billion square feet of commercial real estate space on behalf of institutional, corporate and private clients. Our business is focused on meeting the increasing demands of our clients across multiple service lines including Property, facilities and project management, Leasing, Capital markets and Valuation and other services. Critical Accounting Policies Our audited Consolidated Financial Statements included elsewhere in this report have been prepared in accordance with U.S. GAAP, which requires us to make estimates and assumptions that affect reported amounts. The estimates and assumptions are based on historical experience and on other factors that we believe to be reasonable. Actual results may differ from those estimates. We review these estimates on a periodic basis to ensure reasonableness. Although actual amounts may differ from such estimated amounts, we believe such differences are not likely to be material. For additional detail regarding our critical accounting policies, see Note 2: Summary of Significant Accounting Policies of the Notes to the audited Consolidated Financial Statements. Recently Issued Accounting Pronouncements See recently issued accounting pronouncements within Note 2: Summary of Significant Accounting Policies of the Notes to the audited Consolidated Financial Statements. Revenue Recognition The Company principally earns revenue from Property, facilities and project management, Leasing, Capital markets and Valuation and other. As of January 1, 2018, the Company adopted Topic 606, which replaced most existing revenue recognition guidance under U.S. GAAP. The core principle of Topic 606 requires companies to reevaluate when revenue is recorded on a transaction based upon newly defined criteria, either at a point in time or over time as goods or services are delivered. Topic 606 requires additional disclosures about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and estimates, and changes in those estimates. For further information regarding the impact of the adoption of this standard on the audited Consolidated Financial Statements and related disclosures, as well as significant judgments performed by the Company when applying Topic 606, refer to Note 2: Summary of Significant Accounting Policies and Note 5: Revenue from the Notes to the audited Consolidated Financial Statements for the year ended December 31, 2018. Business Combinations, Goodwill and Indefinite-Lived Intangible Assets The Company has grown, in part, through a series of acquisitions. See Note 1: Organization and Business Overview of the Notes to the audited Consolidated Financial Statements. We account for business combinations using the acquisition method of accounting, which requires that once control is obtained, all of the assets acquired and liabilities assumed, including amounts attributable to noncontrolling interests, be recorded at their respective fair values as of the acquisition date. Determination of the fair values of the assets and liabilities acquired requires estimates and the use of valuation techniques when market values are not readily available. The Company recorded goodwill and intangible assets resulting from these acquisitions. Goodwill represents the excess of purchase consideration over the fair value of the net assets of businesses acquired. Goodwill and indefinite-lived intangible assets are tested for impairment annually, or more frequently if events or changes in circumstances indicate that they may be impaired. The initial impairment evaluation of goodwill is a qualitative assessment and is performed to assess whether the fair value of a reporting unit (“RU”) is less than its carrying amount and only proceeds to the quantitative impairment test if it is more likely than not that the fair value of the RU is less than its carrying amount. If the Company determines the quantitative impairment test is required, the estimated fair value of the RU is compared to its carrying amount, including goodwill. If the estimated fair value of a RU exceeds its carrying value, goodwill is not considered to be impaired. If the carrying amount exceeds the estimated fair value, an impairment loss is recognized equal to that excess. The loss recognized cannot exceed the carrying amount of goodwill. The Company records an impairment loss for other definite and indefinite-lived intangible assets if impairment triggers exist and the fair value of the asset is less than the asset’s carrying amount. For a detailed discussion of goodwill and indefinite-lived intangible assets, see Note 6: Goodwill and Other Intangible Assets of the Notes to the audited Consolidated Financial Statements. Income Taxes Income taxes are accounted for under the asset and liability method in accordance with US GAAP. Deferred tax assets and liabilities are recognized for the expected future tax consequences attributable to differences between carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. 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. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that the new rate is enacted. A valuation allowance is established against deferred tax assets when it is more likely than not that some portion or all of the deferred tax asset will not be realized in the future. Accounting for tax positions requires judgments, including estimating reserves for potential uncertainties. We also assess our ability to utilize tax attributes, including those in the form of net operating loss carryforwards, for which the benefits have already been reflected in the financial statements. We do not record valuation allowances for deferred tax assets that we believe will be realized in future periods. While we believe the resulting tax balances as of December 31, 2018 and 2017 are appropriately accounted for in accordance with US GAAP, as applicable, the ultimate outcome of such matters could result in favorable or unfavorable adjustments to our audited Consolidated Financial Statements and such adjustments could be material. In determining the amount of current and deferred tax, the Company considers the impact of uncertain tax positions and whether additional taxes and interest may be due. New information may become available that causes the Company to change its judgment regarding the adequacy of existing tax liabilities; such changes to tax liabilities will impact tax expense in the period that such a determination is made. On December 22, 2017, H.R. 1, the Tax Cuts and Jobs Act (“the Tax Act”) was enacted. The Tax Act significantly revised the U.S. corporate income tax regime by, among other things, lowering the U.S. federal corporate rate from 35% to 21% effective January 1, 2018 while also implementing a new tax system on non-US earnings and imposing a repatriation tax on deemed repatriated earnings of foreign subsidiaries. US GAAP requires the impact of tax legislation to be recognized in the period in which the law was enacted. Some amounts were recorded as a discrete item in the Benefit from income taxes in the consolidated statement of operations for the year ended December 31, 2018. Prior to December 31, 2018, changes as a result of the Tax Act were recorded as provisional amounts and the Company’s best estimates. Any adjustments recorded to the provisional amounts through the fourth quarter of 2018 were included in the statement of operations as an adjustment to income tax expense. The provision for income taxes comprises current and deferred income tax expense and is recognized in the audited Consolidated Financial Statements. To the extent that the income taxes are for items recognized directly in equity, the related income tax effects are recognized in equity. The Company provides for the effects of income taxes on interim financial statements based on estimates of the effective tax rate for the full year, which is based on forecasted income by country and expected enacted tax rates. For additional discussion on income taxes, see Note 12: Income Taxes of the Notes to the audited Consolidated Financial Statements. Items Affecting Comparability When reading our financial statements and the information included in this Annual Report, it should be considered that we have experienced, and continue to experience, several material trends and uncertainties that have affected our financial condition and results of operations that could affect future performance. We believe that the following material trends and uncertainties are important to understand the variability of our historical earnings and cash flows and any potential future variability. Macroeconomic Conditions Our results of operations are significantly impacted by economic trends, government policies and the global and regional real estate markets. These include the following: overall economic activity; changes in interest rates; the impact of tax and regulatory policies; changes in employment rates; level of commercial construction spending; the cost and availability of credit; and the geopolitical environment. Our operating model helps to partially mitigate the negative effect of difficult market conditions on our margins as a substantial portion of our costs are variable compensation expenses, specifically commissions and bonuses paid to our professionals in our Leasing and Capital market service lines. Nevertheless, adverse economic trends could pose significant risks to our operating performance and financial condition. Acquisitions Our results include the incremental impact of completed transactions from the date of acquisition, which may impact the comparability of our results on a year-over-year basis. Additionally, there is generally an adverse impact on net income for a period of time after the completion of an acquisition driven by transaction-related and integration expenses. We have historically used strategic and in-fill acquisitions to add new service capabilities, to increase our scale within existing capabilities and to expand our presence in new or existing geographic regions globally. We believe that strategic acquisitions will increase revenue, provide cost synergies and generate incremental income in the long term. Seasonality A significant portion of our revenue is seasonal, especially for service lines such as Leasing and Capital markets, which impacts the comparison of our financial condition and results of operations on a quarter-by-quarter basis. Generally, our industry is focused on completing transactions by calendar year-end with a significant concentration in the last quarter of the calendar year while certain expenses are recognized more evenly throughout the calendar year. Historically, our revenue and operating income tend to be lowest in the first quarter, and highest in the fourth quarter of each year. The Property, facilities and project management service line partially mitigates this intra-year seasonality, due to the recurring nature of this service line, which generates more stable revenues throughout the year. Inflation Our commission and other operating costs tied to revenue are primarily impacted by factors in the commercial real estate market. These factors have the potential to be affected by inflation. Other costs such as wages and costs of goods and services provided by third parties also have the potential to be impacted by inflation. However, we do not believe that inflation has materially impacted our operations. International Operations Our business consists of service lines operating in multiple regions inside and outside of the U.S. Our international operations expose us to global economic trends as well as foreign government tax, regulatory and policy measures. Additionally, outside of the U.S., we generate earnings in other currencies and are subject to fluctuations relative to the USD. As we continue to grow our international operations through acquisitions and organic growth, these currency fluctuations, most notably the Australian dollar, euro and British Pound Sterling, have the potential to positively or adversely affect our operating results measured in USD. It can be difficult to compare period-over-period financial statements when the movement in currencies against the USD does not reflect trends in the local underlying business as reported in its local currency. In order to assist our investors and improve comparability of results, we present the year-over-year changes in certain of our non-GAAP financial measures, such as Fee revenue and Adjusted EBITDA, in "local" currency. The local currency change represents the year-over-year change assuming no movement in foreign exchange rates from the prior year. We believe that this provides our management and investors with a better view of comparability and trends in the underlying operating business. Adoption of New Accounting Standards On January 1, 2018, the Company adopted Topic 606 using the modified retrospective method. Results for reporting periods beginning after January 1, 2018 are presented under Topic 606. Comparative information continues to be reported under the accounting standards in effect for those periods. The impact to revenue for the year ended December 31, 2018 was an increase of $432.8 million, which included an increase of $400.2 million related to reimbursed expenses due to implementation of the updated principal versus agent considerations in Topic 606 and the acceleration in the timing of revenue recognition related to variable consideration primarily for Leasing services of $32.6 million. For further information regarding the impact of the adoption of this standard on the audited Consolidated Financial Statements and related disclosures, as well as significant judgments performed by the Company when applying Topic 606, refer to Note 2: Summary of Significant Accounting Policies and Note 5: Revenue from the Notes to the audited Consolidated Financial Statements for the year ended December 31, 2018. Key Performance Measures We regularly review a number of metrics to evaluate our business, measure our progress and make strategic decisions. The measures of Fee revenue, Fee-based operating expenses, Adjusted EBITDA, Adjusted EBITDA margin and local currency, which are non-GAAP measures are currently utilized by management to assess performance, and we disclose these measures to investors to assist them in providing a meaningful understanding of our performance. One of our current objectives is to identify the most relevant key performance indicators to stakeholders to allow them to analyze our business. See "Use of Non-GAAP Financial Measures" and "Results of Operations" below. Use of Non-GAAP Financial Measures We have used the following measures, which are considered "non-GAAP financial measures" under SEC guidelines: i. Fee revenue and Fee-based operating expenses; ii. Adjusted earnings before interest, taxes, depreciation and amortization ("Adjusted EBITDA") and Adjusted EBITDA margin; and iii. Local currency. Our management principally uses these non-GAAP financial measures to evaluate operating performance, develop budgets and forecasts, improve comparability of results and assist our investors in analyzing the underlying performance of our business. These measures are not recognized measurements under GAAP. When analyzing our operating results, investors should use them in addition to, but not as an alternative for, the most directly comparable financial results calculated and presented in accordance with GAAP. Because the Company’s calculation of these non-GAAP financial measures may differ from other companies, our presentation of these measures may not be comparable to similarly titled measures of other companies. The Company believes that these measures provide a more complete understanding of ongoing operations, enhance comparability of current results to prior periods and may be useful for investors to analyze our financial performance. The measures eliminate the impact of certain items that may obscure trends in the underlying performance of our business. The Company believes that they are useful to investors, for the additional purposes described below. Fee revenue: The Company believes that investors may find this measure useful to analyze the financial performance of our Property, facilities and project management service line and our business generally. Fee revenue is GAAP revenue excluding costs reimbursable by clients which have substantially no margin, and as such provides greater visibility into the underlying performance of our business. Additionally, pursuant to business combination accounting rules, certain fees that may have been deferred by the acquiree may be recorded as a receivable on the acquisition date by the Company. Such fees are included in Fee revenue as acquisition accounting adjustments based on when the acquiree would have recognized revenue in the absence of being acquired by the Company. Fee-based operating expenses: Consistent with GAAP, reimbursed costs for certain customer contracts are presented on a gross basis ("gross contract costs") in both revenue and operating expenses. As described above, gross contract costs are excluded from revenue in determining “Fee revenue.” Gross contract costs are similarly excluded from operating expenses in determining “Fee-based operating expenses.” Excluding gross contract costs from Fee-based operating expenses more accurately reflects how we manage our expense base and operating margins and, accordingly, is useful to investors and other external stakeholders for evaluating performance. Adjusted EBITDA and Adjusted EBITDA margin: We have determined Adjusted EBITDA to be our primary measure of segment profitability. We believe that investors find this measure useful in comparing our operating performance to that of other companies in our industry because these calculations generally eliminate integration and other costs related to acquisitions, pre-IPO stock-based compensation, the deferred payment obligation related to the acquisition of Cassidy Turley and other items. Adjusted EBITDA also excludes the effects of financings, income tax and the non-cash accounting effects of depreciation and intangible asset amortization. Adjusted EBITDA margin, a non-GAAP measure of profitability as a percent of revenue, is calculated by dividing Adjusted EBITDA by Fee revenue. Local currency: In discussing our results, we refer to percentage changes in local currency. These metrics are calculated by holding foreign currency exchange rates constant in year-over-year comparisons. Management believes that this methodology provides investors with greater visibility into the performance of our business excluding the effect of foreign currency rate fluctuations. Results of Operations The following table sets forth items derived from our audited consolidated statements of operations for the years ended December 31, 2018, 2017 and 2016 (in millions): Below is a reconciliation of Net loss attributable to the Company to Adjusted EBITDA (in millions): (1) Depreciation and amortization includes merger and acquisition-related depreciation and amortization of $205.8 million, $193.0 million and $182.0 million for the years ended December 31, 2018, 2017 and 2016, respectively. (2) Interest expense, net of interest income includes one-time write-off of financing fees and other fees incurred in relation to debt extinguishments and modifications of $53.8 million, $0.0 million and $9.0 million for the years ended December 31, 2018, 2017 and 2016, respectively. (3) Integration and other costs related to acquisitions represents certain direct and incremental costs resulting from acquisitions and certain related integration efforts as a result of those acquisitions, as well as costs related to our restructuring efforts and initial public offering/private placement. (4) Pre-IPO stock-based compensation represents non-cash compensation expense associated with our pre-IPO equity compensation plans. Refer to Note 10: Stock-based Payments of the Notes to the audited Consolidated Financial Statements for the year ended December 31, 2018 for additional information. (5) Cassidy Turley deferred payment obligation represents expense associated with a deferred payment obligation related to the acquisition of Cassidy Turley on December 31, 2014, which was paid before December 31, 2018. Refer to Note 10: Stock-based Payments of the Notes to the audited Consolidated Financial Statements for the year ended December 31, 2018 for additional information. (6) Other includes sponsor monitoring fees of approximately $3.4 million, $5.0 million, and $5.0 million for the years ended December 31, 2018, 2017 and 2016 respectively, accounts receivable securitization costs of approximately $6.7 million and $8.2 million for the years ended December 31, 2018 and 2017, respectively; and $(2.0) million other items for the year ended December 31, 2016. Below is the reconciliation of Total costs and expenses to Fee-based operating expenses (in millions): Below is the reconciliation of Fee-based operating expenses by segment to Consolidated Fee-based operating expenses (in millions): (1) Represents integration and other costs related to acquisitions, comprised of certain direct and incremental costs resulting from acquisitions and related integration efforts, as well as costs related to our restructuring programs, excluding the impact of acquisition accounting revenue adjustments as these amounts do not impact operating expenses. Year ended December 31, 2018 compared to year ended December 31, 2017 Revenue Revenue was $8.2 billion, an increase of $1.3 billion or 19%. Gross contract costs, primarily in the Property, facilities and project management service line, increased $644.5 million driven by the $400.2 million impact of the adoption of Topic 606. Additionally, Fee revenue was $6.0 billion, an increase of $643.0 million or 12%, on a local currency basis, reflecting increases in Leasing, Capital markets and Property, facilities and project management. Leasing Fee revenue increased by $272.7 million or 16%, on a local currency basis driven primarily by the Americas. Capital markets Fee revenue increased by $219.2 million or 29%, on a local currency basis, driven by an Americas increase of $169.1 million or 32%, on a local currency basis, with the remainder of Fee revenue growth primarily in APAC. Property, facilities and project management increased by $145.7 million or 6%, on a local currency basis, driven primarily by an Americas increase of $72.0 million or 4% on a local currency basis, with the remainder of the Fee revenue growth primarily in EMEA. Operating expenses Operating expenses were $8.2 billion, an increase of $1.1 billion or 16%. The increase in operating expenses reflected increased cost associated with revenue growth and the $400.2 million increase to gross contract costs resulting from the adoption of Topic 606 discussed above. Additionally, Fee-based operating expenses, excluding Depreciation and amortization, integration and other costs related to acquisitions and stock-based compensation, were $5.3 billion, a 10% increase, on a local currency basis. The growth in Fee-based operating expenses reflected higher cost of services associated with Fee revenue growth. Interest expense, net Net interest expense was $228.8 million, an increase of $45.7 million, driven by $53.8 million of charges related to the 2018 debt refinancing and extinguishment activities. Net interest expense does not include accounts receivable securitization costs of $6.7 million and $8.2 million for the years ending December 31, 2018 and 2017, respectively. Benefit from income taxes The benefit from income taxes was $25.0 million, a decrease of $95.5 million. The decrease was driven by the 2017 one-time deferred tax benefit received from the decrease in the U.S. corporate tax rate from 35% to 21% and the subsequent re-measurement of deferred tax liabilities, lower net loss before taxes in 2018 and the establishment of additional valuation allowances. Net loss and Adjusted EBITDA Net loss was $185.8 million, a decrease of $35.5 million, primarily driven by the increase in Fee revenue exceeding the increase in Fee-based operating expenses, partially offset by a lower benefit from income taxes and higher interest expense. Adjusted EBITDA was $659.1 million, an increase of $137.1 million or 26%, on a local currency basis, driven by the increase in Fee revenue exceeding the increase in Fee-based operating expenses and the $10.9 million local currency impact of the adoption of Topic 606. Adjusted EBITDA margin, calculated on a Fee revenue basis, was 11.1%, compared to 9.9% in the prior year, driven by Fee revenue mix and operating leverage. Year Ended December 31, 2017 compared to year ended December 31, 2016 Revenue Revenue was $6.9 billion, an increase of $708.2 million or 11%, which included an increase in gross contract costs of $221.3 million primarily in the Property, facilities and project management service line. Revenue growth also reflected the year-to-year increases in service line and segment Fee revenue discussed below. Foreign currency had a $44.2 million favorable impact on Revenue, driving approximately 1% growth of revenue. Additionally, Fee revenue was $5.3 billion, an increase of $480.0 million. Fee revenue increased $447.7 million or 10%, on a local currency basis. Foreign currency had a $32.2 million favorable impact on Fee revenue, driving approximately 1% growth of Fee revenue. Fee revenue reflected increases in Property, facilities and project management and Leasing. Property, facilities and project management Fee revenue increased $279.8 million or 13%, on a local currency basis, driven by an Americas increase of $187.5 million or 13%, on a local currency basis, and an APAC increase of $66.4 million or 12%, on a local currency basis. Leasing Fee revenue increased $143.4 million or 10%, on a local currency basis, driven by an Americas increase of $101.5 million or 9%, on a local currency basis, and an EMEA increase of $23.0 million or 11%, on a local currency basis. Operating expenses Operating expenses were $7.1 billion, an increase of $583.9 million or 8%. The increase in operating expenses reflected increased cost associated with revenue growth, including gross contract costs, partially offset by lower integration and other costs related to acquisitions. Additionally, Fee-based operating expenses, excluding Depreciation and amortization, integration and other costs related to acquisitions and stock-based compensation, were $4.8 billion, a 9% increase on a local currency basis. The growth in Fee-based operating expenses reflected higher costs in Property, facility and project management and Leasing associated with Fee revenue growth. Interest expense, net Net interest expense, increased by $11.3 million as a result of higher average annual borrowings. Average annual borrowings increased from $2.5 billion during 2016 to $2.7 billion during 2017 with Interest expense as a percentage of average outstanding debt remaining relatively unchanged. Benefit from income taxes The benefit from income taxes was $120.5 million, an increase of $96.2 million. The benefit included a discrete tax benefit of $60.9 million related to the Tax Act as well as the impact of valuation allowances and other discrete items. Refer to the Income Tax discussion in the Summary of Critical Accounting Policies and Estimates and Note 12 of the Notes to the audited Consolidated Financial Statements for a further discussion of our effective tax rate. Net loss and Adjusted EBITDA Net loss decreased from $434.2 million to $221.3 million in 2017 driven by the increase in Fee revenue exceeding the increase in Fee-based operating expenses, lower integration and other costs related to acquisitions and increased benefit from income taxes. Adjusted EBITDA increased by $44.1 million or 9%, on a local currency basis, driven by the increase in Fee revenue exceeding the increase in Fee-based operating expenses. Adjusted EBITDA margin, calculated on a Fee revenue basis, was relatively unchanged from 2016 to 2017 at 10%. Segment Operations We report our operations through the following segments: (1) Americas, (2) Europe, Middle East and Africa ("EMEA") and (3) Asia Pacific ("APAC"). The Americas consists of operations located in the United States, Canada and key markets in Latin America. EMEA includes operations in the United Kingdom, France, Netherlands and other markets in Europe and the Middle East. APAC includes operations in Australia, Singapore, China and other markets in the Asia Pacific region. For segment reporting, gross contract costs are excluded from revenue in determining Fee revenue. Gross contract costs are excluded from operating expenses in determining Fee-based operating expenses. Additionally, our measure of segment results, Adjusted EBITDA, excludes depreciation and amortization, as well as integration and other costs related to acquisitions, pre-IPO stock-based compensation, expense related to the Cassidy Turley deferred payment obligation and other items. Americas Results The following table summarizes our results of operations by our Americas operating segment for the years ended December 31, 2018, 2017 and 2016 (in millions): Year ended December 31, 2018 compared to year ended December 31, 2017 Americas revenue was $5.7 billion, an increase of $1.1 billion or 24%. The change in revenue includes higher gross contract costs of $332.8 million as a result of the adoption of Topic 606. Additionally, Fee revenue was $4.0 billion, an increase of $462.5 million or 13%, on a local currency basis. The increase in Fee revenue was driven primarily by growth in Leasing and Capital markets. The adoption of Topic 606 positively impacted Fee revenue in the Leasing service line by $32.3 million, on a local currency basis. Fee-based operating expenses were $3.6 billion, an increase of $355.3 million or 11%, on a local currency basis. The growth in Fee-based operating expenses was driven primarily by higher cost of services associated with Fee revenue growth. Adjusted EBITDA was $450.3 million, an increase of $107.4 million or 31%, on a local currency basis, driven by increases in Fee revenue exceeding the increases in Fee-based operating expenses and the $13.5 million local currency impact of the adoption of Topic 606. Adjusted EBITDA margin, calculated on a Fee revenue basis, was 11.1%, compared to 9.6% in the prior year. Year ended December 31, 2017 compared to year ended December 31, 2016 Americas revenue was $4.6 billion and Fee revenue was $3.6 billion, increases of $475.9 million and $293.3 million, respectively. Additionally, Fee revenue increased $284.4 million or 9%, on a local currency basis, reflecting broad growth across all four service lines. The increase in Fee revenue was driven primarily by Property, facilities and project management and Leasing. Fee-based operating expenses were $3.3 billion, an 8% increase on a local currency basis. The growth in Fee-based operating expenses was driven primarily by higher cost of services associated with Fee revenue growth. Adjusted EBITDA increased by $32.0 million or 10%, on a local currency basis, driven by the increase in Fee revenue exceeding the increase in Fee-based operating expenses. Adjusted EBITDA margin, calculated on a Fee revenue basis, was 9.6%, compared to 9.4%. EMEA Results The following table summarizes our results of operations by our EMEA operating segment for the years ended December 31, 2018, 2017 and 2016 (in millions): Year ended December 31, 2018 compared to year ended December 31, 2017 EMEA revenue was $999.8 million, an increase of $136.5 million or 16%. Foreign currency had a $15.2 million or 2% favorable impact on Revenue. The change in revenue includes higher gross contract costs of $24.0 million as a result of the adoption of Topic 606. Additionally, Fee revenue was $887.9 million, an increase of $90.1 million or 11%, on a local currency basis, driven primarily by growth in Property, facilities and project management and Capital markets. Fee-based operating expenses were $784.6 million, an increase of $90.3 million or 13%, on a local currency basis. The growth in Fee-based operating expenses was driven primarily by higher cost of services associated with Fee revenue growth. Adjusted EBITDA was $107.9 million, remained relatively consistent on a local currency basis, driven by increases in Fee revenue approximately equaling the increases in Fee-based operating expenses. Adjusted EBITDA margin, calculated on a Fee revenue basis, was 12.2%, compared to 13.9% in the prior year. Year ended December 31, 2017 compared to year ended December 31, 2016 EMEA revenue was $863.3 million and Fee revenue was $785.2 million, increases of $107.8 million and $95.5 million, respectively. Additionally, Fee revenue increased by $84.1 million or 13%, on a local currency basis, reflecting broad growth across all four service lines. The increase in Fee revenue was driven primarily by Property, facilities and project management, Leasing and Capital markets. Fee-based operating expenses were $688.5 million, a 14% increase on a local currency basis. The growth in Fee- based operating expenses was driven primarily by higher cost of services associated with Fee revenue growth. Adjusted EBITDA increased by $10.3 million or 12%, on a local currency basis, driven by the increase in Fee revenue exceeding the increase in Fee-based operating expenses. Adjusted EBITDA margin, calculated on a Fee revenue basis, was 13.9%, compared to 13.2%. APAC Results The following table summarizes our results of operations by our APAC operating segment for the years ended December 31, 2018, 2017 and 2016 (in millions): Year ended December 31, 2018 compared to year ended December 31, 2017 APAC revenue was $1.5 billion, an increase of $35.0 million. The change in revenue includes higher gross contract costs of $43.4 million as a result of the adoption of Topic 606. Additionally, Fee revenue was $1.0 billion, an increase of $90.4 million or 9%, on a local currency basis. The increase in Fee revenue was driven primarily by growth in Capital markets, Leasing and Valuation and other. Fee-based operating expenses were $920.0 million, an increase of $63.0 million or 7%, on a local currency basis. The growth in Fee-based operating expenses was driven primarily by higher cost of services associated with Fee revenue growth. Adjusted EBITDA was $100.9 million, an increase of $27.4 million or 35%, on a local currency basis, driven by the increase in Fee revenue exceeding the increase in Fee-based operating expenses. Adjusted EBITDA margin, calculated on a Fee revenue basis, was 9.9% compared to 8.0% in the prior year. Year ended December 31, 2017 compared to year ended December 31, 2016 APAC revenue was $1.5 billion and Fee revenue was $937.8 million, increases of $124.5 million and $91.2 million, respectively. Additionally, Fee revenue increased by $79.2 million or 10% on a local currency basis. The increase in Fee revenue was driven primarily by Property, facilities and project management and Leasing, partially offset by Capital markets. Fee-based operating expenses were $863.5 million, a 10% increase on a local currency basis. The growth in Fee-based operating expenses was driven primarily by higher cost of services associated with Fee revenue growth. Adjusted EBITDA increased by $1.9 million or 3%, on a local currency basis, driven by the increase in Fee revenue exceeding the increase in Fee-based operating expenses. Adjusted EBITDA margin, calculated on a Fee revenue basis, was 8.0% compared to 8.6%. Liquidity and Capital Resources We believe that we have adequate funds and liquidity to satisfy our working capital and other funding requirements with internally generated cash flow and, as necessary, cash on hand and borrowings under our revolving credit facility. We have historically relied on our internally generated cash flow to fund our working capital needs and ongoing capital expenditures on an annual basis. Our internally generated cash flow is seasonal and is typically lowest in the first quarter of the year, when revenue is lowest, and greatest in the fourth quarter of the year, when revenue is highest. The seasonal nature of our internally generated cash flow can result in a mismatch with funding needs for working capital and ongoing capital expenditures, which we manage using available cash on hand and, as necessary, borrowings under our revolving credit facility. In the absence of a large strategic acquisition or other extraordinary events, we believe our cash on hand, cash flow from operations and availability under our revolving credit facility will be sufficient to meet our anticipated cash requirements for the foreseeable future, and at a minimum for the next 12 months. We may seek to take advantage of opportunities to refinance existing debt instruments, as we have done in the past, with new debt instruments at interest rates, maturities and on terms we consider attractive. As of December 31, 2018, the Company had $1.7 billion of liquidity, consisting of cash on hand of $895.3 million and our undrawn revolving credit facility of $810.0 million. In August 2018, the $450.0 million Second Lien Loan was repaid with IPO proceeds of approximately $1.0 billion; the new Credit Agreement was entered into to increase liquidity and extend maturity; the First Lien Loan was repaid; and the revolving credit facility was modified which expanded borrowing capacity from $486.0 million to $810.0 million. During 2018, we did not draw on our Revolver. The Company had outstanding debt of $2.7 billion as of December 31, 2018, which net of cash on hand, provided for a net debt position of approximately $1.8 billion. The decrease in net debt of approximately $0.6 billion from December 31, 2017 was driven by proceeds from the IPO. Our level of indebtedness increases the possibility that we may be unable to pay the principal amount of our indebtedness and other obligations when due. In addition, we may incur additional debt from time to time to finance strategic acquisitions, investments, joint ventures or for other purposes, subject to the restrictions contained in the documents governing our indebtedness. If we incur additional debt, the risks associated with our leverage, including our ability to service our debt, would increase. See “Risk Factors." Despite our current indebtedness levels, we and our subsidiaries may still be able to incur substantially more debt, which could further exacerbate the risks associated with our substantial leverage. The second long-term liquidity need is the payment of obligations related to acquisitions. For the year ended December 31, 2018, we paid $44.2 million in cash consideration for our various acquisitions. Our acquisition structures often include deferred and/or contingent payments in future periods that are subject to the passage of time, achievement of certain performance metrics and/or other conditions. As of December 31, 2018 and 2017, we had accrued $73.0 million and $104.6 million, respectively, of deferred and earn-out consideration payable, which was included in Accounts payable and accrued expenses and in Other long-term liabilities in the accompanying audited consolidated balance sheets. Of the total balance as of December 31, 2018 and 2017, we have accrued $38.3 million and $51.3 million for earn-out consideration, respectively. As of December 31, 2018, the maximum potential payment for these earn-outs was $48.6 million, subject to the achievement of certain performance conditions. As a professional services firm, funding our operating activities is not capital intensive. Total capital expenditures for the year ended December 31, 2018 were $84.2 million. Historical Cash Flows Operating Activities We used $2.2 million of cash for operating activities for the year ended December 31, 2018, a change of $6.6 million from the prior year. The change was driven by a $124.1 million payment related to our Cassidy Turley deferred purchase obligation partially offset by a decrease in net loss of $35.5 million and higher non-cash charges including for debt extinguishment in the amount of $50.4 million. Operating activities provided $4.4 million in cash for the year ended December 31, 2017, a change of $339.5 million from the prior year. This change was driven by a decrease of $229.0 million in the net loss from 2016 to 2017 as well as lower payments for integration-related activities. Investing Activities We used $218.0 million in cash for investing activities for the year ended December 31, 2018, an increase of $74.8 million from the prior year. The change was driven primarily by a return of beneficial interest in the A/R Securitization of $85.0 million. Refer to Note 17: Accounts Receivable Securitization for more information. We used $143.2 million in cash in investing activities for the year ended December 31, 2017, an increase of $5.5 million from the prior year. The increase was driven by increased capital expenditures primarily related to the continued integration of C&W Group. Financing Activities Financing activities provided $725.9 million in cash for the year ended December 31, 2018, an increase of $558.2 million from the prior year, driven by proceeds of approximately $1.0 billion from the IPO and Concurrent Private Placement, partially offset by the $450.0 million repayment of the Second Lien loan. Financing activities provided $167.7 million in cash for the year ended December 31, 2017, a decrease of $188.8 million from the prior year. This decrease was driven by lower net borrowings of $157.9 million and lower proceeds from the issuance of shares of $16.4 million in 2017. Summary of Contractual Obligations The following is a summary of our various contractual obligations and other commitments as of December 31, 2018 (in millions): Debt obligations - Represents the gross outstanding long-term debt balance payable at maturity, excluding unamortized discount and issuance costs. Because the majority of our debt bears interest at variable rates, the precise amount of annual interest payments cannot be determined and such amounts are therefore excluded from the table above. Using current rates expected annual interest payments would be approximately $157.4 million until our facility matures in 2025. See Note 9: Long-term Debt and Other Borrowings of the Notes to the audited Consolidated Financial Statements for further discussion. Lease obligations - Our lease obligations primarily consist of operating and capital leases of office space in various buildings for our own use. The total minimum rents expected to be received and recorded as sublease income in the future for operating subleases as of December 31, 2018 was $58.9 million. See Note 14: Commitments and Contingencies of the Notes to the audited Consolidated Financial Statements for further discussion. Defined benefit plan obligations - Represents estimates of the expected benefits to be paid out by our defined benefit plans. These obligations will be funded from the assets held by these plans. If the assets these plans hold are not sufficient to fund these payments, we will fund the remaining obligations. We have historically funded pension costs as actuarially determined and as applicable laws and regulations require. We expect to contribute to our defined benefit pension plans in 2019; see Note 10: Employee Benefits of the Notes to the audited Consolidated Financial Statements for further discussion. Other contractual obligations recorded on the balance sheet include deferred consideration of $34.7 million and contingent consideration of $38.3 million as of December 31, 2018. These items are not included in the table above, as timing and amount of payments cannot be determined due to their nature as estimates or outcomes having connection to future events. As of December 31, 2018, our current and non-current tax liabilities, including interest and penalties, totaled $62.7 million. Of this amount, we can reasonably estimate that $38.6 million will require cash settlement in less than one year. We are unable to reasonably estimate the timing of the effective settlement of tax positions for the remaining $24.1 million. In addition, we recognized an estimated tax liability of $1.2 million related to the 2017 and 2018 transition tax on mandatory deemed repatriation due to the Tax Act, net of $29.0 million of foreign income tax credit carryforwards used to reduce the liability. The estimated state tax liability and a portion of the estimated federal tax liability totaling $0.2 million is payable in less than one year. The remainder of the federal tax liability of $1.0 million is payable over the following six years. Off-Balance Sheet Arrangements The Company’s guarantees primarily relate to requirements under certain client service contracts and have arisen through the normal course of business. Our current expectation is that future payment or performance related to non-performance under these guarantees is considered remote. See Note 14: Commitments and Contingencies of the Notes to the audited Consolidated Financial Statements for further information. The Company is party to an A/R Securitization arrangement whereby it continuously sells trade receivables to an unaffiliated financial institution, which has an investment limit of $125.0 million. Receivables are derecognized from our balance sheet upon sale, for which we receive cash payment and record a deferred purchase price receivable. As of December 31, 2018, the Company has not reached the investment limit. The A/R Securitization terminates on August 20, 2021, unless extended or an earlier termination event occurs. See Note 17: Accounts Receivable Securitization of the Notes to the audited Consolidated Financial Statements for further information. Indebtedness We have incurred debt to finance the acquisitions of DTZ, Cassidy Turley and C&W Group, Inc. In addition, we may incur additional debt from time to time to finance strategic acquisitions, investments, joint ventures or for other purposes, subject to the restrictions contained in the documents governing our indebtedness. 2018 Credit Agreement On August 21, 2018, we entered into a $3.5 billion credit agreement, comprised of a $2.7 billion term loan and an $810.0 million revolving facility. Net proceeds from the 2018 First Lien Loan were $2.7 billion ($2.7 billion aggregate principal amount less $13.5 million stated discount and $20.4 million in debt transaction costs). With the proceeds from the 2018 First Lien Loan, we subsequently paid off all outstanding principal and accrued interest of $2.6 billion and $25.9 million, respectively, under the credit agreement dated as of November 4, 2014 (the “2014 Credit Agreement”), respectively, which also resulted in the write-off of unamortized deferred financing fees of $39.2 million. The 2018 Credit Agreement bears interest at a variable interest rate that we may select pursuant to the terms of the 2018 Credit Agreement. As of the year ended December 31, 2018, the rate is equal to 1-month LIBOR plus 3.25%. The 2018 First Lien Loan matures on August 21, 2025. The effective interest rate of the 2018 First Lien Loan is 6.0% as of December 31, 2018. The 2018 Credit Agreement requires quarterly principal payments equal to 0.25% of the aggregate principal amount of the 2018 First Lien Loan, including incremental borrowings. Revolver As of December 31, 2018, we had 0 outstanding funds drawn under the Revolver, which matures on August 21, 2023. The Company did not draw on the Revolver at any point during 2018. Financial Covenants and Terms The 2018 Credit Agreement has a springing financial covenant, for the benefit of the Revolver lenders only that is tested on the last day of each fiscal quarter if the outstanding loans under the Revolver exceed an applicable threshold. If the financial covenant is triggered, the First Lien Net Leverage Ratio is tested for compliance not to exceed 5.80 to 1.00. The financial covenant has not been triggered since we entered into the 2018 Credit Agreement. Similarly, the financial covenant under our original First Lien Credit Agreement was not triggered in any period since its inception in 2014. The Company was in compliance with all of its loan provisions under its 2018 First Lien Credit Agreement as of December 31, 2018. Derivatives We are exposed to certain risks arising from both business operations and economic conditions, including interest rate risk and foreign currency risk. We manage interest rate risk primarily by managing the amount, sources and duration of debt funding and by using derivative financial instruments. Derivative financial instruments are used to manage differences in the amount, timing and duration of known or expected cash payments principally related to borrowings under our 2018 First Lien Credit Agreement as well as certain foreign currency exposures. See Note 8: Derivative Financial Instruments and Hedging Activities of the Notes to audited Consolidated Financial Statements as well as "Quantitative and Qualitative Disclosures About Market Risk" for additional information about risks managed through derivative activities.
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-0.016757
0
<s>[INST] As discussed in “Cautionary Note Regarding ForwardLooking Statements,” the following discussion and analysis contains forwardlooking statements that involve risks and uncertainties. Our actual results may materially differ from those discussed in such forwardlooking statements. Factors that could cause or contribute to these differences include, but are not limited to, those identified below and those discussed in “Risk Factors” under Part I, Item 1A in this report. Our fiscal year ends December 31. With respect to presentation, all statements asserting an "increase" or "decrease" relate to changes from prior applicable periods of comparison. Overview Cushman & Wakefield is a leading global commercial real estate services firm, built on a trusted brand and backed by approximately 51,000 employees and serving the world's real estate owners and occupiers through a scalable platform. We operate from approximately 400 offices in 70 countries, managing over 3.6 billion square feet of commercial real estate space on behalf of institutional, corporate and private clients. Our business is focused on meeting the increasing demands of our clients across multiple service lines including Property, facilities and project management, Leasing, Capital markets and Valuation and other services. Critical Accounting Policies Our audited Consolidated Financial Statements included elsewhere in this report have been prepared in accordance with U.S. GAAP, which requires us to make estimates and assumptions that affect reported amounts. The estimates and assumptions are based on historical experience and on other factors that we believe to be reasonable. Actual results may differ from those estimates. We review these estimates on a periodic basis to ensure reasonableness. Although actual amounts may differ from such estimated amounts, we believe such differences are not likely to be material. For additional detail regarding our critical accounting policies, see Note 2: Summary of Significant Accounting Policies of the Notes to the audited Consolidated Financial Statements. Recently Issued Accounting Pronouncements See recently issued accounting pronouncements within Note 2: Summary of Significant Accounting Policies of the Notes to the audited Consolidated Financial Statements. Revenue Recognition The Company principally earns revenue from Property, facilities and project management, Leasing, Capital markets and Valuation and other. As of January 1, 2018, the Company adopted Topic 606, which replaced most existing revenue recognition guidance under U.S. GAAP. The core principle of Topic 606 requires companies to reevaluate when revenue is recorded on a transaction based upon newly defined criteria, either at a point in time or over time as goods or services are delivered. Topic 606 requires additional disclosures about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and estimates, and changes in those estimates. For further information regarding the impact of the adoption of this standard on the audited Consolidated Financial Statements and related disclosures, as well as significant judgments performed by the Company when applying Topic 606, refer to Note 2: Summary of Significant Accounting Policies and Note 5: Revenue from the Notes to the audited Consolidated Financial Statements for the year ended December 31, 2018. Business Combinations, Goodwill and IndefiniteLived Intangible Assets The Company has grown, in part, through a series of acquisitions. See Note 1: Organization and Business Overview of the Notes to the audited Consolidated Financial Statements. We account for business combinations using the acquisition method of accounting, which requires that once control is obtained, all of the assets acquired and liabilities assumed, including amounts attributable to noncontrolling interests, be recorded at their respective fair values as of the acquisition date. Determination of the fair values of the assets and liabilities acquired requires estimates and the use of valuation techniques when market values are not readily available. The Company recorded goodwill and intangible assets resulting from these acquisitions. Goodwill represents the excess of purchase consideration over the fair value of the net assets of businesses acquired. Goodwill and indefinitelived intangible assets are tested for impairment annually, or more frequently if events or changes in circumstances indicate that they may be impaired. The initial impairment evaluation [/INST] Negative. </s>
2,019
7,762
1,628,369
Cushman & Wakefield plc
2020-02-28
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 our audited Consolidated Financial Statements and related notes included elsewhere in this Annual Report on Form 10-K. As discussed in “Cautionary Note Regarding Forward-Looking Statements,” the following discussion and analysis contains forward-looking statements that involve risks and uncertainties. Our actual results may materially differ from those discussed in such forward-looking statements. Factors that could cause or contribute to these differences include, but are not limited to, those identified below and those discussed in “Risk Factors” under Part I, Item 1A in this Annual Report. Our fiscal year ends December 31. With respect to presentation, all statements asserting an "increase" or "decrease" relate to changes from prior applicable periods of comparison. Overview Cushman & Wakefield is a leading global commercial real estate services firm, built on a trusted brand and backed by approximately 53,000 employees and serving the world's real estate owners and occupiers through a scalable platform. We operate from approximately 400 offices in 60 countries, managing over 4.1 billion square feet of commercial real estate space on behalf of institutional, corporate and private clients. Our business is focused on meeting the increasing demands of our clients across multiple service lines including Property, facilities and project management, Leasing, Capital markets and Valuation and other services. Critical Accounting Policies Our audited Consolidated Financial Statements have been prepared in accordance with U.S. GAAP, which requires us to make estimates and assumptions that affect reported amounts. The estimates and assumptions are based on historical experience and on other factors that we believe to be reasonable. Actual results may differ from those estimates. We review these estimates on a periodic basis to ensure reasonableness. Although actual amounts may differ from such estimated amounts, we believe such differences are not likely to be material. For additional detail regarding our critical accounting policies, see Note 2: Summary of Significant Accounting Policies of the Notes to the audited Consolidated Financial Statements. Recently Issued Accounting Pronouncements See recently issued accounting pronouncements within Note 2: Summary of Significant Accounting Policies of the Notes to the audited Consolidated Financial Statements. Leases The Company adopted ASU No. 2018-11, Topic 842, effective January 1, 2019, which improves clarity and comparability by disclosing the recognition of lease assets and lease liabilities on the balance sheet as well as key leasing arrangements. Refer to Note 13: Leases of the Notes to the audited Consolidated Financial Statements for the impact the adoption of these standards had on the Company's financial statements and related disclosure. Revenue Recognition The Company principally earns revenue from Property, facilities and project management, Leasing, Capital markets and Valuation and other. In 2018, the Company adopted ASU No. 2014-09, Topic 606 ("Topic 606"), which replaced most existing revenue recognition guidance under U.S. GAAP. The core principle of Topic 606 requires companies to reevaluate when revenue is recorded on a transaction based upon newly defined criteria, either at a point in time or over time as goods or services are delivered. Under current revenue recognition, revenue is recognized upon transfer of control of promised services to clients in an amount that reflects the consideration the Company expects to receive in exchange for those services. For further information regarding the impact of the adoption of this standard on the audited Consolidated Financial Statements and related disclosures, as well as significant judgments performed by the Company when applying Topic 606, refer to Note 2: Summary of Significant Accounting Policies and Note 5: Revenue from the Notes to the audited Consolidated Financial Statements for the year ended December 31, 2019. Business Combinations, Goodwill and Indefinite-Lived Intangible Assets The Company has grown, in part, through a series of acquisitions. See Note 1: Organization and Business Overview of the Notes to the audited Consolidated Financial Statements. We account for business combinations using the acquisition method of accounting, which requires that once control is obtained, all of the assets acquired and liabilities assumed, including amounts attributable to noncontrolling interests, be recorded at their respective fair values as of the acquisition date. Determination of the fair values of the assets and liabilities acquired requires estimates and the use of valuation techniques when market values are not readily available. The Company recorded goodwill and intangible assets resulting from these acquisitions. Goodwill represents the excess of purchase consideration over the fair value of the net assets of businesses acquired. Goodwill and indefinite-lived intangible assets are tested for impairment annually, or more frequently if events or changes in circumstances indicate that they may be impaired. The initial impairment evaluation of goodwill is a qualitative assessment and is performed to assess whether the fair value of a reporting unit (“RU”) is less than its carrying amount and only proceeds to the quantitative impairment test if it is more likely than not that the fair value of the RU is less than its carrying amount. If the Company determines the quantitative impairment test is required, the estimated fair value of the RU is compared to its carrying amount, including goodwill. If the estimated fair value of a RU exceeds its carrying value, goodwill is not considered to be impaired. If the carrying amount exceeds the estimated fair value, an impairment loss is recognized equal to that excess. The loss recognized cannot exceed the carrying amount of goodwill. The Company records an impairment loss for other definite and indefinite-lived intangible assets if impairment triggers exist and the fair value of the asset is less than the asset’s carrying amount. For a detailed discussion of goodwill and indefinite-lived intangible assets, see Note 6: Goodwill and Other Intangible Assets of the Notes to the audited Consolidated Financial Statements. Income Taxes Income taxes are accounted for under the asset and liability method in accordance with US GAAP. Deferred tax assets and liabilities are recognized for the expected future tax consequences attributable to differences between carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. 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. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that the new rate is enacted. A valuation allowance is established against deferred tax assets when it is more likely than not that some portion or all of the deferred tax asset will not be realized in the future. Accounting for tax positions requires judgments, including estimating reserves for potential uncertainties. We also assess our ability to utilize tax attributes, including those in the form of net operating loss carryforwards, for which the benefits have already been reflected in the financial statements. We do not record valuation allowances for deferred tax assets that we believe will be realized in future periods. While we believe the resulting tax balances as of December 31, 2019 and 2018 are appropriately accounted for in accordance with US GAAP, the ultimate outcome of such matters could result in favorable or unfavorable adjustments to our audited Consolidated Financial Statements and such adjustments could be material. In determining the amount of current and deferred tax, the Company considers the impact of uncertain tax positions and whether additional taxes and interest may be due. New information may become available that causes the Company to change its judgment regarding the adequacy of existing tax liabilities; such changes to tax liabilities will impact tax expense in the period that such a determination is made. On December 22, 2017, H.R. 1, the Tax Cuts and Jobs Act (“the Tax Act”) was enacted. The Tax Act significantly revised the U.S. corporate income tax regime by, among other things, lowering the U.S. federal corporate rate from 35% to 21% effective January 1, 2018 while also implementing a new tax system on non-US earnings and imposing a repatriation tax on deemed repatriated earnings of foreign subsidiaries. US GAAP requires the impact of tax legislation to be recognized in the period in which the law was enacted. Some amounts were recorded as a discrete item in the Benefit from income taxes in the consolidated statement of operations for the year ended December 31, 2018. Prior to December 31, 2018, changes as a result of the Tax Act were recorded as provisional amounts and the Company’s best estimates. Any adjustments recorded to the provisional amounts through the fourth quarter of 2018 were included in the statement of operations as an adjustment to income tax expense. The provision for income taxes comprises current and deferred income tax expense and is recognized in the audited Consolidated Financial Statements. To the extent that the income taxes are for items recognized directly in equity, the related income tax effects are recognized in equity. The Company provides for the effects of income taxes on interim financial statements based on estimates of the effective tax rate for the full year, which is based on forecasted income by country and expected enacted tax rates. For additional discussion on income taxes, see Note 11: Income Taxes of the Notes to the audited Consolidated Financial Statements. Items Affecting Comparability When reading our financial statements and the information included in this Annual Report, it should be considered that we have experienced, and continue to experience, several material trends and uncertainties that have affected our financial condition and results of operations that could affect future performance. We believe that the following material trends and uncertainties are important to understand the variability of our historical earnings and cash flows and any potential future variability. Macroeconomic Conditions Our results of operations are significantly impacted by economic trends, government policies and the global and regional real estate markets. These include the following: overall economic activity; changes in interest rates; the impact of tax and regulatory policies; changes in employment rates; level of commercial construction spending; the cost and availability of credit; and the geopolitical environment. Our operating model helps to partially mitigate the negative effect of difficult market conditions on our margins as a substantial portion of our costs are variable compensation expenses, specifically commissions and bonuses paid to our professionals in our Leasing and Capital market service lines. Nevertheless, adverse economic trends could pose significant risks to our operating performance and financial condition. Acquisitions Our results include the incremental impact of completed transactions from the date of acquisition, which may impact the comparability of our results on a year-over-year basis. Additionally, there is generally an adverse impact on net income for a period of time after the completion of an acquisition driven by transaction-related and integration expenses. We have historically used strategic and in-fill acquisitions to add new service capabilities, to increase our scale within existing capabilities and to expand our presence in new or existing geographic regions globally. We believe that strategic acquisitions will increase revenue, provide cost synergies and generate incremental income in the long term. Seasonality A significant portion of our revenue is seasonal, especially for service lines such as Leasing and Capital markets, which impacts the comparison of our financial condition and results of operations on a quarter-by-quarter basis. Generally, our industry is focused on completing transactions by calendar year-end with a significant concentration in the last quarter of the calendar year while certain expenses are recognized more evenly throughout the calendar year. Historically, our revenue and operating income tend to be lowest in the first quarter, and highest in the fourth quarter of each year. The Property, facilities and project management service line partially mitigates this intra-year seasonality, due to the recurring nature of this service line, which generates more stable revenues throughout the year. Inflation Our commission and other operating costs tied to revenue are primarily impacted by factors in the commercial real estate market. These factors have the potential to be affected by inflation. Other costs such as wages and costs of goods and services provided by third parties also have the potential to be impacted by inflation. However, we do not believe that inflation has materially impacted our operations. International Operations Our business consists of service lines operating in multiple regions inside and outside of the U.S. Our international operations expose us to global economic trends as well as foreign government tax, regulatory and policy measures. Additionally, outside of the U.S., we generate earnings in other currencies and are subject to fluctuations relative to the U.S. dollar (USD). As we continue to grow our international operations through acquisitions and organic growth, these currency fluctuations, most notably the Australian dollar, euro and British pound sterling, have the potential to positively or adversely affect our operating results measured in USD. It can be difficult to compare period-over-period financial statements when the movement in currencies against the USD does not reflect trends in the local underlying business as reported in its local currency. In order to assist our investors and improve comparability of results, we present the year-over-year changes in certain of our non-GAAP financial measures, such as Fee revenue and Adjusted EBITDA, in "local" currency. The local currency change represents the year-over-year change assuming no movement in foreign exchange rates from the prior year. We believe that this provides our management and investors with a better view of comparability and trends in the underlying operating business. Key Performance Measures We regularly review a number of metrics to evaluate our business, measure our progress and make strategic decisions. The measures of Fee revenue, Fee-based operating expenses, Adjusted EBITDA, Adjusted EBITDA margin and local currency, which are non-GAAP measures are currently utilized by management to assess performance, and we disclose these measures to investors to assist them in providing a meaningful understanding of our performance. One of our current objectives is to identify the most relevant key performance indicators to stakeholders to allow them to analyze our business. See "Use of Non-GAAP Financial Measures" and "Results of Operations" below. Use of Non-GAAP Financial Measures We have used the following measures, which are considered "non-GAAP financial measures" under SEC guidelines: i. Fee-based operating expenses; ii. Adjusted earnings before interest, taxes, depreciation and amortization ("Adjusted EBITDA") and Adjusted EBITDA margin; and iii. Local currency. Our management principally uses these non-GAAP financial measures to evaluate operating performance, develop budgets and forecasts, improve comparability of results and assist our investors in analyzing the underlying performance of our business. These measures are not recognized measurements under GAAP. When analyzing our operating results, investors should use them in addition to, but not as an alternative for, the most directly comparable financial results calculated and presented in accordance with GAAP. Because the Company’s calculation of these non-GAAP financial measures may differ from other companies, our presentation of these measures may not be comparable to similarly titled measures of other companies. The Company believes that these measures provide a more complete understanding of ongoing operations, enhance comparability of current results to prior periods and may be useful for investors to analyze our financial performance. The measures eliminate the impact of certain items that may obscure trends in the underlying performance of our business. The Company believes that they are useful to investors, for the additional purposes described below. Fee-based operating expenses: Consistent with GAAP, reimbursed costs for certain customer contracts are presented on a gross basis in both revenue and operating expenses for which the Company recognizes substantially no margin. Total costs and expenses includes Fee-based operating expenses and “Cost of gross contract reimbursables” as well as other expenses such as depreciation and amortization, integration and other costs related to merger, pre-IPO stock based compensation, Cassidy Turley deferred payment obligation, acquisition related costs and other efficiency initiatives. We believe Fee-based operating expenses more accurately reflects the costs we incur during the course of delivering services to our clients and is more consistent with how we manage our expense base and operating margins. Adjusted EBITDA and Adjusted EBITDA margin: We have determined Adjusted EBITDA to be our primary measure of segment profitability. We believe that investors find this measure useful in comparing our operating performance to that of other companies in our industry because these calculations generally eliminate integration and other costs related to merger, pre-IPO stock-based compensation, the deferred payment obligation related to the acquisition of Cassidy Turley and other items. Adjusted EBITDA also excludes the effects of financings, income tax and the non-cash accounting effects of depreciation and intangible asset amortization. Adjusted EBITDA margin, a non-GAAP measure of profitability as a percent of revenue, is calculated by dividing Adjusted EBITDA by Total service line fee revenue. Local currency: In discussing our results, we refer to percentage changes in local currency. These metrics are calculated by holding foreign currency exchange rates constant in year-over-year comparisons. Management believes that this methodology provides investors with greater visibility into the performance of our business excluding the effect of foreign currency rate fluctuations. Results of Operations In accordance with Item 303 of Regulation S-K, the Company has excluded discussion of 2017 results in “Management's Discussion and Analysis of Financial Condition and Results of Operations,” as this discussion can be found in our 2018 Annual Report on Form 10-K filed with the SEC under "Management's Discussion and Analysis of Financial Condition and Results of Operations." The following table sets forth items derived from our audited consolidated statements of operations for the years ended December 31, 2019 and 2018 (in millions): (1) Service line fee revenue represents revenue for fees generated from each of our service lines (2) Gross contract reimbursables reflects revenue paid by clients which have substantially no margin (3) Calculated as a percentage of Total service line fee revenue Below is a reconciliation of Net income (loss) to Adjusted EBITDA (in millions): (1) Depreciation and amortization includes merger and acquisition-related depreciation and amortization of $209.2 million and $205.8 million for the years ended December 31, 2019 and 2018 respectively. (2) Interest expense, net of interest income includes one-time write-off of financing fees and other fees incurred in relation to debt extinguishments and modifications of $0.0 million and $53.8 million for the years ended December 31, 2019 and 2018, respectively. (3) Integration and other costs related to merger include certain direct and incremental integration and restructuring efforts, as well as costs related to our initial public offering/private placement. (4) Pre-IPO stock-based compensation represents non-cash compensation expense associated with our pre-IPO equity compensation plans. Refer to Note 12: Stock-based Payments of the Notes to the Consolidated Financial Statements for the year ended December 31, 2019 for additional information. (5) Cassidy Turley deferred payment obligation represents expense associated with a deferred payment obligation related to the acquisition of Cassidy Turley on December 31, 2014, which was paid out before the end of 2018. Refer to Note 12: Stock-based Payments of the Notes to the Consolidated Financial Statements for the year ended December 31, 2019 for additional information. (6) Acquisition related costs and other efficiency initiatives reflects incremental costs related to in-fill M&A as well as one-time efficiency projects. This excludes certain direct and incremental integration and restructuring efforts, as well as costs related to our initial public offering/private placement. (7) Other reflects compliance implementation and one-time project costs of $10.4 million for the year ended December 31, 2019 and other items including accounts receivable securitization. Year ended December 31, 2019 compared to year ended December 31, 2018 Revenue Revenue was $8.8 billion, an increase of $531.1 million or 6%. Gross contract reimbursables, primarily in the Property, facilities and project management service line, increased $81.6 million, driven by incremental revenue growth from the Americas. Additionally, Total service line fee revenue (“Fee revenue”) was $6.4 billion, an increase of $537.5 million or 9%, on a local currency basis, reflecting increases in Property, facilities and project management and Capital markets. Property, facilities and project management increased by $373.8 million or 14%, on a local currency basis, driven primarily by an Americas increase of $251.8 million or 15% on a local currency basis, with the remainder of the Fee revenue growth primarily in APAC. Capital markets Fee revenue increased by $78.3 million or 8%, on a local currency basis, driven by an Americas increase of $43.4 million or 6%, on a local currency basis, with the remainder of Fee revenue growth primarily in APAC. Costs and expenses Total costs and expenses were $8.6 billion, an increase of $356.4 million or 4%. Fee based operating expenses increased 9% on a local currency basis to $5.7 billion including Americas, EMEA and APAC of $3.9 billion, $0.8 billion and $1.0 billion, respectively. This increase was principally driven by revenue growth (also up 9% year over year). Cost of gross contracts reimbursables increased $81.6 million due to continued growth in the Property, facilities and the project management service line. These increases were partially offset by lower integration and other costs related to merger and pre-IPO stock-based compensation. Summary of Total costs and expenses (in millions): (1) Represents integration and other costs related to merger, comprised of certain direct and incremental costs resulting from merger and related integration efforts, as well as costs related to our restructuring programs, excluding the impact of acquisition accounting revenue adjustments as these amounts do not impact operating expenses. Interest expense, net Net interest expense was $150.6 million, a decrease of $78.2 million, driven by $53.8 million of charges related to the 2018 debt refinancing and extinguishment activities. Income tax expense Income tax expense was $42.6 million, an increase of $67.6 million. The increase is due to decreasing global operating loss carryforwards, specifically in the US. Net income and Adjusted EBITDA Net income was $0.2 million, an increase of $186.0 million, primarily driven by a decrease in integration and other costs related to merger, lower interest expense, lower pre-IPO stock-based compensation and stronger operating results partially offset by higher income tax expense. Adjusted EBITDA was $724.4 million, an increase of $72.6 million or 11%, on a local currency basis, driven by the increase in Fee revenue exceeding the increase in Fee-based operating expenses. Adjusted EBITDA margin, calculated on a Fee revenue basis, was 11.3%, which was up 25 basis points. Segment Operations We report our operations through the following segments: (1) Americas, (2) Europe, Middle East and Africa ("EMEA") and (3) Asia Pacific ("APAC"). The Americas consists of operations located in the United States, Canada and key markets in Latin America. EMEA includes operations in the United Kingdom, France, Netherlands and other markets in Europe and the Middle East. APAC includes operations in Australia, Singapore, China and other markets in the Asia Pacific region. For segment reporting, Service line fee revenue represents revenue for fees generated from each of our of service lines. Gross contract reimbursables reflect revenue paid by clients which have substantially no margin. Our measure of segment results, Adjusted EBITDA, excludes depreciation and amortization, as well as integration and other costs related to merger, pre-IPO stock-based compensation, expense related to the Cassidy Turley deferred payment obligation and other items. In accordance with Item 303 of Regulation S-K, the Company has excluded the discussion of 2017 results in “Management's Discussion and Analysis of Financial Condition and Results of Operations”, as this discussion can be found in our 2018 Annual Report on Form 10-K filed with the SEC under "Management's Discussion and Analysis of Financial Condition and Results of Operations". Americas Results The following table summarizes our results of operations by our Americas operating segment for the years ended December 31, 2019 and 2018 (in millions): (1) Service line fee revenue represents revenue for fees generated from each of our service lines (2) Gross contract reimbursables reflects revenue paid by clients which have substantially no margin (3) Calculated as a percentage of Total service line fee revenue Year ended December 31, 2019 compared to year ended December 31, 2018 Americas revenue was $6.2 billion, an increase of $447.4 million or 8%. The change in revenue includes higher Gross contract reimbursables of $117.9 million attributed to the growth in Property, facilities and project management, driven by incremental revenue growth. Additionally, Fee revenue was $4.4 billion, an increase of $343.9 million or 9%, on a local currency basis. The increase in Fee revenue was driven primarily by growth in Property, facilities and project management, Valuation and other, and Capital markets. Fee-based operating expenses were $3.9 billion, an increase of $293.3 million or 8%, on a local currency basis. The growth in Fee-based operating expenses was driven primarily by higher cost of services associated with Fee revenue growth. Adjusted EBITDA was $499.8 million, an increase of $50.7 million or 11%, on a local currency basis, driven by the decline in integration and other costs related to mergers. Adjusted EBITDA margin, calculated on a Fee revenue basis, was 11.4%, compared to 11.1% in the prior year. EMEA Results The following table summarizes our results of operations by our EMEA operating segment for the years ended December 31, 2019 and 2018 (in millions): (1) Service line fee revenue represents revenue for fees generated from each of our service lines (2) Gross contract reimbursables reflects revenue paid by clients which have substantially no margin (3) Calculated as a percentage of Total service line fee revenue Year ended December 31, 2019 compared to year ended December 31, 2018 EMEA revenue was $1.0 billion, an increase of $38.4 million or 4%. The change in revenue includes lower Gross contract reimbursables of $3.7 million, on a local currency basis. Foreign currency had a $45.2 million or 5% unfavorable impact on Revenue. Additionally, Fee revenue was $928.5 million, an increase of $79.9 million or 9%, on a local currency basis, driven primarily by growth in Property, facilities and project management and Capital markets. Fee-based operating expenses were $832.9 million, an increase of $84.4 million or 11%, on a local currency basis. The growth in Fee-based operating expenses was driven primarily by higher cost of services associated with Fee revenue growth. Adjusted EBITDA was $100.4 million, a decrease of $4.1 million or 4% on a local currency basis, driven by increases in Fee-based operating expenses exceeding the increases in Fee revenue. Adjusted EBITDA margin, calculated on a Fee revenue basis, was 10.8%, compared to 12.2% in the prior year. APAC Results The following table summarizes our results of operations by our APAC operating segment for the years ended December 31, 2019 and 2018 (in millions): (1) Service line fee revenue represents revenue for fees generated from each of our service lines (2) Gross contract reimbursables reflects revenue paid by clients which have substantially no margin (3) Calculated as a percentage of Total service line fee revenue Year ended December 31, 2019 compared to year ended December 31, 2018 APAC revenue was $1.5 billion, an increase of $45.3 million. The change in revenue includes lower Gross contract reimbursables of $5.6 million, on a local currency basis. Foreign currency had a $63.2 million or 4% unfavorable impact on Revenue. Additionally, Fee revenue was $1.1 billion, an increase of $114.1 million or 12%, on a local currency basis. The increase in Fee revenue was driven primarily by growth in Properties, facilities, and project management, Capital markets and Valuation and other. Fee-based operating expenses were $976.6 million, an increase of $88.7 million or 10%, on a local currency basis. The growth in Fee-based operating expenses was driven primarily by higher cost of services associated with Fee revenue growth. Adjusted EBITDA was $124.2 million, an increase of $25.9 million or 26%, on a local currency basis, driven by the increase in Fee revenue exceeding the increase in Fee-based operating expenses. Adjusted EBITDA margin, calculated on a Fee revenue basis, was 11.3% compared to 9.9% in the prior year. Liquidity and Capital Resources We believe that we have adequate funds and liquidity to satisfy our working capital and other funding requirements with internally generated cash flow and, as necessary, cash on hand and borrowings under our revolving credit facility. We have historically relied on our internally generated cash flow to fund our working capital needs and ongoing capital expenditures on an annual basis. Our internally generated cash flow is seasonal and is typically lowest in the first quarter of the year, when revenue is lowest, and greatest in the fourth quarter of the year, when revenue is highest. The seasonal nature of our internally generated cash flow can result in a mismatch with funding needs for working capital and ongoing capital expenditures, which we manage using available cash on hand and, as necessary, borrowings under our revolving credit facility. In the absence of a large strategic acquisition or other extraordinary events, we believe our cash on hand, cash flow from operations and availability under our revolving credit facility will be sufficient to meet our anticipated cash requirements for the foreseeable future, and at a minimum for the next 12 months. We may seek to take advantage of opportunities to refinance existing debt instruments, as we have done in the past, with new debt instruments at interest rates, maturities and on terms we consider attractive. As of December 31, 2019, the Company had $1.8 billion of liquidity, consisting of cash on hand of $813.2 million and our undrawn revolving credit facility of $1.0 billion. In August 2018, the $450.0 million Second Lien Loan was repaid with IPO proceeds of approximately $1.0 billion; the new Credit Agreement was entered into to increase liquidity and extend maturity; the First Lien Loan was repaid; and the revolving credit facility was modified which expanded borrowing capacity from $486.0 million to $810.0 million, which was further expanded to $1.0 billion in December 2019. As of December 31, 2019, we have not drawn on our Revolver. The Company had outstanding debt of $2.6 billion as of December 31, 2019, which net of cash on hand, provided for a net debt position of approximately $1.8 billion. The increase in net debt of approximately $58.3 million from December 31, 2018 was attributed to an increase in cash spending on acquisitions in 2019. Our level of indebtedness increases the possibility that we may be unable to pay the principal amount of our indebtedness and other obligations when due. In addition, we may incur additional debt from time to time to finance strategic acquisitions, investments, joint ventures or for other purposes, subject to the restrictions contained in the documents governing our indebtedness. If we incur additional debt, the risks associated with our leverage, including our ability to service our debt, would increase. See “Risk Factors." Despite our current indebtedness levels, we and our subsidiaries may still be able to incur substantially more debt, which could further exacerbate the risks associated with our substantial leverage. The second long-term liquidity need is the payment of obligations related to acquisitions. For the year ended December 31, 2019, we paid $275.9 million in cash consideration for our various acquisitions, net of cash acquired. Our acquisition structures often include deferred and/or contingent payments in future periods that are subject to the passage of time, achievement of certain performance metrics and/or other conditions. As of December 31, 2019 and 2018, we had accrued $65.1 million and $73.0 million, respectively, of deferred and earn-out consideration payable, which was included in Accounts payable and accrued expenses and in Other long-term liabilities in the accompanying audited consolidated balance sheets. Of the total balance as of December 31, 2019 and 2018, we have accrued $24.6 million and $38.3 million for earn-out consideration, respectively. As of December 31, 2019, the maximum potential payment for these earn-outs was $30.6 million, subject to the achievement of certain performance conditions. As a professional services firm, funding our operating activities is not capital intensive. Total capital expenditures for the year ended December 31, 2019 were $80.3 million. Historical Cash Flows Operating Activities We provided $269.3 million of cash for operating activities for the year ended December 31, 2019, a change of $271.5 million from the prior year. The change was driven primarily by an increase of $186.0 million to net income and a $124.1 million prior year one-time payment related to our Cassidy Turley deferred purchase obligation. Investing Activities We used $274.9 million in cash for investing activities for the year ended December 31, 2019, an increase of $56.9 million from the prior year. The change was driven primarily by acquisitions of businesses, net of cash acquired in the amount of $275.9 million. Financing Activities Financing activities used $89.6 million in cash for the year ended December 31, 2019, a change of $815.5 million from the prior year, primarily driven by proceeds from the initial public offering and concurrent private placement in 2018 of approximately $1.0 billion, partially offset by the $450.0 million repayment of the Second Lien loan in 2018. Summary of Contractual Obligations The following is a summary of our various contractual obligations and other commitments as of December 31, 2019 (in millions): Debt obligations. Represents the gross outstanding long-term debt balance payable at maturity, excluding unamortized discount and issuance costs. Because the majority of our debt bears interest at variable rates, the precise amount of annual interest payments cannot be determined and such amounts are therefore excluded from the table above. Using rates at December 31, 2019, expected annual interest payments would be approximately $137.9 million until our facility matures in 2025. See Note 9: Long-term Debt and Other Borrowings of the Notes to the audited Consolidated Financial Statements for further discussion. Lease obligations. Our lease obligations primarily consist of operating leases of office space in various buildings for our own use. See Note 13: Leases of the Notes to the audited Consolidated Financial Statements for further discussion. Defined benefit plan obligations. Represents estimates of the expected benefits to be paid out by our defined benefit plans. These obligations will be funded from the assets held by these plans. If the assets these plans hold are not sufficient to fund these payments, we will fund the remaining obligations. We have historically funded pension costs as actuarially determined and as applicable laws and regulations require. We expect to contribute to our defined benefit pension plans in 2019; see Note 10: Employee Benefits of the Notes to the audited Consolidated Financial Statements for further discussion. Other contractual obligations recorded on the balance sheet include deferred consideration of $40.5 million and contingent consideration of $24.6 million as of December 31, 2019. These items are not included in the table above, as timing and amount of payments cannot be determined due to their nature as estimates or outcomes having connection to future events. As of December 31, 2019, our current and non-current tax liabilities, including interest and penalties, totaled $88.0 million. Of this amount, we can reasonably estimate that $54.5 million will require cash settlement in less than one year. We are unable to reasonably estimate the timing of the effective settlement of tax positions for the remaining $33.5 million. Off-Balance Sheet Arrangements The Company’s guarantees primarily relate to requirements under certain client service contracts through the normal course of business. Our current expectation is that future payment or performance related to non-performance under these guarantees is considered remote. See Note 14: Commitments and Contingencies of the Notes to the audited Consolidated Financial Statements for further information. The Company is party to an A/R Securitization arrangement whereby it continuously sells trade receivables to an unaffiliated financial institution, which has an investment limit of $125.0 million. Receivables are derecognized from our balance sheet upon sale, for which we receive cash payment and record a deferred purchase price receivable. As of December 31, 2019, the Company has not reached the investment limit. The A/R Securitization terminates on August 20, 2022, unless extended or an earlier termination event occurs. See Note 17: Accounts Receivable Securitization of the Notes to the audited Consolidated Financial Statements for further information. Indebtedness We have incurred debt to finance the acquisitions of DTZ, Cassidy Turley and C&W Group, Inc. In addition, we may incur additional debt from time to time to finance strategic acquisitions, investments, joint ventures or for other purposes, subject to the restrictions contained in the documents governing our indebtedness. 2018 Credit Agreement On August 21, 2018, we entered into a $3.5 billion credit agreement, comprised of a $2.7 billion term loan and an $810 million revolving facility, which was expanded to $1.0 billion in December 2019. Net proceeds from the 2018 First Lien Loan were $2.7 billion ($2.7 billion aggregate principal amount less $13.5 million stated discount and $20.6 million in debt transaction costs). With the proceeds from the 2018 First Lien Loan, we subsequently paid off all outstanding principal and accrued interest of $2.6 billion and $25.9 million, respectively, under the credit agreement dated as of November 4, 2014 (the “2014 Credit Agreement”), respectively, which also resulted in the write-off of unamortized deferred financing fees of $39.2 million. The 2018 Credit Agreement bears interest at a variable interest rate that we may select pursuant to the terms of the 2018 Credit Agreement. As of the year ended December 31, 2019, the rate is equal to 1-month LIBOR plus 3.25%. The 2018 First Lien Loan matures on August 21, 2025. The effective interest rate of the 2018 First Lien Loan is 5.3% as of December 31, 2019. The 2018 Credit Agreement requires quarterly principal payments equal to 0.25% of the aggregate principal amount of the 2018 First Lien Loan, including incremental borrowings. Revolver As of December 31, 2019, we had 0 outstanding funds drawn under the Revolver, which matures on August 21, 2023. The Company did not draw on the Revolver at any point during 2019. Financial Covenants and Terms The 2018 Credit Agreement has a springing financial covenant that is tested on the last day of each fiscal quarter if the outstanding loans under the Revolver exceed an applicable threshold. If the financial covenant is triggered, the First Lien Net Leverage Ratio is tested for compliance not to exceed 5.80 to 1.00. The financial covenant has not been triggered since we entered into the 2018 Credit Agreement. Similarly, the financial covenant under our original First Lien Credit Agreement was not triggered in any period since its inception in 2014. The Company was in compliance with all of its loan provisions under its 2018 First Lien Credit Agreement as of December 31, 2019. Derivatives We are exposed to certain risks arising from both business operations and economic conditions, including interest rate risk and foreign currency risk. We manage interest rate risk primarily by managing the amount, sources and duration of debt funding and by using derivative financial instruments. Derivative financial instruments are used to manage differences in the amount, timing and duration of known or expected cash payments principally related to borrowings under our 2018 First Lien Credit Agreement as well as certain foreign currency exposures. See Note 8: Derivative Financial Instruments and Hedging Activities of the Notes to audited Consolidated Financial Statements as well as "Quantitative and Qualitative Disclosures About Market Risk" for additional information about risks managed through derivative activities. Debt Refinancing In January 2020, the Company refinanced the aggregate principal amount of its $2.7 billion term loan under substantially identical terms, including the same maturity date of August 21, 2025, except that the applicable margin on the LIBOR for the replacement term loan in respect of the Eurodollar Rate Loans is 2.75% as compared to 3.25%, and for the Base Rate Loans is 1.75% compared to 2.25%.
0.087175
0.087374
0
<s>[INST] As discussed in “Cautionary Note Regarding ForwardLooking Statements,” the following discussion and analysis contains forwardlooking statements that involve risks and uncertainties. Our actual results may materially differ from those discussed in such forwardlooking statements. Factors that could cause or contribute to these differences include, but are not limited to, those identified below and those discussed in “Risk Factors” under Part I, Item 1A in this Annual Report. Our fiscal year ends December 31. With respect to presentation, all statements asserting an "increase" or "decrease" relate to changes from prior applicable periods of comparison. Overview Cushman & Wakefield is a leading global commercial real estate services firm, built on a trusted brand and backed by approximately 53,000 employees and serving the world's real estate owners and occupiers through a scalable platform. We operate from approximately 400 offices in 60 countries, managing over 4.1 billion square feet of commercial real estate space on behalf of institutional, corporate and private clients. Our business is focused on meeting the increasing demands of our clients across multiple service lines including Property, facilities and project management, Leasing, Capital markets and Valuation and other services. Critical Accounting Policies Our audited Consolidated Financial Statements have been prepared in accordance with U.S. GAAP, which requires us to make estimates and assumptions that affect reported amounts. The estimates and assumptions are based on historical experience and on other factors that we believe to be reasonable. Actual results may differ from those estimates. We review these estimates on a periodic basis to ensure reasonableness. Although actual amounts may differ from such estimated amounts, we believe such differences are not likely to be material. For additional detail regarding our critical accounting policies, see Note 2: Summary of Significant Accounting Policies of the Notes to the audited Consolidated Financial Statements. Recently Issued Accounting Pronouncements See recently issued accounting pronouncements within Note 2: Summary of Significant Accounting Policies of the Notes to the audited Consolidated Financial Statements. Leases The Company adopted ASU No. 201811, Topic 842, effective January 1, 2019, which improves clarity and comparability by disclosing the recognition of lease assets and lease liabilities on the balance sheet as well as key leasing arrangements. Refer to Note 13: Leases of the Notes to the audited Consolidated Financial Statements for the impact the adoption of these standards had on the Company's financial statements and related disclosure. Revenue Recognition The Company principally earns revenue from Property, facilities and project management, Leasing, Capital markets and Valuation and other. In 2018, the Company adopted ASU No. 201409, Topic 606 ("Topic 606"), which replaced most existing revenue recognition guidance under U.S. GAAP. The core principle of Topic 606 requires companies to reevaluate when revenue is recorded on a transaction based upon newly defined criteria, either at a point in time or over time as goods or services are delivered. Under current revenue recognition, revenue is recognized upon transfer of control of promised services to clients in an amount that reflects the consideration the Company expects to receive in exchange for those services. For further information regarding the impact of the adoption of this standard on the audited Consolidated Financial Statements and related disclosures, as well as significant judgments performed by the Company when applying Topic 606, refer to Note 2: Summary of Significant Accounting Policies and Note 5: Revenue from the Notes to the audited Consolidated Financial Statements for the year ended December 31, 2019. Business Combinations, Goodwill and IndefiniteLived Intangible Assets The Company has grown, in part, through a series of acquisitions. See Note 1: Organization and Business Overview of the Notes to the audited Consolidated Financial Statements. We account for business combinations using the acquisition method of accounting, which requires that once control is obtained, all of the assets acquired and liabilities assumed, including amounts attributable to noncontrolling interests, be recorded at their respective fair values as of the acquisition date [/INST] Positive. </s>
2,020
6,578
1,730,430
Kiniksa Pharmaceuticals, Ltd.
2019-03-12
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 appearing elsewhere in this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10-K, including information with respect to our plans and strategy for our business, 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, that involve risks and uncertainties. As a result of many factors, including those factors set forth in the risks identified in Part I-Item 1A “Risk Factors’’ section of this Annual Report on Form 10-K and our other filings with the Securities and Exchange Commission, or SEC, our actual results could differ materially from the results, performance or achievements expressed in or implied by these forward-looking statements. Overview We are a biopharmaceutical company focused on discovering, acquiring, developing and commercializing therapeutic medicines for patients suffering from debilitating diseases with significant unmet medical need. We have a pipeline of product candidates across various stages of development, focused on autoinflammatory and autoimmune conditions. We believe that our product candidates are grounded in strong biologic rationales or validated mechanisms of action and have the potential to address multiple indications. Our product candidates include rilonacept, mavrilimumab, KPL-716, KPL-404 and KPL-045. Our lead candidate is rilonacept, an interleukin-1α, and interleukin-1β, cytokine trap. We are developing rilonacept for the potential treatment of recurrent pericarditis, an inflammatory cardiovascular disease and are enrolling a single, pivotal, placebo-controlled, randomized-withdrawal design, global Phase 3 clinical trial of rilonacept in subjects with recurrent pericarditis, named RHAPSODY. We also have an ongoing open-label Phase 2 proof-of-concept clinical trial in subjects with both symptomatic recurrent pericarditis as well as other patient subsets within pericarditis, including asymptomatic steroid-dependent subjects with recurrent pericarditis and subjects with post-pericardiotomy syndrome. We completed enrollment in this trial and presented interim data from this trial in December 2018. We expect to present additional data at the American College of Cardiology 68th Annual Scientific Session & EXPO 2019 in March 2019. Mavrilimumab is a monoclonal antibody that antagonizes colony stimulating factor. We are evaluating mavrilimumab for the potential treatment of giant cell arteritis, or GCA, an inflammatory disease of the blood vessels. We have commenced dosing in multiple countries in a randomized, double-blind, placebo-controlled, Phase 2 proof-of-concept trial for the study of mavrilimumab in GCA. In the United States, the FDA initially placed our IND for the trial on clinical hold due to its request for additional information regarding the 510(k)-cleared delivery device to be used in our trial. We have since provided the FDA with the requested information and our IND is now active. We plan for U.S. subjects to be included in our ongoing, global Phase 2 proof-of-concept clinical trial. KPL-716 is a monoclonal antibody that simultaneously inhibits the signaling of the cytokines interleukin 31, or IL 31, and oncostatin M, or OSM, by targeting their common receptor subunit, oncostatin M receptor beta. We plan to study KPL-716 in a variety of pruritic, inflammatory, and fibrotic indications driven by these cytokines. In September 2018, we announced interim results from the randomized, double-blind, placebo-controlled, single-ascending-dose, sequential-group portion of the Phase 1a/1b clinical trial in healthy volunteers and in subjects with moderate-to-severe atopic dermatitis experiencing moderate-to-severe pruritus. We are enrolling a 12-week, repeated single-dose cohort as an additional part of the Phase 1b portion of the Phase 1a/1b clinical trial in subjects with moderate-to-severe atopic dermatitis experiencing moderate-to-severe pruritus. We expect to report top-line data from this cohort in the second half of 2019. We plan to initiate an adaptive design Phase 2a/2b clinical trial in prurigo nodularis in the first half of 2019 and expect to report top-line data from the first part of this trial in the first half of 2020. We also plan to initiate an exploratory, pilot Phase 2 clinical trial in the first half of 2019 designed to explore the role of IL-31 and OSM in a number of diseases characterized by chronic pruritus and plan to report top-line data from this trial in the second half of 2020. KPL-404 is a monoclonal antibody inhibitor of the CD40 co-stimulatory molecule. We are continuing our pre-clinical activities with KPL-404 in T-cell dependent, B-cell mediated diseases, and expect to file an IND with the FDA for this program in the second half of 2019 and initiate a Phase 1 clinical trial in the first half of 2020. In September 2017, we licensed the right to conduct research and development on KPL-404 from Primatope Therapeutics, Inc., or Primatope, the company that owned or controlled the intellectual property related to KPL-404. In March 2019, we acquired all of the issued and outstanding equity securities of Primatope in exchange for upfront consideration of $10.0 million at closing as well as milestone payments of up to $8.0 million ($5.0 million of which had been achieved as of the closing date and was paid at closing), each paid or payable in a combination of cash and our Class A common shares (inclusive of escrow and holdback amounts) in accordance with the terms and conditions of our stock purchase option agreement with Primatope. KPL-045, is a monoclonal antibody inhibitor of the CD30L co-stimulatory molecule. We are evaluating the progression of KPL-045 pending preclinical data from the program in the context of our portfolio. Since our inception in 2015, we have devoted substantially all of our efforts and financial resources to organizing and staffing our company, business planning, raising capital, acquiring, in-licensing or discovering product candidates and securing related intellectual property rights and conducting research and development activities for our programs. We do not have any products approved for sale and have not generated any revenue from product sales. We may never be able to develop or commercialize a marketable product. We have not yet successfully completed any Phase 3 or other pivotal clinical trials, obtained any regulatory approvals, manufactured a commercial-scale drug, or conducted sales and marketing activities. Prior to the completion of our initial public offering, or IPO, in May 2018, we had funded our operations primarily with proceeds from the sale of preferred shares, from which we received net proceeds of $310.6 million. On May 23, 2018, our registration statement on Form S-1 relating to our IPO was declared effective by the SEC. On May 29, 2018, we completed our IPO of 8,477,777 Class A common shares at $18.00 per share for gross proceeds of $152.6 million. In addition, on June 22, 2018, we completed the sale of 1,006,425 Class A common shares to the underwriters of the IPO following the exercise of their over-allotment option to purchase additional shares at $18.00 per share for gross proceeds of $18.1 million. The aggregate net proceeds to us from the IPO, inclusive of the over-allotment option exercise, was $155.5 million after deducting underwriting discounts and commissions and other offering costs. Upon the closing of the IPO, all convertible preferred shares then outstanding automatically converted into 5,546,019 Class A common shares, 1,070,502 Class B common shares, 12,995,954 Class A1 common shares and 16,057,618 Class B1 common shares. On February 4, 2019, we completed a follow-on offering of 2,654,984 Class A common shares and concurrent private placement of 2,000,000 Class A1 common shares, both at $18.26 per share for aggregate gross proceeds of $85.0 million. In addition, on March 1, 2019, we completed the sale of 161,126 Class A common shares to the underwriters of the follow-on offering following the exercise in part of their over-allotment option to purchase additional shares at $18.26 per share for gross proceeds of $2.9 million. The aggregate net proceeds to us from the follow-on offering and concurrent private placement, inclusive of the over-allotment option exercise, was $83.0 million after deducting underwriting discounts and commissions and other offering costs. We have incurred significant operating losses since inception. 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. Our net losses were $103.2 million and $64.9 million for the years ended December 31, 2018 and 2017, respectively. As of December 31, 2018 and 2017, we had an accumulated deficit of $194.2 million and $91.0 million, respectively. We expect to continue to incur significant operating losses for at least the next several years as we advance our product candidates through all stages of development and clinical trials and, ultimately, seek regulatory approval. In addition, if we obtain marketing approval for any of our product candidates, we expect to incur significant commercialization expenses related to product manufacturing, marketing, sales and distribution. We may also incur expenses in connection with the in-licensing or acquisition of additional product candidates. We expect to continue to incur additional costs associated with operating as a public company, including significant legal, accounting, investor relations and other expenses that we did not incur as a private company. As a result, we will need substantial additional funding to support our continuing operations and pursue our growth strategy. Until such time as we can generate significant revenue from product sales, if ever, we expect to finance our operations through the sale of equity, debt financings or other capital sources, which may include collaborations with other companies or other strategic transactions. We may be unable to raise additional funds or enter into such other agreements or arrangements when needed on favorable terms, or at all. If we fail to raise capital or enter into such agreements as and when needed, we may have to significantly delay, scale back or discontinue the development and commercialization of one or more of our product candidates or delay our pursuit of potential in-licenses or acquisitions. Because of the numerous risks and uncertainties associated with product development, we are unable to predict the timing or amount of increased expenses or when or if we will be able to achieve or maintain profitability. Even if we are able to generate product sales, we may not become profitable. If we fail to become profitable or are unable to sustain profitability on a continuing basis, then we may be unable to continue our operations at planned levels and be forced to reduce or terminate our operations. As of December 31, 2018 and 2017, we had cash, cash equivalents and short-term investments of $307.3 million and $45.6 million, respectively. We believe that our existing cash, cash equivalents and short-term investments, will enable us to fund our operating expenses and capital expenditure requirements for at least the next 12 months. We have based this estimate 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.” Our future viability beyond that point is dependent on our ability to raise additional capital to finance our operations. Components of Our Results of Operations Revenue To date, we have not generated any revenue from product sales and do not expect to generate any revenue from the sale of products in the foreseeable future. If our development efforts for our product candidates are successful and result in regulatory approval, we may generate revenue in the future from product sales. Operating Expenses Research and Development Expenses Research and development expenses consist primarily of costs incurred in connection with the discovery and development of our product candidates. We expense research and development costs as incurred. These expenses may include: · expenses incurred to conduct the necessary pre-clinical studies and clinical trials required to obtain regulatory approval; · expenses incurred under agreements with contract research organizations, or CROs, that are primarily engaged in the oversight and conduct of our clinical trials and contract manufacturing organizations, or CMOs, that are primarily engaged to provide pre-clinical and clinical drug substance and product for our research and development programs; · other costs related to acquiring and manufacturing pre-clinical studies and clinical trial materials, including manufacturing validation batches, as well as investigative sites and consultants that conduct our clinical trials, pre-clinical studies and other scientific development services; · payments made in cash or equity securities under third-party licensing, acquisition and option agreements; · employee-related expenses, including salaries and benefits, travel and share-based compensation expense for employees engaged in research and development functions; · costs related to compliance with regulatory requirements; and · allocated facilities-related costs, depreciation and other expenses, which include rent and utilities. We recognize external development costs based on an evaluation of the progress to completion of specific tasks using information provided to us by our service providers. 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 actual costs. Nonrefundable advance payments for goods or services to be received in the future for use in research and development activities are recorded as prepaid expenses. Such amounts are recognized as an expense as the goods are delivered or the related services are performed, or until it is no longer expected that the goods will be delivered or the services rendered. Our direct research and development expenses are tracked on a program-by-program basis for our product candidates and consist primarily of external costs, such as fees paid to outside consultants, CROs, CMOs and research laboratories in connection with our pre-clinical development, process development, manufacturing and clinical development activities. Our direct research and development expenses by program also include fees incurred under license, acquisition and option agreements. We do not allocate employee costs or facility expenses, including depreciation or other indirect costs, to specific programs because these costs are deployed across multiple programs and, as such, are not separately classified. We use internal resources primarily to conduct our research and discovery as well as for managing our pre-clinical development, process development, manufacturing and clinical development activities. The table below summarizes our research and development expenses incurred by program: (1)The amount for the year ended December 31, 2017 includes expense of $5.0 million related to an upfront payment under our license agreement with Regeneron. (2)The amount for the year ended December 31, 2018 consists of $5.0 million related to a pass-through payment due upon the achievement of a specified clinical milestone event due under our license agreement with MedImmune. The amount for the year ended December 31, 2017 consists of $18.0 million related to an upfront payment and an accrued milestone under our license agreement with MedImmune. (3)The amount for the year ended December 31, 2017 includes expense of $4.0 million related to a milestone payment under our asset purchase agreement with Biogen associated with the achievement of a specified clinical milestone event. (4)The amount for the year ended December 31, 2018 includes expense of $0.8 million related to the extension of the option period under our stock purchase option agreement with Primatope. The amount for the year ended December 31, 2017 includes expense of $0.5 million related to upfront payments for the initial option period under our stock purchase option agreement with Primatope. (5)The amount for the year ended December 31, 2017 includes expense of $1.5 million related to an upfront payment under our license agreement with Novo Nordisk. 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. As a result, we expect that our research and development expenses will increase substantially over the next several years as we complete our ongoing and planned clinical trials for rilonacept, mavrilimumab and KPL-716, as well as conduct other pre-clinical and clinical development including regulatory filings for our other product candidates and our discovery research efforts and our related personnel costs will increase, including costs associated with share-based compensation. We also expect to incur additional expenses related to milestone and royalty payments payable to third parties with whom we have entered into license, acquisition and option agreements to acquire the rights to our product candidates. The successful development and commercialization of our product candidates is highly uncertain. At this time, we cannot reasonably estimate or know the nature, timing and costs of the efforts that will be necessary to complete the pre-clinical and clinical development of any of our product candidates or when, if ever, material net cash inflows may commence from any of our product candidates. This uncertainty is due to the numerous risks and uncertainties associated with product development and commercialization, including the uncertainty of: · the scope, progress, outcome and costs of our pre-clinical development activities, clinical trials and other research and development activities; · establishing an appropriate safety and efficacy profile with Investigational New Drug, or IND, enabling and clinical studies; · successful patient enrollment in and the initiation and completion of clinical trials; · the timing, receipt and terms of any marketing approvals from applicable regulatory authorities including the U.S. Federal Drug Administration, or FDA; · the extent of any required post-marketing approval commitments to applicable regulatory authorities; · establishing clinical and commercial manufacturing capabilities or making arrangements with third-party manufacturers in order to ensure that we or our third-party manufacturers are able to make product successfully; · development and timely delivery of clinical-grade and commercial-grade drug formulations that can be used in our clinical trials and for commercial launch; · obtaining, maintaining, defending and enforcing patent claims and other intellectual property rights; · significant and changing government regulation; · launching commercial sales of our product candidates, if and when approved, whether alone or in collaboration with others; and · maintaining a continued acceptable safety profile of our product candidates following approval, if any, of our product candidates. General and administrative expenses General and administrative expenses consist primarily of salaries and benefits, travel and share-based compensation expense for personnel in executive, business development, finance, human resources, legal, information technology, pre-commercial and support personnel functions. General and administrative expenses also include insurance and professional fees for legal, patent, consulting, accounting and audit services. We expect that our general and administrative expenses will continue to increase in the future as we increase our headcount to support our continued research activities and development of our product candidates and prepare for potential commercialization activities. We also anticipate that we will incur increased accounting, audit, legal, regulatory, compliance and director and officer insurance costs as well as investor and public relations expenses associated with being a public company. Interest income Interest income consists of income recognized from investments in money market funds and U.S. Treasury notes. Income taxes As an exempted company incorporated under the laws of Bermuda, we are principally subject to taxation in Bermuda. Under the current laws of Bermuda, tax on a company’s income is assessed at a zero percent tax rate. As a result, we have not recorded any income tax benefits from our losses incurred in Bermuda during each reporting period, and no net operating loss carryforwards will be available to us for those losses. Our wholly owned U.S. subsidiary, Kiniksa Pharmaceuticals Corp., or Kiniksa US, is subject to federal and state income taxes in the United States. Our provision for income taxes relates to taxable income generated by Kiniksa US under a cost-plus arrangement that it has with us. As of December 31, 2018, we had state research and development tax credit carryforwards of approximately $0.1 million available to reduce future tax liabilities, which begin to expire in 2033. 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 $86.6 million for the year ended December 31, 2018, compared to $56.4 million for the year ended December 31, 2017. The increase of $30.2 million was primarily due to a $15.2 million increase in external fees related to our development programs, as well as an increase of $15.0 million in unallocated research and development expenses. The direct costs for our rilonacept program were $13.5 million for the year ended December 31, 2018, compared to $6.3 million during the year ended December 31, 2017, or an increase of $7.2 million. During the year ended December 31, 2018, expenses incurred related to clinical research and development for our Phase 2 open label clinical trial and initiation of our Phase 3 clinical trial compared to the year ended December 31, 2017, in which expenses incurred were primarily due to the $5.0 million upfront payment made under our license agreement with Regeneron. The direct costs of $15.3 million for our mavrilimumab program during the year ended December 31, 2018 were due to $5.0 million related to a pass-through payment due upon the achievement of a specified clinical milestone event due under our license agreement with MedImmune as well as expenses related to preparation for our planned clinical trials, including a Phase 2 trial in GCA and manufacturing process development related expenses compared to the year ended December 31, 2017 in which the expenses incurred related primarily to the $8.0 million upfront payment and $10.0 million accrued milestone under our license agreement with MedImmune. The direct costs for our KPL-716 program were $25.6 million for the year ended December 31, 2018, compared to $24.2 million during the year ended December 31, 2017, or an increase of $1.4 million. During the year ended December 31, 2018, expenses incurred related to manufacturing and development costs for our clinical drug supply and our Phase 1a/1b clinical trial, compared to the year ended December 31, 2017, in which expenses incurred also included a $4.0 million milestone payment made upon the achievement of a specified clinical milestone event under our agreement with Biogen. The direct costs for our KPL-404 program were $6.0 million during the year ended December 31, 2018, compared to $0.5 million during the year ended December 31, 2017, or an increase of $5.4 million. During the year ended December 31, 2018, expenses incurred primarily related to clinical research and development, including manufacturing development costs as well as $0.8 million related to the extension of the option period under our stock purchase option agreement with Primatope, compared to the year ended December 31, 2017, in which expenses incurred related to the $0.5 million initial option period payment under our stock purchase option agreement with Primatope. The direct costs for our KPL-045 program were $5.7 million during the year ended December 31, 2018, compared to $1.7 million during the year ended December 31, 2017, or an increase of $4.0 million. During the year ended December 31, 2018, expenses incurred related to clinical research and development, including manufacturing development costs, compared to the year ended December 31, 2017, in which expenses incurred related primarily to the upfront payment of $1.5 million made under our license agreement with Novo Nordisk. Unallocated research and development expenses were $20.7 million for the year ended December 31, 2018 compared to $5.7 million for the year ended December 31, 2017. The increase of $15.0 million in unallocated research and development expenses was due to an increase of $10.5 million in personnel-related costs, including share-based compensation, and an increase of $4.5 million in other costs, including research costs related to potential future programs. The increase in personnel-related costs was primarily due to the hiring of additional personnel in our research and development functions, particularly those responsible for coordinating with CMOs on process development and manufacturing of drug supply and coordinating with CROs on the conduct and oversight of our current and planned clinical trials as well as research studies and development programs for our product candidates. Personnel-related costs for the year ended December 31, 2018 and 2017 included share-based compensation of $2.3 million and $0.3 million, respectively. General and Administrative Expenses General and administrative expenses were $21.6 million for the year ended December 31, 2018 compared to $9.0 million for the year ended December 31, 2017. The increase of $12.6 million was primarily due to increases of $7.7 million in personnel-related costs and $3.4 million in professional fees. The increase in personnel-related costs was due to the hiring of additional personnel in our general and administrative functions, primarily in our corporate departments, including legal, finance and human resources, as we became a public company and continued to expand our operations to support the organization. Personnel-related costs for the year ended December 31, 2018 and 2017 included share-based compensation of $3.4 million and $0.6 million, respectively. Professional fees increased due to legal costs incurred in connection with maintaining and registering worldwide patents and costs associated with our ongoing business operations, as well as higher recruiting, market research expenses, accounting and other costs incurred due to becoming a public company. Interest Income Interest income was $4.7 million for the year ended December 31, 2018 compared to $0.5 million for the year ended December 31, 2017. The increase was due to both higher average invested balances and higher interest rates on U.S. Treasury notes in 2018. Benefit (Provision) for Income Taxes We recorded an insignificant benefit (provision) for income taxes for the year ended December 31, 2018 and 2017. Liquidity and Capital Resources Since our inception, we have not generated any revenue from any sources, including from product sales, and have incurred significant operating losses and negative cash flows from our operations. Prior to the completion of our IPO in May 2018, we funded our operations primarily with proceeds from the sale of preferred shares, from which we had received net proceeds of $310.6 million. On May 23, 2018, our registration statement on Form S-1 relating to our IPO was declared effective by the SEC. On May 29, 2018, we completed the IPO of 8,477,777 Class A common shares at $18.00 per share for gross proceeds of $152.6 million. In addition, on June 22, 2018, we completed the sale of 1,006,425 Class A common shares to the underwriters of the IPO following the exercise of their over-allotment option to purchase additional shares at $18.00 per share, for gross proceeds of $18.1 million. The aggregate net proceeds to us from the IPO, inclusive of the over-allotment option exercise, was $155.5 million after deducting underwriting discounts and commissions and other offering costs. On February 4, 2019, we completed a follow-on offering of 2,654,984 Class A common shares and concurrent private placement of 2,000,000 Class A1 common shares, both at $18.26 per share for aggregate gross proceeds of $85.0 million. In addition, on March 1, 2019, we completed the sale of 161,126 Class A common shares to the underwriters of the follow-on offering following the exercise in part of their over-allotment option to purchase additional shares at $18.26 per share for gross proceeds of $2.9 million. The aggregate net proceeds to us from the follow-on offering and concurrent private placement, inclusive of the over-allotment option exercise, was $83.0 million after deducting underwriting discounts and commissions and other offering costs. As of December 31, 2018, we had cash, cash equivalents and short-term investments of $307.3 million. Cash Flows The following table summarizes our cash flows for each of the periods presented: Operating Activities During the year ended December 31, 2018, operating activities used $81.0 million of cash, primarily resulting from our net loss of $103.2 million, partially offset by net non-cash charges of $3.9 million and net cash provided by changes in our operating assets and liabilities of $18.3 million. Net cash provided by changes in our operating assets and liabilities for the year ended December 31, 2018 consisted of a $14.3 million increase in accrued expenses and other liabilities and a $8.8 million increase in accounts payable, partially offset by a $4.8 million increase in prepaid expenses and other current assets. The increase in accrued expenses was primarily due to our increased level of operating activities and the timing of vendor invoicing and payments, an increase in accrued milestones as well as an increase in accrued employee compensation expense. The increase in accounts payable was primarily due to increased operating activities as well as the timing of vendor invoicing and payments. The increase in prepaid expenses and other current assets was due to increases in prepaid insurance expenses, interest receivable and prepaid expenses to CMOs related to manufacturing development and CROs related to our clinical trials. During the year ended December 31, 2017, operating activities used $50.2 million of cash, primarily resulting from our net loss of $64.9 million, partially offset by non-cash charges of $0.7 million and net cash provided by changes in our operating assets and liabilities of $13.9 million. Net cash provided by changes in our operating assets and liabilities for the year ended December 31, 2017 consisted of a $14.1 million increase in accrued expenses and a $1.0 million increase in accounts payable, both partially offset by a $1.2 million increase in prepaid expenses and other current assets. The increase in accrued expenses was primarily due to an accrued milestone of $10.0 million related to our mavrilimumab program, increased clinical trial and manufacturing activities as well as increased accrued legal and professional fees and accrued employee compensation-related expenses. The increase in accounts payable was due to our increased level of operating activities and the timing of vendor invoicing and payments. The increase in prepaid expenses and other current assets was primarily due to prepaid clinical trial and manufacturing costs associated with our research and development programs. Investing Activities During the year ended December 31, 2018, investing activities used $239.2 million of cash, consisting of $5.3 million of purchases of property and equipment and $402.0 million of purchases of short-term investments partially offset by $168.1 million from proceeds of maturities of short-term investments. During the year ended December 31, 2017, investing activities used $0.1 million of cash, consisting of purchases of property and equipment. Financing Activities During the year ended December 31, 2018, net cash provided by financing activities was $346.7 million, primarily consisting of proceeds of $159.2 million from our issuance and sale of Class A common shares, net of underwriting commissions and discounts upon completion of our IPO, inclusive of the over-allotment option exercise, $190.8 million in net proceeds from our issuance and sale of Series C preferred shares, and $0.4 million in proceeds from the exercise of share options and our employee share purchase plan, partially offset by $3.7 million of payments of other offering costs associated with our IPO, inclusive of the over-allotment option exercise. During the year ended December 31, 2017, net cash provided by financing activities was $39.9 million, consisting of net proceeds from our issuance and sale of Series B preferred shares. Funding Requirements We expect our expenses to increase substantially in connection with our ongoing activities, particularly as we advance the clinical trials and pre-clinical activities of our product candidates. Additionally, we expect to continue to incur additional costs associated with operating as a public company, including significant legal, accounting, investor relations and other expenses that we did not incur as a private company. Our expenses will also increase as we: · continue to conduct our current clinical trials and initiate our planned clinical trials, for rilonacept, mavrilimumab and KPL-716; · advance pre-clinical development of our early-stage programs; · manufacture, or have manufactured on our behalf, our pre-clinical and clinical drug material and develop processes for late stage and commercial manufacturing; · seek regulatory approvals for any product candidates that successfully complete clinical trials; · establish a sales, marketing, medical affairs and distribution infrastructure to commercialize any product candidates for which we may obtain marketing approval and intend to commercialize on our own; · hire additional clinical, quality control and scientific personnel; · expand our operational, financial and management systems and increase personnel, including personnel to support our clinical development, manufacturing and commercialization efforts and our operations as a public company; · maintain, expand and protect our intellectual property portfolio; and · in-license or acquire other product candidates and technologies or their related businesses. We believe that our existing cash, cash equivalents and short-term investments will enable us to fund our operating expenses and capital expenditure requirements for at least the next 12 months. We have based these estimates on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we expect. We anticipate that we may require additional capital if we choose to pursue in-licenses or acquisitions of other product candidates. If we receive regulatory approval for rilonacept or our other product candidates, we expect to incur significant commercialization expenses related to product manufacturing, sales, marketing and distribution, depending on where we choose to commercialize. Because of the numerous risks and uncertainties associated with research, development and commercialization of biologic product candidates, we are unable to estimate the exact amount of our working capital requirements. Our future funding requirements will depend on and could increase significantly as a result of many factors, including: · the scope, progress, results and costs of researching and developing our product candidates, and conducting pre-clinical and clinical trials; · the costs, timing and outcome of regulatory review of our product candidates; · the costs, timing and ability to manufacture our product candidates to supply our clinical and pre-clinical development efforts and our clinical trials; · the costs of future activities, including product sales, medical affairs, marketing, manufacturing and distribution, for any of our product candidates for which we receive marketing approval; · the costs of manufacturing commercial-grade product and necessary inventory to support commercial launch; · the ability to receive additional non-dilutive funding, including grants from organizations and foundations; · the revenue, if any, received from commercial sale of our products, should any of our product candidates receive marketing approval; · the costs of preparing, filing and prosecuting patent applications, maintaining and enforcing our intellectual property rights and defending intellectual property-related claims; · our ability to establish and maintain collaborations on favorable terms, if at all; · the extent to which we acquire or in-license other product candidates and technologies; and · the timing, receipt and amount of sales of, or milestone payments related to or royalties on, our current or future product candidates, if any. Until such time, if ever, as we can generate substantial product revenue, we expect to finance our cash needs through a combination of public or private equity offerings, debt financings, governmental funding, collaborations, strategic partnerships or marketing, distribution or licensing arrangements with third parties. To the extent that we raise additional capital through the sale of equity or convertible debt securities, our shareholders’ ownership interest may be materially diluted, and the terms of such securities could include liquidation or other preferences that adversely affect our shareholders’ rights as a common shareholder. Debt financing and preferred equity financing, if available, may involve agreements that include restrictive covenants that limit our ability to take specified actions, such as incurring additional debt, making capital expenditures or declaring dividends. In addition, debt financing would result in fixed payment obligations. If we raise funds through governmental funding, collaborations, strategic partnerships or marketing, distribution 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. If we are unable to raise additional funds when needed, we may be required to delay, reduce or eliminate our product development or future commercialization efforts. Contractual Obligations and Commitments 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)Represents a payment of $10.0 million we are obligated to make under our license agreement with MedImmune upon the earlier to occur of (a) the first achievement of a specified regulatory milestone for a product licensed under the agreement and (b) December 31, 2018 and a $5.0 million related to a pass-through payment due upon the achievement of a specified clinical milestone event under our license agreement with MedImmune. (2)Amounts in the table reflect commitments for costs associated with our external CMOs, which we have engaged to manufacture pre-clinical and clinical trial materials. Manufacturing commitments 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 preceding table are limited to the non-cancelable portion of the agreement terms or the minimum cancellation fee. (3)Amounts in the table reflect minimum payments due under operating lease agreements entered into by our wholly owned U.S. subsidiary Kiniksa US for office and laboratory space in Lexington, Massachusetts which expires in 2021 and office space in San Diego, California which expires in 2020. Our contracts with CMOs, CROs and other third parties for the manufacture of our product candidates and to support clinical trials and pre-clinical research studies and testing are generally cancelable by us upon prior notice. Payments due upon cancellation consisting only of payments for services provided or expenses incurred, including noncancelable obligations of our service providers, up to the date of cancellation are not included in the preceding table as the amount and timing of such payments are not known. Under various agreements with third parties, we have agreed to make milestone payments, pay royalties, annual maintenance fees and to meet due diligence requirements based upon specified milestones. We generally have not included any contingent payment obligations, such as milestones, royalties or due diligence, in the table above as the amount, timing and likelihood of such payments are not known. We have not included any of the annual maintenance fee payments in the above table, as although the amount and timing are known, we cannot currently determine the final termination dates of the agreements and, as a result, we cannot determine the total amounts of such payments we will be required to make under the agreements. Under our license agreement with Regeneron, we are obligated to make future regulatory milestone payments of $27.5 million in the aggregate. Thereafter, we have agreed to evenly split profits on our sales of rilonacept with Regeneron after deducting certain commercialization expenses subject to specified limits. Under our license agreement with MedImmune, we are obligated to make future clinical, regulatory and initial sales milestone payments of up to $72.5 million in aggregate for the first two indications we develop, including, a $5.0 million pass-through payment due upon the achievement of a specified clinical milestone event which was met in the fourth quarter of 2018. Also included is a milestone payment of $10.0 million due upon the earlier to occur of a specified regulatory milestone and December 31, 2018, and clinical and regulatory milestone payments of up to $15.0 million in the aggregate for each subsequent indication. The $10.0 million milestone payment was accrued on our consolidated balance sheet as of December 31, 2017 and recognized as research and development expense during the year ended December 31, 2017. The $5.0 million pass-through payment was accrued on our consolidated balance sheet as of December 31, 2018 and recognized as research and development expense during the year ended December 31, 2018. Such payments are included in the table above. We are also obligated to make milestone payments to MedImmune of up to $85.0 million upon the achievement of annual net sales thresholds of up to, but excluding, $1.0 billion in annual net sales as well as additional milestone payments aggregating up to $1.1 billion upon the achievement of additional specified annual net sales thresholds starting at $1.0 billion and higher. Commencing on the first commercial sale of licensed products, we are obligated to pay tiered royalties on escalating tiers of annual net sales of licensed products starting in the low double-digit percentages and ending at twenty percent. We must pay such royalties on a product-by-product and country-by-country basis until the latest to occur of the expiration of licensed patents, the expiration of regulatory exclusivity or the tenth anniversary of the first commercial sale of such product in such country. Under our asset purchase agreement with Biogen, we are obligated to make future milestone payments of up to $325.0 million upon the achievement of specified clinical and regulatory milestones as well as upon the achievement of annual net sales thresholds, including a $10.0 million payment due upon the achievement of a specified clinical milestone event which may be met in the first half of 2019. We have also agreed to pay certain obligations under third-party contracts retained by Biogen that relate to KPL-716. Additionally, we are obligated to pay tiered royalties on escalating tiers of annual net sales of licensed products starting in the high single-digit percentages and ending below the teens. Under our license agreement with Novo Nordisk, we are obligated to make future milestone payments upon the achievement of specified clinical, regulatory, initial sales milestones as well as upon the achievement of annual net sales thresholds, including a payment of $1.0 million upon the earlier to occur of a specified regulatory milestone and January 2020. We are also obligated to pay royalties on annual net sales of products licensed under the agreement. In addition, we are obligated to make a payment upon the completion of technology transfer. In March 2019, we acquired all of the issued and outstanding equity securities of Primatope in exchange for upfront consideration of $10.0 million at closing as well as milestone payments of up to $8.0 million ($5.0 million of which had been achieved as of the closing date and was paid at closing) each paid or payable in a combination of cash and our Class A common shares (inclusive of escrow and holdback amounts) in accordance with the terms and conditions of our stock purchase option agreement with Primatope. Critical Accounting Policies and Significant Judgments and Estimates Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States. The preparation of our consolidated financial statements and related disclosures requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue, costs and expenses, and the disclosure of contingent assets and liabilities in our financial statements. We base our estimates on historical experience, known trends and events and various other factors that we believe are 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. We evaluate our estimates and assumptions on an ongoing basis. Our 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 at the end of this prospectus, 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 Expenses As part of the process of preparing our consolidated financial statements, we are required to estimate our accrued research and development expenses. 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 actual costs. The majority of our service providers invoice us in arrears for services performed, on a pre-determined schedule or when contractual milestones are met; however, some require advanced payments. We make estimates of our accrued expenses as of each balance sheet date in the consolidated financial statements based on facts and circumstances known to us at that time. We periodically confirm the accuracy of these estimates with the service providers and make adjustments if necessary. Examples of estimated accrued research and development expenses include fees paid to: · vendors, including research laboratories, in connection with pre-clinical development activities; · CROs and investigative sites in connection with pre-clinical studies and clinical trials; and · CMOs in connection with drug substance and drug product formulation of pre-clinical studies and clinical trial materials. We base our expenses related to pre-clinical studies and clinical trials on our estimates of the services received and efforts expended pursuant to quotes and contracts with multiple research institutions and CROs that conduct and manage pre-clinical studies and clinical trials 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 expense. Payments under some of these contracts depend on factors such as the successful enrollment of patients and the completion of clinical trial milestones. 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 the estimate, we adjust the accrual or the amount of prepaid expenses 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 may result in reporting amounts that are too high or too low in any particular period. To date, there have not been any material adjustments to our prior estimates of accrued research and development expenses. Share-Based Compensation We measure options and other share-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 over the requisite service period, which is generally the vesting period of the respective award. We have only issued options and restricted share awards with service-based vesting conditions and record the expense for these awards using the straight-line method. For share-based awards granted to consultants and non-employees, we recognize compensation expense over the period during which services are rendered by such consultants and non-employees until completed. At the end of each financial reporting period prior to completion of the service, the fair value of these awards is remeasured using the then-current fair value of our Class A common shares and updated assumption inputs in the Black-Scholes option-pricing model. We estimate the fair value of each option grant using the Black-Scholes option-pricing model, which uses as inputs the fair value of our Class A common shares and assumptions we make for the volatility of our Class A common shares, the expected term of our options, the risk-free interest rate for a period that approximates the expected term of our options and our expected dividend yield. Until our IPO, we were a private company and we lacked company-specific historical and implied volatility information. Accordingly, we estimate our expected volatility based on the historical volatility of publicly traded peer companies and expect to continue to do so until such time as we have adequate historical data regarding the volatility of our traded share price. The expected term of our options has been determined utilizing the “simplified” method for awards that qualify as “plain-vanilla” options, while the expected term of our options granted to consultants and nonemployees has been determined based on the contractual term of the options. The risk-free interest rate is determined by reference to the U.S. Treasury yield curve in effect at the time of grant of the award for time periods approximately equal to the expected term of the award. Expected dividend yield is based on the fact that we have never paid cash dividends and do not expect to pay any cash dividends in the foreseeable future. Emerging Growth Company Status The Jumpstart Our Business 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. 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. Recently Issued Accounting Pronouncements 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 annual consolidated financial statements appearing at the end of this Annual Report on Form 10-K.
0.050984
0.05108
0
<s>[INST] Overview We are a biopharmaceutical company focused on discovering, acquiring, developing and commercializing therapeutic medicines for patients suffering from debilitating diseases with significant unmet medical need. We have a pipeline of product candidates across various stages of development, focused on autoinflammatory and autoimmune conditions. We believe that our product candidates are grounded in strong biologic rationales or validated mechanisms of action and have the potential to address multiple indications. Our product candidates include rilonacept, mavrilimumab, KPL716, KPL404 and KPL045. Our lead candidate is rilonacept, an interleukin1α, and interleukin1β, cytokine trap. We are developing rilonacept for the potential treatment of recurrent pericarditis, an inflammatory cardiovascular disease and are enrolling a single, pivotal, placebocontrolled, randomizedwithdrawal design, global Phase 3 clinical trial of rilonacept in subjects with recurrent pericarditis, named RHAPSODY. We also have an ongoing openlabel Phase 2 proofofconcept clinical trial in subjects with both symptomatic recurrent pericarditis as well as other patient subsets within pericarditis, including asymptomatic steroiddependent subjects with recurrent pericarditis and subjects with postpericardiotomy syndrome. We completed enrollment in this trial and presented interim data from this trial in December 2018. We expect to present additional data at the American College of Cardiology 68th Annual Scientific Session & EXPO 2019 in March 2019. Mavrilimumab is a monoclonal antibody that antagonizes colony stimulating factor. We are evaluating mavrilimumab for the potential treatment of giant cell arteritis, or GCA, an inflammatory disease of the blood vessels. We have commenced dosing in multiple countries in a randomized, doubleblind, placebocontrolled, Phase 2 proofofconcept trial for the study of mavrilimumab in GCA. In the United States, the FDA initially placed our IND for the trial on clinical hold due to its request for additional information regarding the 510(k)cleared delivery device to be used in our trial. We have since provided the FDA with the requested information and our IND is now active. We plan for U.S. subjects to be included in our ongoing, global Phase 2 proofofconcept clinical trial. KPL716 is a monoclonal antibody that simultaneously inhibits the signaling of the cytokines interleukin 31, or IL 31, and oncostatin M, or OSM, by targeting their common receptor subunit, oncostatin M receptor beta. We plan to study KPL716 in a variety of pruritic, inflammatory, and fibrotic indications driven by these cytokines. In September 2018, we announced interim results from the randomized, doubleblind, placebocontrolled, singleascendingdose, sequentialgroup portion of the Phase 1a/1b clinical trial in healthy volunteers and in subjects with moderatetosevere atopic dermatitis experiencing moderatetosevere pruritus. We are enrolling a 12week, repeated singledose cohort as an additional part of the Phase 1b portion of the Phase 1a/1b clinical trial in subjects with moderatetosevere atopic dermatitis experiencing moderatetosevere pruritus. We expect to report topline data from this cohort in the second half of 2019. We plan to initiate an adaptive design Phase 2a/2b clinical trial in prurigo nodularis in the first half of 2019 and expect to report topline data from the first part of this trial in the first half of 2020. We also plan to initiate an exploratory, pilot Phase 2 clinical trial in the first half of 2019 designed to explore the role of IL31 and OSM in a number of diseases characterized by chronic pruritus and plan to report topline data from this trial in the second half of 20 [/INST] Positive. </s>
2,019
8,209
1,730,430
Kiniksa Pharmaceuticals, Ltd.
2020-03-05
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 our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K, or Annual Report. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report, including information with respect to our plans and strategy for our business, includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, or the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act, that involve risks and uncertainties. As a result of many factors, including those factors set forth in the risks identified in Part I-Item 1A “Risk Factors’’ section of this Annual Report and our other filings with the Securities and Exchange Commission, or SEC, our actual results could differ materially from the results, performance or achievements expressed in or implied by these forward-looking statements. Overview We are a biopharmaceutical company focused on discovering, acquiring, developing and commercializing therapeutic medicines for patients with significant unmet medical need. We have a pipeline of clinical-stage product candidates that are based on strong biologic rationale or validated mechanisms, target underserved conditions and offer the potential for differentiation. These assets are designed to modulate immunological signaling pathways that are implicated across a spectrum of diseases. Our product candidates include rilonacept, mavrilimumab, KPL-716 and KPL-404. Our lead candidate is rilonacept, an interleukin-1α, and interleukin-1β, cytokine trap. We are developing rilonacept for the potential treatment of recurrent pericarditis, a painful inflammatory cardiovascular disease with an estimated U.S. prevalent population of approximately 40,000 patients seeking and receiving medical treatment. We are conducting a global, double-blind, placebo-controlled, randomized-withdrawal design, pivotal Phase 3 clinical trial of rilonacept in subjects with recurrent pericarditis, named RHAPSODY. We expect top-line data from this trial in the second half of 2020. We presented final data from our open-label Phase 2 proof-of-concept clinical trial in subjects with both symptomatic recurrent pericarditis as well as other patient subsets within pericarditis, including asymptomatic steroid-dependent subjects with recurrent pericarditis and subjects with post-pericardiotomy syndrome. We received Breakthrough Therapy designation from the Food and Drug Administration, or FDA, for rilonacept for the treatment of recurrent pericarditis in 2019, and reported final data from our open label Phase 2 proof of concept clinical trial of rilonacept in a range of recurrent pericarditis populations at the American Heart Association Scientific Sessions in November 2019. Mavrilimumab is a monoclonal antibody that antagonizes granulocyte-macrophage colony stimulating factor. We are evaluating mavrilimumab for the potential treatment of giant cell arteritis, or GCA, a chronic inflammatory disease of the medium-to-large arteries with an estimated U.S. prevalence of approximately 75,000 to 150,000 patients. We are conducting a randomized, double-blind, placebo-controlled, global Phase 2 proof-of-concept trial for the study of mavrilimumab in GCA. We expect top-line data from this trial in the second half of 2020. In December 2019, we entered into a clinical collaboration with Kite Pharma, Inc., a Gilead Company, or Kite, to initiate a Phase 2 clinical trial evaluating the combination of Yescarta® (axicabtagene ciloleucel) and mavrilimumab in relapsed or refractory large B-Cell lymphoma. The objective of the Phase 2 trial is to determine the effect of mavrilimumab on the safety of Yescarta. Treatment related induction of GM-CSF has been identified through clinical, translational and preclinical studies as a potential key signal associated with side effects of chimeric antigen receptor T, or CAR T, cell therapy. Preclinical evidence suggest the potential for interruption of GM-CSF signaling to disrupt CAR T cell mediated inflammation without disrupting anti-tumor activity. Kite will be the sponsor of this study and responsible for its conduct. KPL-716 is a monoclonal antibody that simultaneously inhibits the signaling of the cytokines interleukin 31, or IL-31, and oncostatin M, or OSM, by targeting their common receptor subunit, oncostatin M receptor beta, or OSMRβ. We are conducting a randomized, double-blind, placebo-controlled, Phase 2a clinical trial of KPL-716 in subjects with prurigo nodularis, a chronic inflammatory skin condition with an estimated U.S. prevalence of approximately 300,000 patients. We expect data from this trial by the end of April 2020. We are also conducting an exploratory Phase 2 clinical trial in diseases characterized by chronic pruritus. This randomized, double-blind, placebo-controlled trial is designed to identify chronic pruritic conditions where signaling through OSMRβ may be playing a role and to investigate the efficacy, safety and tolerability of KPL-716 in reducing the moderate-to-severe pruritus experienced by these subjects. We expect interim data from cohorts of this trial in the first half of 2020. In August 2019, we reported interim data from our 12 week, repeated single dose cohort of the Phase 1b clinical trial in subjects with moderate-to-severe atopic dermatitis experiencing moderate-to-severe pruritus, which was designed to provide safety and exploratory data on disease response markers. KPL-404 is a monoclonal antibody inhibitor of the CD40/CD40L interaction, a central control node of T-cell-dependent, B-cell-mediated humoral adaptive immunity. In the first quarter of 2019, we acquired all of the outstanding capital stock of Primatope Therapeutics, Inc., or Primatope, the company that owned or controlled the intellectual property related to KPL-404. In the second half of 2019, we initiated a single-ascending-dose Phase 1 clinical trial of KPL-404 in healthy volunteers. The first-in-human trial is designed to provide safety and pharmacokinetics data as well as data regarding receptor occupancy and T-cell dependent antibody response (TDAR) in these subjects. We expect top-line data in the second half of 2020. Our future success is dependent on our ability to develop, obtain regulatory approval for and successfully commercialize one or more of our product candidates. We have not yet demonstrated our ability to successfully conduct and complete a Phase 3 or other pivotal clinical trial, obtain regulatory approvals, manufacture a commercial scale drug, or conduct sales and marketing activities. We currently generate no revenue from sales of any products, and we may never be able to develop or commercialize a marketable product. On May 23, 2018, our registration statement on Form S-1 relating to our initial public offering, or IPO, was declared effective by the SEC. On May 29, 2018, we completed our IPO of 8,477,777 Class A common shares at $18.00 per share for gross proceeds of $152.6 million. In addition, on June 22, 2018, we completed the sale of 1,006,425 Class A common shares to the underwriters of the IPO following the exercise of their over-allotment option to purchase additional shares at $18.00 per share for gross proceeds of $18.1 million. The aggregate net proceeds to us from the IPO, inclusive of the over-allotment option exercise, was $155.5 million after deducting underwriting discounts and commissions and other offering costs. Upon the closing of the IPO, all convertible preferred shares then outstanding automatically converted into 5,546,019 Class A common shares, 1,070,502 Class B common shares, 12,995,954 Class A1 common shares and 16,057,618 Class B1 common shares. On February 4, 2019, we completed a follow-on offering of 2,654,984 Class A common shares and concurrent private placement of 2,000,000 Class A1 common shares, both at $18.26 per share for aggregate gross proceeds of $85.0 million. In addition, on March 1, 2019, we completed the sale of 161,126 Class A common shares to the underwriters of the follow-on offering following the exercise in part of their over-allotment option to purchase additional shares at $18.26 per share for gross proceeds of $2.9 million. The aggregate net proceeds to us from the follow-on offering and concurrent private placement, inclusive of the over-allotment option exercise, was $83.0 million after deducting underwriting discounts and commissions and other offering costs. We have incurred significant operating losses since inception. 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. Our net losses were $161.9 million and $103.2 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019 and 2018, we had an accumulated deficit of $356.1 million and $194.2 million, respectively. We expect to continue to incur significant operating losses for at least the next several years as we advance our product candidates through preclinical and clinical development and, ultimately, seek regulatory approval. In addition, if we obtain marketing approval for any of our product candidates, we expect to incur significant commercialization expenses related to product manufacturing, marketing, sales and distribution. We may also incur expenses in connection with the in-licensing or acquisition of additional product candidates. We expect to incur significant expenses in connection with our ongoing activities, particularly as we advance the clinical trials, preclinical activities of our product candidates, and prepare for commercial operations. Additionally, we expect to continue to incur additional costs associated with operating as a public company, including significant legal, accounting, investor relations and other expenses. As a result, until such time as we can generate significant revenue from product sales, if ever, we expect to finance our operations through public or private securities offerings, debt financings or other sources, which may include licensing, collaborations or other strategic transactions or arrangements. We may be unable to raise additional funds or enter into such other transactions or arrangements when needed on favorable terms, or at all. If we fail to raise capital or enter into such transactions or arrangements as and when needed, we may have to significantly delay, scale back or discontinue the development and commercialization of one or more of our product candidates or delay our pursuit of potential in-licenses or acquisitions. Because of the numerous risks and uncertainties associated with product development, we are unable to predict the timing or amount of increased expenses or when or if we will be able to achieve or maintain profitability. Even if we are able to generate product sales, we may not become profitable. If we fail to become profitable or are unable to sustain profitability on a continuing basis, then we may be unable to continue our operations at planned levels and be forced to reduce or terminate our operations. As of December 31, 2019 and 2018, we had cash, cash equivalents and short-term investments of $233.4 million and $307.3 million, respectively. We believe that our existing cash, cash equivalents and short-term investments will enable us to fund our operating expenses and capital expenditure requirements for at least the next 12 months from the date of filing this Annual Report. We have based this estimate 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.” Our future viability beyond that point is dependent on our ability to raise additional capital to finance our operations. Components of Our Results of Operations Revenue To date, we have not generated any revenue from any products, and may never be able to develop and commercialize a marketable product. If our development efforts for our product candidates are successful and result in regulatory approval, we may generate revenue in the future from product sales. Operating Expenses Research and Development Expenses Research and development expenses consist primarily of costs incurred in connection with the research and development of our product candidates. We expense research and development costs as incurred. These expenses may include: · expenses incurred to conduct the necessary preclinical studies and clinical trials required to obtain regulatory approval; · expenses incurred under agreements with contract research organizations, or CROs, that are primarily engaged in the oversight and conduct of our clinical trials and contract manufacturing organizations, or CMOs, that are primarily engaged to provide preclinical and clinical drug substance and product for our research and development programs for our product candidates; · other costs related to acquiring and manufacturing preclinical and clinical trial materials, including manufacturing validation batches, as well as investigative sites and consultants that conduct our clinical trials, preclinical studies and other scientific development services; · payments made in cash or equity securities under third-party licensing, acquisition and other similar agreements; · employee-related expenses, including salaries and benefits, travel and share-based compensation expense for employees engaged in research and development functions; · costs related to compliance with regulatory requirements; and · allocated facilities-related costs, depreciation and other expenses, which include rent and utilities. We recognize external development costs based on an evaluation of the progress to completion of specific tasks using information provided to us by our service providers. 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 actual costs. Nonrefundable advance payments for goods or services to be received in the future for use in research and development activities are recorded as prepaid expenses. Such amounts are recognized as an expense as the goods are delivered or the related services are performed, or until it is no longer expected that the goods will be delivered or the services rendered. Our direct research and development expenses are tracked on a program-by-program basis for our product candidates and consist primarily of external costs, such as fees paid to outside consultants, CROs, CMOs and research laboratories in connection with our preclinical development, process development, manufacturing and clinical development activities. Our direct research and development expenses by program also include fees incurred under license, acquisition and other similar agreements. We do not allocate employee costs or facility expenses, including depreciation or other indirect costs, to specific programs because these costs are deployed across multiple programs and, as such, are not separately classified. We use internal resources primarily to conduct our research and discovery activities as well as for managing our preclinical and clinical development, process development and manufacturing activities. The table below summarizes our research and development expenses incurred by program: (1)The amount for the year ended December 31, 2018 consists of $5.0 million related to a pass-through payment due upon the achievement of a specified clinical milestone event due under our license agreement with MedImmune, Limited, or MedImmune. (2)The amount for the year ended December 31, 2019 includes expense of $10.0 million related to a milestone under our asset purchase agreement with Biogen MA, Inc., or Biogen, associated with the achievement of a specified clinical milestone event. (3)The amount for the year ended December 31, 2019 includes expense of $18.0 million related to our acquisition of the issued and outstanding equity securities of Primatope and milestone achievements, paid in a combination of cash and Class A common shares (inclusive of escrow and holdback amounts) in accordance with the stock purchase option agreement with Primatope, or the Primatope Agreement. The amount for the year ended December 31, 2018 includes expense of $0.8 million related to the extension of the option period under the Primatope Agreement. Research and development activities are central to our business. Product candidates in later stages of clinical development generally have higher costs than those in earlier stages of clinical development, primarily due to the increased size and duration of later-stage clinical trials. As a result, we expect that our research and development expenses will be substantial over the next several years as we conduct our ongoing and planned clinical trials for rilonacept, mavrilimumab, KPL-716 and KPL-404, as well as conduct other preclinical and clinical development including regulatory filings for our product candidates. As a result, our related personnel costs will increase, including costs associated with share-based compensation. We also expect to incur additional expenses related to milestone and royalty payments payable to third parties with whom we have entered into license, acquisition and other similar agreements to acquire the rights to our product candidates. The successful development and commercialization of our product candidates is highly uncertain. At this time, we cannot reasonably estimate or know the nature, timing and costs of the efforts that will be necessary to complete the preclinical and clinical development of any of our product candidates or when, if ever, material net cash inflows may commence from any of our product candidates. This uncertainty is due to the numerous risks and uncertainties associated with product development and commercialization, including the uncertainty of: · the scope, progress, outcome and costs of our preclinical development activities, clinical trials and other research and development activities; · establishing an appropriate safety and efficacy profile with Investigational New Drug, or IND, enabling and clinical studies; · successful patient enrollment in and the initiation and completion of clinical trials; · the timing, receipt and terms of any marketing approvals from applicable regulatory authorities including the U.S. Federal Drug Administration, or FDA; · the extent of any required post-marketing approval commitments to applicable regulatory authorities; · establishing clinical and commercial manufacturing capabilities or making arrangements with third-party manufacturers in order to ensure that we or our third-party manufacturers are able to make product successfully; · development and timely delivery of clinical-grade and commercial-grade drug formulations that can be used in our clinical trials and for commercial launch; · obtaining, maintaining, defending and enforcing patent claims and other intellectual property rights; · significant and changing government regulation; · launching commercial sales of our product candidates, if and when approved, whether alone or in collaboration with others; and · maintaining a continued acceptable safety profile of our product candidates following approval, if any, of our product candidates. General and Administrative Expenses General and administrative expenses consist primarily of salaries and benefits, travel and share-based compensation expense for personnel in executive, business development, finance, human resources, legal, information technology, pre-commercial and support personnel functions. General and administrative expenses also include insurance and professional fees for legal, patent, consulting, accounting and audit services. We expect that our general and administrative expenses will continue to increase in the future as we continue to prepare for potential commercialization activities and increase our headcount to support our business objectives. We also anticipate that we will continue to incur significant costs associated with being a public company, including accounting, audit, legal, compliance and director and officer insurance costs as well as investor and public relations expenses. Interest Income Interest income consists of income recognized from investments in money market funds and U.S. Treasury notes. Income Taxes As an exempted company incorporated under the laws of Bermuda, we are principally subject to taxation in Bermuda. Under the current laws of Bermuda, tax on a company’s income is assessed at a zero percent tax rate. As a result, we have not recorded any income tax benefits from our losses incurred in Bermuda during each reporting period, and no net operating loss carryforwards are currently available to us for those losses, while our assets remain in Bermuda. Our wholly owned U.S. subsidiary, Kiniksa Pharmaceuticals Corp., or Kiniksa US, and Primatope are subject to federal and state income taxes in the United States. Our wholly owned subsidiary Kiniksa Pharmaceuticals (UK), Ltd., and its wholly owned subsidiaries, Kiniksa Pharmaceuticals (Germany) GmbH and Kiniksa Pharmaceuticals (France) SARL are subject to taxation in their respective countries. Our benefit for income taxes relates to deferred tax attributes and net credits earned against taxable income generated by our wholly owned subsidiaries, primarily, Kiniksa US, under cost-plus arrangements that they have with us. As of December 31, 2019 and 2018, the Company had federal research and development tax credit carryforwards of approximately $0.2 million and $0 respectively, available to reduce future tax liabilities, which begin to expire in 2039. As of December 31, 2019 and 2018, the Company had state research and development tax credit carryforwards of approximately $0.3 million and $0.1 million respectively, available to reduce future tax liabilities, which begin to expire in 2034. 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: Research and Development Expenses Research and development expenses were $135.0 million for the year ended December 31, 2019, compared to $86.6 million for the year ended December 31, 2018. The increase of $48.4 million was primarily due to a $27.1 million increase in external fees related to our development programs for our product candidates, as well as an increase of $21.2 million in unallocated research and development expenses. The direct costs for our rilonacept program were $25.7 million for the year ended December 31, 2019, compared to $13.5 million for the year ended December 31, 2018, or an increase of $12.2 million. During the year ended December 31, 2019, expenses incurred primarily related to conducting RHAPSODY, our global, pivotal Phase 3 clinical trial in recurrent pericarditis, including purchases of drug materials under our clinical supply agreement with Regeneron, compared to the year ended December 31, 2018, in which expenses incurred related to clinical research and development for our Phase 2 open label clinical trial and initiation of RHAPSODY. The direct costs of our mavrilimumab program were $13.8 million for the year ended December 31, 2019, compared to $15.3 million for the year ended December 31, 2018, or a decrease of $1.5 million. During the year ended December 31, 2019, expenses incurred related primarily to our global Phase 2 clinical trial in GCA and manufacturing process development related expenses, compared to the year ended December 31, 2018, in which expenses incurred related to $5.0 million pass-through payment due upon the achievement of a specified clinical milestone event due under our license agreement with MedImmune as well as expenses related to preparation for our planned global Phase 2 trial in GCA and manufacturing process development expenses. The direct costs for our KPL-716 program were $28.8 million for the year ended December 31, 2019, compared to $25.6 million for the year ended December 31, 2018, or an increase of $3.2 million. During the year ended December 31, 2019, expenses incurred related primarily to a milestone payment of $10.0 million under our asset purchase agreement with Biogen associated with the achievement of a specified clinical milestone event as well as expenses incurred for our Phase 2a clinical trial in prurigo nodularis, our exploratory Phase 2 clinical trial in diseases characterized by chronic pruritus, our Phase 1b clinical trial, and manufacturing and development costs for our clinical drug supply, compared to the year ended December 31, 2018, in which expenses incurred related to manufacturing and development costs for our clinical drug supply, our Phase 1a/1b clinical trial, and our LOTUS-PN observational study. The direct costs for our KPL-404 program were $22.8 million for the year ended December 31, 2019, compared to $6.0 million for the year ended December 31, 2018, or an increase of $16.8 million. During the year ended December 31, 2019, expenses incurred primarily related to $18.0 million of expense related to the acquisition of the issued and outstanding equity securities of Primatope and milestone achievements, comprised of upfront consideration of $10.0 million paid at closing and milestone payments of $5.0 million, which had been achieved as of the closing date, and $3.0 million, which was achieved after the closing during the year ended December 31, 2019, each paid in a combination of cash and Class A common shares (inclusive of escrow and holdback amounts) in accordance with the Primatope Agreement, as well as preclinical expenses and initiation of our Phase 1 trial. During the year ended December 31, 2018, expenses incurred primarily related to clinical research and development, including manufacturing development costs as well as $0.8 million related to the extension of the option period under our stock purchase option agreement with Primatope. The Primatope acquisition was accounted for as an asset acquisition in 2019 as it did not meet the definition of a business. We recorded the upfront payment, milestone payments and the accrued milestone as research and development expense in the consolidated statement of operations and comprehensive loss because the acquired technology represented in-process research and development and had no alternative future use. The direct costs for our former KPL-045 program were $1.9 million during the year ended December 31, 2019, compared to $5.7 million during the year ended December 31, 2018, or a decrease of $3.8 million. In January 2020, we terminated our license agreement with Novo Nordisk and ceased development of KPL-045. During the year ended December 31, 2019, expenses incurred related to preclinical research and development, including manufacturing development costs, compared to the year ended December 31, 2018, in which expenses incurred related primarily to clinical research and development, including manufacturing development costs. Unallocated research and development expenses were $41.9 million for the year ended December 31, 2019 compared to $20.7 million for the year ended December 31, 2018. The increase of $21.2 million in unallocated research and development expenses was due to an increase of $12.2 million in personnel-related costs, including share-based compensation, and an increase of $9.1 million in other costs, including research costs related to potential future programs and internal lab costs. The increase in personnel-related costs was primarily due to additional personnel in our research and development functions to support our ongoing clinical trials, including development and manufacture of clinical supply and regulatory filings. Personnel-related costs for the year ended December 31, 2019 and 2018 included share-based compensation of $5.7 million and $2.3 million, respectively. General and Administrative Expenses General and administrative expenses were $35.0 million for the year ended December 31, 2019 compared to $21.6 million for the year ended December 31, 2018. The increase of $13.4 million was primarily due to increases of $11.7 million in personnel-related costs and $2.1 million in professional fees, partially offset by a decrease of $0.4 million in other general expenses. The increase in personnel-related costs was due to additional personnel in our general and administrative functions, primarily in our commercial and corporate departments, including legal, finance and human resources. Personnel-related costs for the year ended December 31, 2019 and 2018, included share-based compensation of $9.3 million and $3.4 million, respectively. Professional fees increased due to costs related to commercial preparations, including market research as well as legal costs incurred in connection with maintaining and registering worldwide patents and costs associated with our ongoing business operations, as well as expenses for higher recruiting, accounting and other costs incurred as a public company for a full fiscal year. Interest Income Interest income was $6.0 million for the year ended December 31, 2019 compared to $4.7 million for the year ended December 31, 2018. The increase was largely due to higher average invested balances. Benefit for Income Taxes For the year ended December 31, 2019, we recorded a benefit for income taxes of $2.0 million relating primarily to the impact of the Foreign Derived Intangible Income, or FDII, deduction for 2019 and 2018; and U.S. federal and state research and development tax credits. FDII was enacted as part of the tax reform enacted by the United States in December 2017, generally referred to as the U.S. Tax Cuts and Jobs Act, with additional proposed regulations and guidance issued in 2019. Upon the completion of our assessment we have included the tax impact of FDII in our income tax expense for the year ended December 31, 2019, based on our understanding of the rules available at the time of the filing of this Annual Report. However, the amounts recorded could be impacted in the future when the proposed regulations and guidance are finalized. For the year ended December 31, 2018, we recorded an insignificant benefit for income taxes. Liquidity and Capital Resources Since our inception, we have not generated any revenue from any sources, including from product sales, and have incurred significant operating losses and negative cash flows from our operations. Prior to the completion of our IPO in May 2018, we funded our operations primarily with proceeds from the sale of preferred shares, from which we had received net proceeds of $310.6 million. On May 23, 2018, our registration statement on Form S-1 relating to our IPO was declared effective by the SEC. On May 29, 2018, we completed the IPO of 8,477,777 Class A common shares at $18.00 per share for gross proceeds of $152.6 million. In addition, on June 22, 2018, we completed the sale of 1,006,425 Class A common shares to the underwriters of the IPO following the exercise of their over-allotment option to purchase additional shares at $18.00 per share, for gross proceeds of $18.1 million. The aggregate net proceeds to us from the IPO, inclusive of the over-allotment option exercise, was $155.5 million after deducting underwriting discounts and commissions and other offering costs. On February 4, 2019, we completed a follow-on offering of 2,654,984 Class A common shares and concurrent private placement of 2,000,000 Class A1 common shares, both at $18.26 per share for aggregate gross proceeds of $85.0 million. In addition, on March 1, 2019, we completed the sale of 161,126 Class A common shares to the underwriters of the follow-on offering following the exercise in part of their over-allotment option to purchase additional shares at $18.26 per share for gross proceeds of $2.9 million. The aggregate net proceeds to us from the follow-on offering and concurrent private placement, inclusive of the over-allotment option exercise, was $83.0 million after deducting underwriting discounts and commissions and other offering costs. As of December 31, 2019, we had cash, cash equivalents and short-term investments of $233.4 million. Cash Flows The following table summarizes our cash flows for each of the periods presented: Operating Activities During the year ended December 31, 2019, operating activities used $158.4 million of cash, primarily resulting from our net loss of $161.9 million and net cash used by changes in our operating assets and liabilities of $17.0 million partially offset by non-cash charges of $20.5 million. Net cash used by changes in our operating assets and liabilities for the year ended December 31, 2019 consisted of a $15.0 million decrease in accrued milestones, a $4.7 million decrease in accounts payable, and a $1.3 million decrease in operating lease liabilities partially offset by a $1.0 million increase in prepaid expenses and other current assets, a $0.3 million increase in other long-term liabilities and a $4.6 million increase in accrued expenses. The decrease in accrued milestones resulted from the payment of outstanding milestones for which the expense was recognized in prior years. The decrease in accounts payable was primarily due to the timing of vendor invoicing and payments. The increase in prepaid expenses and other current assets was due to increases in prepaid insurance expenses and prepaid expenses to CROs related to our clinical trials. The decrease in operating lease liabilities is due to monthly payments for our right-of-use assets. During the year ended December 31, 2018, operating activities used $81.0 million of cash, primarily resulting from our net loss of $103.2 million, partially offset by net non-cash charges of $3.9 million and net cash provided by changes in our operating assets and liabilities of $18.3 million. Net cash provided by changes in our operating assets and liabilities for the year ended December 31, 2018 consisted of a $14.3 million increase in accrued expenses and other liabilities and a $8.8 million increase in accounts payable, partially offset by a $4.8 million increase in prepaid expenses and other current assets. The increase in accrued expenses was primarily due to our increased level of operating activities and the timing of vendor invoicing and payments, an increase in accrued milestones as well as an increase in accrued employee compensation expense. The increase in accounts payable was primarily due to increased operating activities as well as the timing of vendor invoicing and payments. The increase in prepaid expenses and other current assets was due to increases in prepaid insurance expenses, interest receivable and prepaid expenses to CMOs related to manufacturing development and CROs related to our clinical trials. Investing Activities During the year ended December 31, 2019, investing activities provided $49.2 million of cash, consisting of $541.2 million from proceeds of maturities of short-term investments partially offset by $488.8 million of purchases of short-term investments and $3.2 million of purchases of property and equipment. During the year ended December 31, 2018, investing activities used $239.2 million of cash, consisting of $5.3 million of purchases of property and equipment and $402.0 million of purchases of short-term investments partially offset by $168.1 million from proceeds of maturities of short-term investments. Financing Activities During the year ended December 31, 2019, financing activities provided $84.1 million of cash, consisting of $83.0 million from proceeds from our issuance and sale of Class A common shares in a follow-on public offering, inclusive of the concurrent issuance and sale of Class A1 common shares in a private placement, and exercise in part of the underwriters’ over-allotment option to purchase additional Class A common shares and concurrent issuance after deduction of underwriting commissions and discounts and other offering costs. During the year ended December 31, 2018, net cash provided by financing activities was $346.7 million, primarily consisting of proceeds of $159.2 million from our issuance and sale of Class A common shares, net of underwriting commissions and discounts upon completion of our IPO, inclusive of the over-allotment option exercise, $190.8 million in net proceeds from our issuance and sale of Series C preferred shares partially offset by $3.7 million of payments of other offering costs associated with our IPO, inclusive of the over-allotment option exercise. Funding Requirements We expect to incur significant expenses in connection with our ongoing activities, particularly as we advance the clinical trials, preclinical activities of our product candidates and prepare for commercial operations. Additionally, we expect to continue to incur additional costs associated with operating as a public company, including significant legal, accounting, investor relations and other expenses. We expect to incur expenses as we: · continue to conduct our current clinical trials and/or initiate our planned clinical trials, for rilonacept, mavrilimumab, KPL-716 and KPL-404 as applicable; · manufacture, or have manufactured on our behalf, our preclinical and clinical drug material and develop processes for late-stage and commercial manufacturing; · seek regulatory approvals for any product candidates that successfully complete clinical trials; · establish a sales, marketing, medical affairs and distribution infrastructure to commercialize any product candidates, including rilonacept, for which we may obtain marketing approval and intend to commercialize on our own; · hire additional clinical, quality and research and development personnel; · expand our operational, financial and management systems and increase personnel globally to support our clinical development, manufacturing and commercialization efforts and our operations as a public company; · maintain, expand and protect our intellectual property portfolio; and · in-license or acquire other product candidates and technologies or their related businesses, if we determine to do so. We believe that our existing cash, cash equivalents and short-term investments will enable us to fund our operating expenses and capital expenditure requirements for at least the next 12 months from the date of filing this Annual Report. We have based these estimates on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we expect. We anticipate that we may require additional capital if we choose to pursue in-licenses or acquisitions of other product candidates and technologies or their related businesses. If we receive regulatory approval for rilonacept or our other product candidates, we expect to incur significant commercialization expenses related to product manufacturing, sales, marketing and distribution, depending on where we choose to commercialize. Because of the numerous risks and uncertainties associated with research, development and commercialization of biologic products, we are unable to estimate the exact amount of our working capital requirements. Our future funding requirements will depend on and could increase significantly as a result of many factors, including: · the scope, progress, results and costs of researching and developing our product candidates, and conducting preclinical and clinical trials; · the costs, timing and outcome of regulatory review of our product candidates; · the costs, timing and ability to manufacture our product candidates to supply our clinical and preclinical development efforts and our clinical trials; · the costs of future activities, including product sales, medical affairs, marketing, manufacturing, pricing and reimbursement, distribution and compliance, for any of our product candidates for which we receive marketing approval; · the costs of manufacturing commercial-grade product and necessary inventory to support commercial launch; · the ability to receive additional non-dilutive funding; · the revenue, if any, received from commercial sale of our products, should any of our product candidates receive marketing approval; · the costs of preparing, filing and prosecuting patent applications, maintaining and enforcing our intellectual property rights and defending intellectual property-related claims; · our ability to establish and maintain licensing, collaboration or other strategic transactions and arrangements on favorable terms, if at all; · the extent to which we acquire or in-license other product candidates, technologies and their related businesses; and · the timing, receipt and amount of sales of, or milestone payments related to or royalties on, our current or future product candidates, if any. Until such time, if ever, as we can generate substantial product revenue, we expect to finance our cash needs through a combination of public or private equity offerings, debt financings, or other sources, including, licensing, collaboration, marketing, distribution or other strategic transactions or arrangements with third parties. To the extent that we raise additional capital through the sale of equity or convertible debt securities, our shareholders’ ownership interest may be materially diluted, and the terms of such securities could include liquidation or other preferences that adversely affect our shareholders’ rights as a common shareholder. Debt financing and preferred equity financing, if available, may involve agreements that include restrictive covenants that limit our ability to take specified actions, such as incurring additional debt, making capital expenditures or declaring dividends. In addition, debt financing would result in fixed payment obligations. If we raise funds through licensing, collaboration, marketing, distribution or other strategic transactions or arrangements with third parties, we may have to relinquish valuable rights to our technologies, product candidates or future revenue streams, or otherwise agree to terms that may not be favorable to us. If we are unable to obtain funding, we could be forced to delay, reduce or eliminate some or all of our research and development programs for product candidates, product portfolio expansion or commercialization efforts, which could adversely affect our business prospects, or we may be unable to continue operations. Contractual Obligations and Commitments 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)Amounts in the table reflect commitments for costs associated with our external CMOs, which we have engaged to manufacture clinical trial materials. Manufacturing commitments 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 preceding table are limited to the non-cancelable portion of the agreement terms or the minimum cancellation fee. (2)Amounts in the table reflect minimum payments due under operating lease agreements entered into by our wholly owned U.S. subsidiary Kiniksa US for office and laboratory space in Lexington, Massachusetts, which expires in 2021, and office space in San Diego, California, which expires in 2020. (3)Amounts in the table reflect the cash awards granted to employees under the Rilonacept Long-Term Incentive Plan, or RLTIP, which become payable in such amounts if the performance goals defined in the RLTIP are achieved at target. Our contracts with CMOs, CROs and other third parties for the manufacture of our product candidates and to support clinical trials and preclinical research studies and testing are generally cancelable by us upon prior notice. Payments due upon cancellation consisting only of payments for services provided or expenses incurred, including noncancelable obligations of our service providers, up to the date of cancellation are not included in the preceding table as the amount and timing of such payments are not known. Under various agreements with third parties, we have agreed to make milestone payments, pay royalties, annual maintenance fees and to meet due diligence requirements based upon specified milestones. We generally have not included any contingent payment obligations, such as milestones, royalties or due diligence, in the table above as the amount, timing and likelihood of such payments are not known. We have not included any of the annual maintenance fee payments in the above table, as although the amount and timing are known, we cannot currently determine the final termination dates of the agreements and, as a result, we cannot determine the total amounts of such payments we will be required to make under the agreements. Under our license agreement with Regeneron, we are obligated to make future regulatory milestone payments of $27.5 million in the aggregate. Thereafter, we have agreed to evenly split profits on our sales of rilonacept with Regeneron after deducting certain commercialization expenses subject to specified limits. Under our license agreement with MedImmune, we are obligated to make future clinical, regulatory and initial sales milestone payments of up to $57.5 million in aggregate for the first two indications we develop. In addition, we are obligated to make clinical and regulatory milestone payments of up to $15,000 in the aggregate for each subsequent indication. We are also obligated to make milestone payments to MedImmune of up to $85.0 million upon the achievement of annual net sales thresholds of up to, but excluding, $1.0 billion in annual net sales as well as additional milestone payments aggregating up to $1.1 billion upon the achievement of additional specified annual net sales thresholds starting at $1.0 billion and higher. Commencing on the first commercial sale of licensed products, we are obligated to pay tiered royalties on escalating tiers of annual net sales of licensed products starting in the low double-digit percentages and ending at twenty percent. We must pay such royalties on a product-by-product and country-by-country basis until the latest to occur of the expiration of licensed patents, the expiration of regulatory exclusivity or the tenth anniversary of the first commercial sale of such product in such country. Under our asset purchase agreement with Biogen, we are obligated to make future milestone payments of up to $315.0 million upon the achievement of specified clinical and regulatory milestones as well as upon the achievement of annual net sales thresholds. We have also agreed to pay certain obligations under third-party contracts retained by Biogen that relate to KPL-716. Additionally, we are obligated to pay tiered royalties on escalating tiers of annual net sales of licensed products starting in the high single-digit percentages and ending below the teens. In January 2020, we terminated our license agreement with Novo Nordisk, as such we are no longer obligated to make future milestone payments under the agreement. Critical Accounting Policies and Significant Judgments and Estimates Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States. The preparation of our consolidated financial statements and related disclosures requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue, costs and expenses, and the disclosure of contingent assets and liabilities in our financial statements. We base our estimates on historical experience, known trends and events and various other factors that we believe are 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. We evaluate our estimates and assumptions on an ongoing basis. Our 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 included elsewhere in this Annual Report, 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 Expenses As part of the process of preparing our consolidated financial statements, we are required to estimate our accrued research and development expenses. 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 actual costs. The majority of our service providers invoice us in arrears for services performed, on a pre-determined schedule or when contractual milestones are met; however, some require advanced payments. We make estimates of our accrued expenses as of each balance sheet date in the consolidated financial statements based on facts and circumstances known to us at that time. We periodically confirm the accuracy of these estimates with the service providers and make adjustments if necessary. Examples of estimated accrued research and development expenses include fees paid to: · vendors, including research laboratories, in connection with preclinical development activities; · CROs and investigative sites in connection with preclinical studies and clinical trials; · third parties in the connection with the achievement of milestones due under license acquisition and other similar agreements; and · CMOs in connection with drug substance and drug product formulation and manufacturing of materials. We base our expenses related to preclinical studies and clinical trials on our estimates of the services received and efforts expended pursuant to quotes and contracts with multiple research institutions and CROs that conduct and manage preclinical studies and clinical trials 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 expense. Payments under some of these contracts depend on factors such as the successful enrollment of patients and the completion of clinical trial milestones. 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 the estimate, we adjust the accrual or the amount of prepaid expenses 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 may result in reporting amounts that are too high or too low in any particular period. To date, there have not been any material adjustments to our prior estimates of accrued research and development expenses. Share-Based Compensation We measure all share-based awards granted to employees and directors based on their fair value on the date of the grant and recognize compensation expense for those awards over the requisite service period. Forfeitures are accounted for as they occur. We issue share-based awards with both service-based vesting conditions and performance-based vesting conditions. Expense for awards with service-based vesting is recorded using the straight-line method, and expense for awards with performance-based vesting conditions is recognized using the accelerated-attribution method. For share-based awards granted to consultants and non-employees, compensation expense is recognized over the vesting period of the awards, which is generally the period during which services are rendered by such consultants and non-employees until completed. At the end of each financial reporting period prior to completion of the service, the fair value of these awards is remeasured using the then-current fair value of our Class A common shares and updated assumption inputs in the Black-Scholes option-pricing model. We classified share-based compensation expense in the consolidated statements of operations and comprehensive loss in the same manner in which the award recipient's payroll costs are classified or in which the award recipient's service payments are classified. The fair value of each restricted share award was estimated on the date of grant based on the fair value of the Company’s Class A common shares or Class B common shares on that same date. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model, which requires inputs based on certain subjective assumptions, including the expected share price volatility, the expected term of the award, the risk-free interest rate, and expected dividends (see Note 9). Prior to May 2018, we were a private company and, accordingly, lacked company-specific historical and implied volatility information. Therefore, we estimate our expected share price volatility based on the historical volatility of publicly traded peer companies and expect to continue to do so until such time as we have adequate historical data regarding the volatility of our traded share price. The expected term of our options has been determined utilizing the “simplified” method for awards that qualify as “plain-vanilla” options. The expected term of options granted to non-employees is equal to the contractual term of the option award. The risk-free interest rate is determined by reference to the U.S. Treasury yield curve in effect at the time of grant of the award for time periods approximately equal to the expected term of the award. Expected dividend yield is based on the fact that we have never paid cash dividends and do not expect to pay any cash dividends in the foreseeable future. The fair value of each restricted share unit award is based on the closing price of our Class A common shares on the date of grant. Restricted share unit awards with an associated performance condition are evaluated on a regular basis for probability of achievement, to determine the timing of recording share-based compensation expense to include in our consolidated statements of operations and comprehensive loss. Emerging Growth Company Status The Jumpstart Our Business 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. 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. Recently Issued Accounting Pronouncements 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 annual consolidated financial statements included elsewhere of this Annual Report.
0.052375
0.052585
0
<s>[INST] Overview We are a biopharmaceutical company focused on discovering, acquiring, developing and commercializing therapeutic medicines for patients with significant unmet medical need. We have a pipeline of clinicalstage product candidates that are based on strong biologic rationale or validated mechanisms, target underserved conditions and offer the potential for differentiation. These assets are designed to modulate immunological signaling pathways that are implicated across a spectrum of diseases. Our product candidates include rilonacept, mavrilimumab, KPL716 and KPL404. Our lead candidate is rilonacept, an interleukin1α, and interleukin1β, cytokine trap. We are developing rilonacept for the potential treatment of recurrent pericarditis, a painful inflammatory cardiovascular disease with an estimated U.S. prevalent population of approximately 40,000 patients seeking and receiving medical treatment. We are conducting a global, doubleblind, placebocontrolled, randomizedwithdrawal design, pivotal Phase 3 clinical trial of rilonacept in subjects with recurrent pericarditis, named RHAPSODY. We expect topline data from this trial in the second half of 2020. We presented final data from our openlabel Phase 2 proofofconcept clinical trial in subjects with both symptomatic recurrent pericarditis as well as other patient subsets within pericarditis, including asymptomatic steroiddependent subjects with recurrent pericarditis and subjects with postpericardiotomy syndrome. We received Breakthrough Therapy designation from the Food and Drug Administration, or FDA, for rilonacept for the treatment of recurrent pericarditis in 2019, and reported final data from our open label Phase 2 proof of concept clinical trial of rilonacept in a range of recurrent pericarditis populations at the American Heart Association Scientific Sessions in November 2019. Mavrilimumab is a monoclonal antibody that antagonizes granulocytemacrophage colony stimulating factor. We are evaluating mavrilimumab for the potential treatment of giant cell arteritis, or GCA, a chronic inflammatory disease of the mediumtolarge arteries with an estimated U.S. prevalence of approximately 75,000 to 150,000 patients. We are conducting a randomized, doubleblind, placebocontrolled, global Phase 2 proofofconcept trial for the study of mavrilimumab in GCA. We expect topline data from this trial in the second half of 2020. In December 2019, we entered into a clinical collaboration with Kite Pharma, Inc., a Gilead Company, or Kite, to initiate a Phase 2 clinical trial evaluating the combination of Yescarta® (axicabtagene ciloleucel) and mavrilimumab in relapsed or refractory large BCell lymphoma. The objective of the Phase 2 trial is to determine the effect of mavrilimumab on the safety of Yescarta. Treatment related induction of GMCSF has been identified through clinical, translational and preclinical studies as a potential key signal associated with side effects of chimeric antigen receptor T, or CAR T, cell therapy. Preclinical evidence suggest the potential for interruption of GMCSF signaling to disrupt CAR T cell mediated inflammation without disrupting antitumor activity. Kite will be the sponsor of this study and responsible for its conduct. KPL716 is a monoclonal antibody that simultaneously inhibits the signaling of the cytokines interleukin 31, or IL31, and oncostatin M, or OSM, by targeting their common receptor subunit, oncostatin M receptor beta, or OSMRβ. We are conducting a randomized, doubleblind, placebocontrolled, Phase 2a clinical trial of KPL716 in subjects with prurigo nodularis, a chronic inflammatory skin condition with an estimated U.S. prevalence of approximately 300,000 patients. We expect data from this trial by the end of April 20 [/INST] Positive. </s>
2,020
8,485
1,696,558
Jerash Holdings (US), Inc.
2018-06-28
2018-03-31
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The following discussion of the Group’s financial condition and results of operations should be read in conjunction with the Group’s consolidated financial statements and the related notes included elsewhere in this filing. EXECUTIVE OVERVIEW Overview Jerash Holdings is a holding company organized as a corporation in Delaware in January 2016 with nominal or no assets or operations. Through our wholly owned operating subsidiaries, the Group is principally engaged in the manufacturing and exporting of customized, ready-made sport and outerwear from knitted fabric produced in the Group’s facilities in Jordan. The Group is an approved manufacturer by many well-known brands and retailers, such as Walmart, Costco, Sears, Hanes, Columbia, Land’s End, VF Corporation (which owns brands such as The North Face, Nautica, Timberland, Wrangler, Lee, Jansport, etc.), and Philip-Van Heusen (which owns brands such as Calvin Klein, Tommy Hilfiger, IZOD, Speedo, etc.). Our production facilities are made up of three factory units and two warehouses and currently employ approximately 2,900 people. Our employees include local Jordanian workers as well as migrant workers from Bangladesh, Sri Lanka, India, Myanmar and Nepal. The total annual capacity at the Group’s facilities is approximately 6.5 million pieces (average for product categories including t-shirts, polos and jackets). Merger On May 11, 2017, we implemented the Merger via two transactions, the first being an equity contribution whereby the shareholders of Global Trend, contributed 100% of the outstanding capital stock of Global Trend to Jerash Holdings in exchange for an aggregate of 8,787,500 shares of common stock of Jerash Holdings with Global Trend becoming the wholly-owned subsidiary of Jerash Holdings. In the second transaction, Global Trend merged with and into Jerash Holdings with Jerash Holdings being the surviving entity, as a result of which Jerash Holdings became the direct parent of Global Trend’s wholly owned operating subsidiaries, Jerash Garments and Treasure Success. Accounting Treatment of Merger For accounting purposes, Global Trend is recognized as the accounting acquirer, and Jerash Holdings is the legal acquirer or accounting acquiree. As such, following the Merger, the historical financial statements of Global Trend are treated as the historical financial statements of the combined company. Accordingly, the financial information in this Annual Report on Form 10-K, including management’s discussion and analysis of financial condition and results of operations and the consolidated financial statements and the related notes thereto appearing elsewhere in this filing, reflect the consolidated financial statements of Global Trend, its subsidiaries and its affiliate, which includes as a variable interest entity Victory Apparel Jordan Company Limited (“Victory Apparel”). Victory Apparel was incorporated in Jordan in 2005 and it is a wholly owned subsidiary of WCL. Wealth Choice Limited (“WCL”) acquired Global Trend and Jerash Garments from two third-party individuals on March 21, 2012. On March 31, 2006, Victory Apparel purchased all of the property and equipment of Jerash Garments at an industrial building in Al Tajamouat Industrial City purchased by Jerash Garments on July 31, 2000. The land and building were not registered in Victory Apparel’s name, and Jerash Garments continued to hold the land and building in its name in trust for Victory Apparel. The declaration of trust was never registered with the Land Registry of Jordan, and on June 30, 2016, Victory Apparel and Jerash Garments dissolved the sale agreement, resulting in the property and equipment being owned free and clear by Jerash Garments. Victory Apparel does not currently have any material assets or operations of its own, and Mr. Choi and Mr. Lee, the Group’s significant stockholders who together indirectly own 100% of Victory Apparel through WCL, intend to dissolve the entity Seasonality of Sales A significant portion of our revenues are received during the first six months of our fiscal year. The majority of our VF Corporation orders are derived from winter season fashions, the sales of which occur in Spring and Summer and are merchandized by VF Corporation during the Autumn months (September through November). As such, the second half of our fiscal years reflect lower sales in anticipation of the spring and summer seasons. One of our strategies is to increase sales with other customers where clothing lines are stronger during the spring months. This strategy also reflects our current plan to increase the Group’s number of customers to mitigate our current concentration risk with VF Corporation. Results of Operations The following table presents certain information from our statement of income for fiscal years 2017 and 2018 and should be read, along with all of the information in this management’s discussion and analysis, in conjunction with the consolidated financial statements and related notes included elsewhere in this filing. (All amounts, other than percentages, in thousands of U.S. dollars) Revenue. Revenue increased by approximately $7.3 million or 12%, to approximately $69.3 million in fiscal 2018 from approximately $62.0 million in fiscal 2017. The growth was mainly the result of the expansion of our business with one of our major customers, particularly, in export product types with higher sales value, such as jackets, and the economic recovery of the U.S., which remains the Group’s major export destination. Approximately 88% and 90% of our products were exported to the U.S. in fiscal 2018 and 2017 respectively. As a garment manufacturing group, we excel in manufacturing sport and outerwear and derive most of our revenue from the manufacturing and sales of sport and outerwear, which is the only segment in which we operate. The table below presents our revenues for fiscal years 2017 and 2018 by geographic area. Revenue by Geographic Area (All amounts, other than percentages, in thousands of U.S. dollars) Since December 2001, all apparel manufactured in Jordan could be exported to the U.S. without duty imposed, pursuant to the U.S. Customs and Border Protection Jordan Free Trade Treaty. This treaty provides substantial competitiveness and benefit for us to expand the Group’s garment export business in the U.S. Our sales to the U.S. increased by approximately 9.8% in fiscal 2018 compared to fiscal 2017. According to the Major Shippers Report issued by the Office of Textiles and Apparel under the U.S. Department of Commerce, U.S. apparel import from Jordan increased by approximately 6.7% from $1.30 billion in the fiscal year ended March 31, 2017 to approximately $1.38 billion in the fiscal year ended March 31, 2018. The Group’s sales growth ratio has been exceeding the industrial average growth ratio, and the Group still has plenty of room to expand our garment export business in the U.S., as Jerash accounts for only 4.8% of the total Jordanian garment exports to the U.S., according to The World Bank. Cost of goods sold. Following the growth in sales revenue, our cost of goods sold increased by approximately $4.7 million or 10%, to approximately $51.3 million in fiscal 2018 from approximately $46.6 million in fiscal 2017. As a percentage of revenues, the cost of goods sold decreased by approximately 1% to 74% in fiscal 2018 from 75% in fiscal 2017. The slight decrease in cost of goods sold as a percentage of revenues was primarily attributable to higher selling price and lower fixed cost per unit due to the increase of production volume. Gross profit margin. Gross profit margin was approximately 26% in fiscal 2018, which increased by approximately 1% from 25% in fiscal 2017. The increase in gross profit margin was primarily driven by higher selling price, economies of scale in general, and improved production efficiency. Selling, general and administrative expenses. Selling, general and administrative expenses increased by approximately 30% from approximately $4.7 million in fiscal 2017 to approximately $6.1 million in fiscal 2018. The increase was mainly attributable to the full year operational expenses of approximately $1.0 million of a company established in Hong Kong for sales and marketing functions in fiscal 2018 (the company had operated for approximately six months in fiscal 2017 after it began operations in October 2016), legal and professional fees for the Merger, private placement completed in fiscal 2018 and initial public offering that closed during the first quarter of fiscal 2019, stock-based compensation expense of $116,578 recognized for warrants issued in fiscal 2018, and additional bank charges resulting from the utilization of bank facilities granted by HSBC in August 2017, as further discussed below in “- Credit Facilities.” Other expense, net. Other expense, net was approximately $32,000 and $50,000 in fiscal 2018 and 2017, respectively which were relatively consistent in both years. Net income before taxation. Net income for the year ended March 31, 2018 increased by approximately 11% from approximately $10.6 million to approximately $11.8 million. The increase was mainly attributable to the increase in inventory turnover by approximately 12% and the improvement in gross profit margin from approximately 25% in fiscal 2017 to approximately 26% in fiscal 2018, for the reasons mentioned above. Income tax expenses. On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (“Tax Act”). The Tax Act included a broad range of complex provisions impacting the taxation of multi-national companies. The Tax Act makes broad and complex changes to the U.S. corporate income tax system and includes a Transition Toll Tax (the “Toll Charge”), which is a one-time mandatory deemed repatriation tax on accumulated foreign subsidiaries’ previously untaxed foreign earnings. The Toll Charge will be paid over an eight-year period, starting in 2018, and will not accrue interest. The Tax Act also imposed a global intangible low-taxed income tax (“GILTI”), which is a new tax on certain off-shore earnings at an effective rate of 10.5% for tax years beginning after December 31, 2017 (increasing to 13.125% for tax years beginning after December 31, 2025) with a partial offset for foreign tax credits. Generally, accounting for the impacts of newly enacted tax legislation. Including the Toll Charge, is required to be completed in the period of enactment, however in response to the complexities and ambiguity surrounding the Tax Act, the SEC released Staff Accounting Bulletin No. 118 (“SAB 118”) to provide companies with relief around the initial accounting for the Tax Act. Pursuant to SAB 118, the SEC has provided a one-year measurement period for companies to analyze and finalize accounting for the Tax Act. During the one-year measurement period, SAB 118 allows companies to recognize provisional amounts when reasonable estimates can be made for the impacts resulting from the Tax Act. We will finalize accounting for the Tax Act during the one-year measurement period, and any adjustments to the provisional amounts will be included in income tax expense or benefit in the appropriate period, and disclosed if material, in accordance with guidance provided by SAB 118. While our accounting for the Tax Act is not complete, we have recognized a provisional charge (based on information available as of June 4, 2018) of approximately $1.4 million related to the Toll Charge. To determine the amount of the Toll Charge, we must determine, in addition to other factors, the amount of post-1986 foreign earnings and profits of the relevant subsidiaries, as well as the amount of non-U.S. income taxes paid on such earnings, if any. The income tax payable attributable to the Toll Charge is due over an eight-year period beginning in 2018. At March 31, 2018, an income tax payable of $1.4 million attributable to the transition tax is reflected in the Consolidated Balance Sheet. The Tax Act has significant complexity and our final tax liability may materially differ from provisional estimates due to additional guidance and regulations that may be issued by the U.S. Treasury Department, the Internal Revenue Service (“IRS”) and state and local tax authorities, and for Jerash’s finalization of the relevant calculations required by the new tax legislation. We continue to analyze the provisions of the Tax Act which are effective after December 30, 2017, including but not limited to the imposition of GILTI. Under GAAP, companies are allowed to make an accounting policy election to either treat taxes resulting from GILTI as a current-period expense when they are incurred or factor such amounts into the measurement of deferred taxes. We have not completed our analysis of the effects of the GILTI provisions and will further consider the accounting policy election within the measurement period as provided under SAB 118. Net income. Net income was $10.4 million and $10.6 million in fiscal 2018 and 2017, respectively. The slight decrease was attributable to the $1.4 million one-time repatriation tax provided for in fiscal 2018 which is to be paid over eight years. Liquidity and Capital Resources Jerash Holdings is a holding company incorporated in Delaware. As a holding company, we rely on dividends and other distributions from our Jordanian subsidiaries to satisfy our liquidity requirements. Current Jordanian regulations permit the Group’s Jordanian subsidiaries to pay dividends to us only out of their accumulated profits, if any, determined in accordance with Jordanian accounting standards and regulations. In addition, our Jordanian subsidiaries are required to set aside at least 10% of their respective accumulated profits each year, if any, to fund certain reserve funds. These reserves are not distributable as cash dividends. The Group has relied on direct payments of expenses by the Group’s subsidiaries (which generate revenues), to meet the Group’s obligations to date. To the extent payments are due in U.S. dollars, the Group has occasionally paid such amounts in Jordanian Dinar to an entity controlled by the Group’s management capable of paying such amounts in U.S. dollars. Such transactions have been made at prevailing exchange rates and have resulted in immaterial losses or gains on currency exchange but no other profit. As of March 31, 2018, we had cash of approximately $8.6 million and restricted cash of approximately $3.6 million compared to cash of approximately $3.7 million and restricted cash of approximately $0.5 million as of March 31, 2017, which was mainly the security deposit for obtaining the credit facilities from HSBC. Our current assets as of March 31, 2018 were approximately $36.9 million, and our current liabilities were approximately $7.9 million, which resulted in a current ratio of approximately 4.7:1. Our current assets as of March 31, 2017 were approximately $30.3 million, and our current liabilities were approximately $11.9 million, which resulted in a current ratio of approximately 2.5:1. Total equity as of March 31, 2018 and 2017 was approximately $34.1 million and 22.0 million, respectively. We had net working capital of $29.0 million and $18.4 million as of March 31, 2018 and 2017, respectively. Based on the Group’s current operating plan, we believe that cash on hand and cash generated from operation will be sufficient to support our working capital needs for the next 12 months from the date this document is filed. We have funded our working capital needs from operations. The Group’s working capital requirements are influenced by the level of the Group’s operations, the numerical and dollar volume of the Group’s sales contracts, the progress of execution on the Group’s customer contracts, and the timing of accounts receivable collections. Credit Facilities On May 29, 2017, the Group’s wholly owned subsidiary, Treasure Success, entered into a facility letter (“Facility Letter”) with Hong Kong and Shanghai Banking Corporation (“HSBC”) to provide credit to the Group. Under the terms of the Facility Letter, the Group has a total credit limit of $8,000,000. The Group anticipates amending the Facility Letter to extend the term of the facility with substantially similar terms. The Facility Letter currently provides us with various credit facilities for importing and settling payment for goods purchased from the Group’s suppliers. The available credit facilities as described in greater detail below includes an import facility, import facilities with loan against import, trust receipts, clean import loan, and advances to us against purchase orders. HSBC charges an interest rate of 1.5% per annum over LIBOR or HIBOR, as applicable, for credit related to the release of goods immediately on the Group’s documentary credit. LIBOR was 1.88% and HIBOR was 0.99% at March 31, 2018. HSBC charges a commission of: i) 0.25% for the first $50,000, ii) 0.125% for the balance in excess of $50,000 and up to $100,000 and iii) 0.0625% for balance in excess of $100,000 and an interest rate of 1.5% per annum over LIBOR or HIBOR, as applicable, for credit related to trust receipts whereby HSBC has title to the goods or merchandise released immediately to us. HSBC has approved certain of the Group’s suppliers that are eligible to use clean import loans. HSBC charges a commission of: i) 0.25% for the first $50,000, ii) 0.125% for the balance in excess of $50,000 and up to $100,000 and iii) 0.0625% for balance in excess of $100,000 and an interest of 1.5% per annum over LIBOR or HIBOR, as applicable, for credit services related to clean import loans or release of the goods or merchandise based on evidence of delivery or invoice. HSBC will advance up to 70% of the purchase order value in the Group’s favor. HSBC charges a handling fee of 0.25% and an interest rate of 1.5% per annum over LIBOR or HIBOR, as applicable, for credit services related to advances. The Facility Letter is collateralized by the guarantees of Jerash Holdings (US), Inc, Jerash Garments, and the personal guarantees of Mr. Choi and Mr. Ng Tsze Lun. Jerash Garments is also required to maintain an account at HSBC for receiving payments from VF Sourcing Asia S.A.R.L. and its related companies. In addition, to secure the Facility Letter, the Group granted HSBC a charge of $3,000,000 over the Company’s deposits. This charge is accounted for as restricted cash in our balance sheet at March 31, 2018. Following the anticipated amendment of the Facility Letter, the Group anticipates that the personal guarantees of Mr. Choi and Mr. Ng, along with the charge over the Group’s deposits will be released in exchange for the addition of Jerash Garments to the Facility Letter, along with Treasure Success and Jerash Holdings providing guarantees of Jerash Garments’ payments under the Facility Letter. The Facility Letter is subject to review at any time and valid until May 1, 2018. HSBC has discretion on whether to renew the Facility Letter prior to expiration and the Group is currently negotiating an extension of the Facility Letter on similar terms. As of March 31, 2018, $624,772 was outstanding under the Facility Letter. Borrowings under the Facility Letter are due within 120 days of each borrowing date or upon demand by HSBC. On June 5, 2017, Treasure Success entered into an Offer Letter - Invoice Discounting / Factoring Agreement and on August 21, 2017, Treasure Success entered into the Invoice Discounting/Factoring Agreement (together, the “Factoring Agreement”) with HSBC for certain debt purchase services related to the Group’s accounts receivables. The Group anticipates amending the Factoring Agreement to extend the term of the facility with substantially similar terms. Under the current terms of the Factoring Agreement, the Group may borrow up to $12,000,000. In exchange for advances on eligible invoices from HSBC for the Group’s approved customers, HSBC charges a fee to advance such payments at a discounting charge of 1.5% per annum over 1-month LIBOR or HIBOR, as applicable. Such fee accrues on a daily basis on the amount of funds in use. HSBC has final determination of the percentage amount available for prepayment from each of the Group’s approved customers. The Group may not prepay an amount from a customer in excess of 85% of the funds available for borrowing. As of March 31, 2018, $355,423 was outstanding under the Invoice Discounting / Factoring Agreement. HSBC also provides credit protection and debt services related to each of the Group’s preapproved customers. For any approved debts or collections assigned to HSBC, HSBC charges a flat fee of 0.35% on the face value of the invoice for such debt or collection. The Group may assign debtor payments that are to be paid to HSBC within 90 days, defined as the maximum terms of payment. The Group may receive advances on invoices that are due within 30 days of the delivery of the Group’s goods, defined as the maximum invoicing period. The advances made by HSBC are collateralized by the guarantees of us and Jerash Garments, and the personal guarantees by Mr. Choi and Mr. Ng Tsze Lun. In addition, to secure the Factoring Agreement, the Group granted HSBC a charge of $3,000,000 over the Group’s deposits. If the Group fails to pay any sum due to HSBC, HSBC may charge a default interest at the rate of 8.5% per annum over the best lending rate quoted by HSBC on such defaulted amount. Following the anticipated amendment of the Factoring Agreement, the Group anticipates that the personal guarantees of Mr. Choi and Mr. Ng, along with the charge over the Group’s deposits will be released in exchange for the addition of Jerash Garments to the Factoring Agreement, along with Treasure Success and Jerash Holdings providing guarantees of Jerash Garments’ payments under the Factoring Agreement. The Factoring Agreement is subject to the review by HSBC at any time, and valid until May 1, 2018 and we are in the process of negotiating an extension on similar terms. Either party may terminate the agreement subject to a 30-day notice period. As of March 31, 2018, there was $355,423 outstanding under the Factoring Agreement. Amounts borrowed under the Factoring Agreement are due within 120 days of each borrowing date or upon demand by HSBC. Years ended March 31, 2018 and 2017 The following table sets forth a summary of the Group’s cash flows for the fiscal years ended March 31, 2017 and 2018. (All in amounts in thousands of U.S. dollars) Operating Activities Net cash provided by operating activities was approximately $5.2 million in fiscal 2018, compared to net cash provided by operating activities of approximately $7.7 million in fiscal 2017. The decrease in net cash provided by operating activities was primarily attributable to the following factors: · Accounts payable decreased by approximately $5.5 million in fiscal 2018, compared to an increase of accounts payable of approximately $10 million in fiscal 2017, due to payments being made earlier than in fiscal 2017. · Accounts payable - related parties decreased by approximately $5.9 million in fiscal 2017, compared to no change in fiscal 2018, which was primarily attributable to the Company conducting business directly with its vendors rather than through its affiliates during fiscal 2018. · Accounts receivable - related party decreased by approximately $2.3 million in fiscal 2018, compared to an increase of approximately $2.3 million in fiscal 2017, due to the Company’s affiliate’s collection of receivables on behalf of the Company pursuant to the support arrangement with that affiliate in the fiscal year ending March 31, 2018. · Advance to suppliers increased by approximately $1.1 million in fiscal 2018, which was primarily attributable to Treasure Success starting to purchase directly from its suppliers in December 2017. Investing Activities Net cash used in investing activities was approximately $0.5 million and $0.8 million for the years ended March 31, 2018 and 2017, respectively. The lower net cash used in investing activities was a combined result of a $0.4 million increase in property, plant, and equipment, and a $0.7 million decrease in other receivables - related party. Financing Activities Net cash provided by financing activities was approximately $0.3 million for the year ended March 31, 2018. The cash inflow was resulted from the net proceeds from a private placement of approximately $1.8 million, proceeds from short-term loans of approximately $1 million and repayment of amounts due from shareholders of approximately $0.7 million, and an increase of restricted cash of approximately $3.1 million. Non-cash Financing Activities The Group has non-cash financing activities related to the placement of common stocks in fiscal 2018. Expense recognized for warrants issued to the placement agent in connection with the private placement was $161,926. There was also a prepaid stock issuance cost of $239,105 netted with proceeds from the private placement. Statutory Reserves In accordance with the Corporate Law in Jordan, Jerash Holdings’ subsidiaries in Jordan are required to make appropriations to certain reserve funds, based on net income determined in accordance with generally accepted accounting principles of Jordan. Appropriations to the statutory reserve are required to be 10% of net income until the reserve is equal to 100% of the entity’s share capital. This reserve is not available for dividend distribution. As the statutory reserve balance was reached prior to fiscal 2015, there was no additional appropriation into the statutory reserve in fiscal 2017 and 2018. The following table provides the amount of the Group’s statutory reserves, the amount of restricted net assets, consolidated net assets, and the amount of restricted net assets as a percentage of consolidated net assets, as of March 31, 2017 and 2018. (All in amounts, other than percentages, in thousands of U.S. dollars) Total restricted net assets accounted for approximately 0.21% of the Group’s consolidated net assets as of March 31, 2018. As the Group’s subsidiaries in Jordan are only required to set aside 10% of net profits to fund the statutory reserves and it has reached the maximum amount. We believe the potential impact of such restricted net assets on our liquidity is limited. Capital Expenditures We had capital expenditures of approximately $0.9 million and $0.5 million in fiscal 2018 and 2017, respectively, for purchases of equipment in connection with our business activities and to increase capacity. Additions in plant and machinery amounted to approximately $0.6 million and $0.2 million in fiscal 2018 and 2017, respectively, and additions to leasehold improvements amounted to approximately $0.2 million and $0.3 million in fiscal 2018 and 2017, respectively. In 2015, the Group commenced a project to build a 450 square meter workshop in the Tafilah Governorate of Jordan, which will primarily be used as a sewing workshop for Jerash Garments. This project is expected to cost $230,000 and is expected to be completed during calendar year 2018. In 2018, the Group commenced another project to build a 5,000 square meter workshop in Al-Hasa County in the Tafilah Governorate of Jordan, which is expected to be completed in the middle of calendar year 2019. Provided that we satisfy certain employment requirements over certain time periods, we do not anticipate incurring any significant costs for the project, which is being constructed in conjunction with the Jordanian Ministry of Labor and the Jordanian Education and Training Department. In the event we breach our agreement with these government agencies, we will have to pay such agencies JOD250,000 or $353,000. See Item 2. Properties above for more information regarding this workshop. The Group projected that there will be an aggregate of approximately $1.7 million of capital expenditures in both fiscal 2019 and 2020 for further enhancement of production capacity to meet future sales growth. We expect that our capital expenditures will increase in the future as our business continues to develop and expand. The Group has used cash generated from our subsidiaries’ operations to fund our capital commitments in the past and anticipate using such funds and proceeds received from our initial public offering to fund capital expenditure commitments in the future. Off-balance Sheet Commitments and Arrangements We have not entered into any other financial guarantees or other commitments to guarantee the payment obligations of any third parties. In addition, the Group has not entered into any derivative contracts that are indexed to our own shares and classified as shareholders’ equity, or that are not reflected in the Group’s consolidated financial statements. Critical Accounting Policies We prepare our financial statements in conformity with accounting principles generally accepted by the United States of America (“U.S. GAAP”), which require us to make judgments, estimates and assumptions that affect our reported amount of assets, liabilities, revenue, costs and expenses, and any related disclosures. Although there were no material changes made to the accounting estimates and assumptions in the past two years, we continually evaluate these estimates and assumptions based on the most recently available information, our own historical experience and various other assumptions that we believe to be reasonable under the circumstances. Since the use of estimates is an integral component of the financial reporting process, actual results could differ from our expectations as a result of changes in our estimates. We believe that the following accounting policies involve a higher degree of judgment and complexity in their application and require us to make significant accounting estimates. Accordingly, these are the policies that we believe are the most critical to understanding and evaluating our consolidated financial condition and results of operations. Revenue recognition Revenue from product sales is recognized, net of estimated provisions for sales allowances and returns, when the merchandise is shipped, and title is transferred. Revenue is recognized when all four of the following criteria are met: (i) persuasive evidence that an arrangement exists (sales agreements and customer purchase orders are used to determine the existence of an arrangement); (ii) delivery of goods has occurred and risks and benefits of ownership have been transferred (which is when the goods are received by the customer at its designated location in accordance with the sales terms); (iii) the sales price is both fixed and determinable, and (iv) collectability is reasonably assured. Most of the Company’s products are custom-made for large brand-name retailers. Historically, sales returns have been minimal. Accounts receivable Accounts receivable are recognized and carried at original invoiced amount less an estimated allowance for uncollectible accounts. The Company usually grants credit to customers with good credit standing with a maximum of 90 days and determines the adequacy of reserves for doubtful accounts based on individual account analysis and historical collection trends. The Company establishes a provision for doubtful receivables when there is objective evidence that the Company may not be able to collect amounts due. The allowance is based on management's best estimates of specific losses on individual exposures, as well as a provision on historical trends of collections. The provision is recorded against accounts receivables balances, with a corresponding charge recorded in the consolidated statements of income and comprehensive income. Actual amounts received may differ from management's estimate of credit worthiness and the economic environment. Delinquent account balances are written off against the allowance for doubtful accounts after management has determined that the likelihood of collection is not probable. No allowance was considered necessary as of March 31, 2018 and 2017. Recent Accounting Pronouncements The Company considers the applicability and impact of all accounting standards updates (“ASUs”). Management periodically reviews new accounting standards that are issued. New Accounting Pronouncements Recently Adopted In July 2015, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2015-11, “Simplifying the Measurement of Inventory.” ASU No. 2015-11 changes the measurement principle for inventory from the lower of cost or market to lower of cost and net realizable value. Net realizable value is defined as the estimated selling prices in the ordinary course of business; less reasonably predictable costs of completion, disposal and transportation. For public business entities, the amendments in this ASU are effective for fiscal years beginning after December 15, 2016, including interim reporting periods within those fiscal years. The Company adopted this guidance in the first quarter of its fiscal year ended March 31, 2018 using a prospective application. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements and related disclosures. In March 2016, the FASB issued ASU 2016-09, “Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting.” This update addresses several aspects of the accounting for share-based compensation transactions including: (a) income tax consequences when awards vest or are settled, (b) classification of awards as either equity or liabilities, (c) a policy election to account for forfeitures as they occur rather than on an estimated basis and (d) classification of excess tax impacts on the statement of cash flows. The Company adopted this guidance in the first quarter of its fiscal year ended March 31, 2018, which did not have a material impact on the Company’s consolidated financial statements and related disclosures. The amendments requiring recognition of excess tax benefits and tax deficiencies in the income statement will be applied prospectively. The Company does not expect the future impact to be material to the consolidated results of operations; however, such determination is subject to change based on facts and circumstances at the time when awards vest or settle. Accounting Pronouncements Not Yet Adopted In May 2014, the FASB issued ASU No. 2014-09, “Revenue from Contracts with Customers (Topic 606)” (“Topic 606”). Topic 606 requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. Topic 606 will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective and permits the use of either the retrospective or cumulative effect transition method. The guidance also requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts. In August 2015, the FASB issued ASU No. 2015-14, “Deferral of the Effective Date”, which defers the effective date for Topic 606 by one year. For public entities, the guidance in Topic 606 will be effective for annual reporting periods beginning after December 15, 2017 (including interim reporting periods within those periods), and for all other entities, Topic 606 will be effective for annual reporting periods beginning after December 15, 2018, and interim reporting periods within annual reporting periods beginning after December 15, 2019. In March 2016, the FASB issued ASU No. 2016-08, “Principal versus Agent Considerations (Reporting Revenue versus Net),” which clarifies the implementation guidance on principal versus agent considerations in the new revenue recognition standard. In April 2016, the FASB issued ASU No. 2016-10, “Identifying Performance Obligations and Licensing,” which reduces the complexity when applying the guidance for identifying performance obligations and improves the operability and understandability of the license implementation guidance. In May 2016, the FASB issued ASU No. 2016-12 “Narrow-Scope Improvements and Practical Expedients,” which amends the guidance on transition, collectability, noncash consideration and the presentation of sales and other similar taxes. Preliminarily, the Company plans to adopt Topic 606 using the retrospective transition method and is continuing to evaluate the impact its pending adoption of Topic 606 will have on its consolidated financial statements. The Company believes that its current revenue recognition policies are generally consistent with the new revenue recognition standards set forth in Topic 606. Potential adjustments to input measures are not expected to be pervasive to the majority of the Company’s contracts. While no significant impact is expected upon adoption of the new guidance, the Company will not be able to make that determination until the time of adoption based upon outstanding contracts at that time. The Company plans to adopt this pronouncement for our fiscal year ending March 31, 2019 and all interim periods within. In February 2016, the FASB issued ASU No. 2016-02, "Leases” to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet with a corresponding liability and disclosing key information about leasing arrangements. For public business entities, the amendments in this ASU are effective for fiscal years beginning after December 15, 2018, including interim reporting periods within those fiscal years. For all other entities, the amendments in this ASU are effective for fiscal years beginning after December 15, 2019, and interim reporting periods within fiscal years beginning after December 15, 2020. Early adoption is permitted. The Company is evaluating the impact of the adoption of this revised guidance on its consolidated financial statements and related disclosures. In May 2017, the FASB issued ASU 2017-09, “Scope of Modification Accounting”, which amends the scope of modification accounting for share-based payment arrangements, provides guidance on the types of changes to the terms or conditions of share-based payment awards to which an entity would be required to apply modification accounting under ASC 718. For all entities, the ASU is effective for annual reporting periods, including interim periods within those annual reporting periods, beginning after December 15, 2017. Early adoption is permitted, including adoption in any interim period. The Company does not expect that adoption of this guidance will have a material impact on its consolidated financial statements and related disclosures.
0.075864
0.076169
0
<s>[INST] EXECUTIVE OVERVIEW Overview Jerash Holdings is a holding company organized as a corporation in Delaware in January 2016 with nominal or no assets or operations. Through our wholly owned operating subsidiaries, the Group is principally engaged in the manufacturing and exporting of customized, readymade sport and outerwear from knitted fabric produced in the Group’s facilities in Jordan. The Group is an approved manufacturer by many wellknown brands and retailers, such as Walmart, Costco, Sears, Hanes, Columbia, Land’s End, VF Corporation (which owns brands such as The North Face, Nautica, Timberland, Wrangler, Lee, Jansport, etc.), and PhilipVan Heusen (which owns brands such as Calvin Klein, Tommy Hilfiger, IZOD, Speedo, etc.). Our production facilities are made up of three factory units and two warehouses and currently employ approximately 2,900 people. Our employees include local Jordanian workers as well as migrant workers from Bangladesh, Sri Lanka, India, Myanmar and Nepal. The total annual capacity at the Group’s facilities is approximately 6.5 million pieces (average for product categories including tshirts, polos and jackets). Merger On May 11, 2017, we implemented the Merger via two transactions, the first being an equity contribution whereby the shareholders of Global Trend, contributed 100% of the outstanding capital stock of Global Trend to Jerash Holdings in exchange for an aggregate of 8,787,500 shares of common stock of Jerash Holdings with Global Trend becoming the whollyowned subsidiary of Jerash Holdings. In the second transaction, Global Trend merged with and into Jerash Holdings with Jerash Holdings being the surviving entity, as a result of which Jerash Holdings became the direct parent of Global Trend’s wholly owned operating subsidiaries, Jerash Garments and Treasure Success. Accounting Treatment of Merger For accounting purposes, Global Trend is recognized as the accounting acquirer, and Jerash Holdings is the legal acquirer or accounting acquiree. As such, following the Merger, the historical financial statements of Global Trend are treated as the historical financial statements of the combined company. Accordingly, the financial information in this Annual Report on Form 10K, including management’s discussion and analysis of financial condition and results of operations and the consolidated financial statements and the related notes thereto appearing elsewhere in this filing, reflect the consolidated financial statements of Global Trend, its subsidiaries and its affiliate, which includes as a variable interest entity Victory Apparel Jordan Company Limited (“Victory Apparel”). Victory Apparel was incorporated in Jordan in 2005 and it is a wholly owned subsidiary of WCL. Wealth Choice Limited (“WCL”) acquired Global Trend and Jerash Garments from two thirdparty individuals on March 21, 2012. On March 31, 2006, Victory Apparel purchased all of the property and equipment of Jerash Garments at an industrial building in Al Tajamouat Industrial City purchased by Jerash Garments on July 31, 2000. The land and building were not registered in Victory Apparel’s name, and Jerash Garments continued to hold the land and building in its name in trust for Victory Apparel. The declaration of trust was never registered with the Land Registry of Jordan, and on June 30, 2016, Victory Apparel and Jerash Garments dissolved the sale agreement, resulting in the property and equipment being owned free and clear by Jerash Garments. Victory Apparel does not currently have any material assets or operations of its own, and Mr. Choi and Mr. Lee, the Group’s significant stockholders who together indirectly own 100% of Victory Apparel through WCL, intend to dissolve the entity Seasonality of Sales A significant portion of our revenues are received during the first six months of our fiscal year. The majority of our VF Corporation orders are derived from winter season fashions, the sales of which occur in Spring and Summer and are merchandized by VF Corporation during the Autumn months (September through November). As such, the second half of our fiscal years reflect [/INST] Positive. </s>
2,018
6,035
1,696,558
Jerash Holdings (US), Inc.
2019-06-28
2019-03-31
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The following discussion of the Group’s financial condition and results of operations should be read in conjunction with the Group’s consolidated financial statements and the related notes included elsewhere in this filing. EXECUTIVE OVERVIEW Overview Jerash Holdings is a holding company organized as a corporation in Delaware in January 2016 with nominal or no assets or operations. Through our wholly owned operating subsidiaries, the Group is principally engaged in the manufacturing and exporting of customized, ready-made sport and outerwear from knitted fabric produced in the Group’s facilities in Jordan. The Group is an approved manufacturer by many well-known brands and retailers, such as Walmart, Costco, Hanes, Columbia, VF Corporation (which owns brands such as The North Face, Timberland, Jansport, etc.), and PVH Corp. (which owns brands such as Calvin Klein, Tommy Hilfiger, IZOD, Speedo, etc.). Our production facilities are made up of four factory units and three warehouses and currently employ approximately 3,600 people. Our employees include local Jordanian workers as well as migrant workers from Bangladesh, Sri Lanka, India, Myanmar and Nepal. The total annual capacity at the Group’s facilities is approximately 8.0 million pieces (average for product categories including t-shirts, polos and jackets). Merger On May 11, 2017, we implemented a merger (the “Merger”) via two transactions, the first being an equity contribution whereby the shareholders of Global Trend, contributed 100% of the outstanding capital stock of Global Trend to Jerash Holdings in exchange for an aggregate of 8,787,500 shares of common stock of Jerash Holdings with Global Trend becoming the wholly-owned subsidiary of Jerash Holdings. In the second transaction, Global Trend merged with and into Jerash Holdings with Jerash Holdings being the surviving entity, as a result of which Jerash Holdings became the direct parent of Global Trend’s wholly owned operating subsidiaries, Jerash Garments and Treasure Success. Accounting Treatment of Merger For accounting purposes, Global Trend is recognized as the accounting acquirer, and Jerash Holdings is the legal acquirer or accounting acquiree. As such, following the Merger, the historical financial statements of Global Trend are treated as the historical financial statements of the combined company. Accordingly, the financial information in this Annual Report on Form 10-K prior to the Merger, including management’s discussion and analysis of financial condition and results of operations and the consolidated financial statements and the related notes thereto appearing elsewhere in this filing, reflect the consolidated financial statements of Global Trend, its subsidiaries and its affiliate, which includes as a variable interest entity Victory Apparel Jordan Company Limited (“Victory Apparel”). Victory Apparel was incorporated in Jordan in 2005 and it is a wholly owned subsidiary of Wealth Choice Limited (“WCL”). WCL acquired Global Trend and Jerash Garments from two third-party individuals on March 21, 2012. On March 31, 2006, Victory Apparel purchased all of the property and equipment of Jerash Garments at an industrial building in Al Tajamouat Industrial City purchased by Jerash Garments on July 31, 2000. The land and building were not registered in Victory Apparel’s name, and Jerash Garments continued to hold the land and building in its name in trust for Victory Apparel. The declaration of trust was never registered with the Land Registry of Jordan, and on June 30, 2016, Victory Apparel and Jerash Garments dissolved the sale agreement, resulting in the property and equipment being owned free and clear by Jerash Garments. Victory Apparel does not currently have any material assets or operations of its own, and Mr. Choi and Mr. Lee, the Group’s significant stockholders who together indirectly own 100% of Victory Apparel through WCL, intend to dissolve the entity. Seasonality of Sales A significant portion of our revenues are received during the first six months of our fiscal year. The majority of our VF Corporation orders are derived from winter season fashions, the sales of which occur in Spring and Summer and are merchandized by VF Corporation during the Autumn months (September through November). As such, the second half of our fiscal years reflect lower sales in anticipation of the spring and summer seasons. One of our strategies is to increase sales with other customers where clothing lines are stronger during the spring months. This strategy also reflects our current plan to increase the Group’s number of customers to mitigate our current concentration risk with VF Corporation. Results of Operations The following table presents certain information from our statement of income for fiscal years 2018 and 2019 and should be read, along with all of the information in this management’s discussion and analysis, in conjunction with the consolidated financial statements and related notes included elsewhere in this filing. (All amounts, other than percentages, in thousands of U.S. dollars) Revenue. Revenue increased by approximately $15.7 million or 23%, to approximately $85.0 million in fiscal 2019 from approximately $69.3 million in fiscal 2018. The growth was mainly the result of the expansion of our business with one of our major customers, particularly, in export product types with higher sales value, such as jackets, the addition of new customers and the continued economic expansion of the U.S., which remains the Group’s major export destination. Approximately 83% and 88% of our products were exported to the U.S. in fiscal 2019 and 2018, respectively. The table below presents our revenues for fiscal years 2018 and 2019 by geographic area. Revenue by Geographic Area (All amounts, other than percentages, in thousands of U.S. dollars) Since January 2010, all apparel manufactured in Jordan can be exported to the U.S. without duty imposed, pursuant to the U.S. Customs and Border Protection Jordan Free Trade Treaty entered into in December 2001. This treaty provides substantial competitiveness and benefit for us to expand the Group’s garment export business in the U.S. Our sales to the U.S. increased by approximately 14% in fiscal 2019 compared to fiscal 2018. According to the Major Shippers Report issued by the Office of Textiles and Apparel under the U.S. Department of Commerce, U.S. apparel import from Jordan increased by approximately 13.33% from $1.38 billion in the fiscal year ended March 31, 2018 to approximately $1.56 billion in the fiscal year ended March 31, 2019. The Group’s sales growth ratio has been exceeding the industrial average growth ratio, and the Group expects it still has plenty of room to expand our garment export business in the U.S., as Jerash accounts for only approximately 5.0% of the total Jordanian garment exports to the U.S., according to data from the Major Shippers Report issued by the U.S. Department of Commerce. Cost of goods sold. Following the growth in sales revenue, our cost of goods sold increased by approximately $14.9 million or 29%, to approximately $66.2 million in fiscal 2019 from approximately $51.3 million in fiscal 2018. As a percentage of revenues, the cost of goods sold increased by approximately 4% to 78% in fiscal 2019 from 74% in fiscal 2018. The increase in cost of goods sold as a percentage of revenues was primarily attributable to lower priced contract orders compared to fiscal 2018, sample orders for customers and lower profit margin orders intended to seize market share in warm weather products. For the fiscal year ended March 31, 2019, the Company purchased approximately 19%, 12% and 11% of its raw materials from three major suppliers. For the fiscal year ended March 31, 2018 the company purchased approximately 43% and 18% of its raw materials from two major suppliers. Gross profit margin. Gross profit margin was approximately 22% in fiscal 2019, which decreased by approximately 4% from 26% in fiscal 2018. The decrease in gross profit margin was primarily driven by the higher proportion of the lower priced contract orders compared to fiscal 2018, sample orders for customers and lower profit margin orders intended to seize market share in warm weather products. Selling, general and administrative expenses. Selling, general and administrative expenses increased by approximately 103% from approximately $6.1 million in fiscal 2018 to approximately $12.4 million in fiscal 2019. The increase was mainly attributable to share-based compensation expense of $3.6 million recognized for stock options issued in fiscal 2019, legal and professional expense in relation to the Company’s listing on the Nasdaq such as listing fees, compliance costs, investor relations expenses and expenses incurred for the expansion of business including gaining new customers and expanding our production capacity. Other income / (expense), net. Other income, net was approximately $23,000 in fiscal 2019 and there was other expense, net of approximately $32,000 in fiscal 2018. The net gain in fiscal 2019 mainly resulted from the impact of variable exchange rates. Net income before taxation. Net income before taxation for the year ended March 31, 2019 decreased by approximately 46% from approximately $11.8 million to approximately $6.4 million. The decrease was mainly attributable to the increase in selling, administrative and general expenses including share-based compensation expense of approximately $3.6 million, increase in legal and professional fees in relation to the Company’s listing on Nasdaq, and the expenses incurred in developing new customers and expanding our production capacity. Decreased gross profit margin, as discussed in cost of goods sold and gross profit margin above, were also a significant driver in the reduction in net income before taxation. U.S. taxation. On December 22, 2017, the United States enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (the “Tax Act”). Under the provisions of the Tax Act, the U.S. corporate tax rate decreased from 35% to 21%. Additionally, the Tax Act imposes a one-time transition tax on deemed repatriation of historical earnings of foreign subsidiaries. Future foreign earnings are subject to U.S. taxation under the new GILTI regime. In accordance with the requirements of Staff Accounting Bulletin 118, the Company has completed its accounting for the Act, as discussed below. During the third quarter of fiscal 2019, we completed our accounting for the impact of the transition tax with the finalization of our fiscal year 2018 tax returns, and we determined that the transition tax liability was approximately $1.7 million. Of this amount, $0.2 million was paid during the 2019 fiscal year, $0.1 million is payable within the 2020 fiscal year, and the remaining $1.4 million is payable in years after the 2020 fiscal year. Furthermore, as discussed in the Company’s third quarter financial statements, we evaluated the impacts of the GILTI provisions of the Tax Act and the application of Accounting Standards Codification 740, Income Taxes. Under U.S. GAAP, the Company is allowed to make an accounting policy choice of either (1) treating taxes due on future U.S. inclusions in taxable income related to GILTI as a current-period expense when incurred (the “period cost method”) or (2) factoring such amounts into the Company’s measurement of its deferred taxes (the “deferred method”). We have selected the period cost method as our accounting policy with respect to the new GILTI tax rules, and therefore we have considered the taxes resulting from GILTI as a current-period expense for the 2019 fiscal year. Jordan taxation. Jerash Garments, Jerash Embroidery, Chinese Garments and Victory Apparel are subject to the regulations of Income Tax Department in Jordan. The corporate income tax rate is 14% for the industrial sector. In accordance with the Investment Encouragement Law, Jerash Garments' export sales to overseas customers are entitled to a 100% income tax exemption for a period of 10 years commencing at the first day of production. This exemption was extended for 5 years to December 31, 2018. Effective January 1, 2019, in accordance to Development Zone law, Jerash Garments and its subsidiaries began paying corporate income tax in Jordan at a rate of 5%. For the year ended March 31, 2019, Jordan income tax was $40,260. Jerash Garments and its subsidiaries are subject to local sales tax of 16%. However, Jerash Garments was granted a sales tax exemption from the Jordanian Investment Commission for the period June 1, 2015 to June 1, 2018 that allowed Jerash Garments to make purchases with no sales tax charge. This exemption was extended to February 15, 2020 and the Company intends to apply to extend the exemption before the expiration date. Hong Kong taxation. Treasure Success is registered in Hong Kong with an income tax rate of 8.25% on assessable profits up to HK$2,000,000 and 16.5% on any part of assessable profits over HK$2,000,000. Treasure Success incurred no income tax expense for fiscal 2019 and 2018 due to its operating loss. In accordance with tax legislation in Hong Kong, the accumulated loss can be used to offset future profit for income tax purposes. Net income. Net income for the year ended March 31, 2019 of approximately $5.1 million decreased by approximately 51% from approximately $10.4 million for the year ended March 31, 2018. The decrease was mainly attributable to the increase in selling, administrative and general expenses including share-based compensation expense of approximately $3.6 million, increases in legal and professional fees relating to the Company’s listing on Nasdaq, and the expenses incurred in developing new customers and expanding our production capacity. Decreased gross profit margin, as discussed in cost of goods sold and gross profit margin above, were also a significant driver in the reduction in net income. Liquidity and Capital Resources Jerash Holdings is a holding company incorporated in Delaware. As a holding company, we rely on dividends and other distributions from our Jordanian subsidiaries to satisfy our liquidity requirements. Current Jordanian regulations permit the Group’s Jordanian subsidiaries to pay dividends to us only out of their accumulated profits, if any, determined in accordance with Jordanian accounting standards and regulations. In addition, our Jordanian subsidiaries are required to set aside at least 10% of their respective accumulated profits each year, if any, to fund certain reserve funds. These reserves are not distributable as cash dividends. The Group has relied on direct payments of expenses by the Group’s subsidiaries (which generate revenues), to meet the Group’s obligations to date. To the extent payments are due in U.S. dollars, the Group has occasionally paid such amounts in Jordanian Dinar to an entity controlled by the Group’s management capable of paying such amounts in U.S. dollars. Such transactions have been made at prevailing exchange rates and have resulted in immaterial losses or gains on currency exchange but no other profit. As of March 31, 2019, we had cash of approximately $27.2 million and restricted cash of approximately $0.7 million compared to cash of approximately $8.6 million and restricted cash of approximately $3.6 million as of March 31, 2018, which was mainly the security deposit for obtaining the credit facilities from HSBC. Our current assets as of March 31, 2019 were approximately $55.4 million, and our current liabilities were approximately $7.6 million, which resulted in a current ratio of approximately 7.3:1. Our current assets as of March 31, 2018 were approximately $36.9 million, and our current liabilities were approximately $7.9 million, which resulted in a current ratio of approximately 4.7:1. Total equity as of March 31, 2019 and 2018 was approximately $50.3 million and 34.1 million, respectively. We had net working capital of $47.8 million and $28.9 million as of March 31, 2019 and 2018, respectively. Based on the Group’s current operating plan, we believe that cash on hand and cash generated from operation will be sufficient to support our working capital needs for the next 12 months from the date this document is filed. We have funded our working capital needs from operations. The Group’s working capital requirements are influenced by the level of the Group’s operations, the numerical and dollar volume of the Group’s sales contracts, the progress of execution on the Group’s customer contracts, and the timing of accounts receivable collections. Credit Facilities HSBC Facility On May 29, 2017, the Group’s wholly owned subsidiary, Treasure Success, entered into a facility letter (“2017 Facility Letter”) with Hong Kong and Shanghai Banking Corporation (“HSBC”) to provide credit to the Group, which was later amended by an offer letter between HSBC, Treasure Success and Jerash Garments dated June 19, 2018 (“2018 Facility Letter,” and together with the 2017 Facility Letter, the “HSBC Facility”). The 2018 Facility Letter, which became effective on January 22, 2019, served to extend the term of the 2017 Facility Letter with some changes to the collateral for the HSBC Facility. Under the terms of the HSBC Facility, the Group has a total credit limit of $8,000,000. The 2018 Facility Letter extends the HSBC Facility through May 1, 2019, and the Group anticipates amending the HSBC Facility to extend the term of the facility with substantially similar terms and that the Group will continue to be able to use the borrowings under the HSBC facility through any negotiation period. The HSBC Facility currently provides us with various credit facilities for importing and settling payment for goods purchased from the Group’s suppliers. The available credit facilities as described in greater detail below includes an import facility, import facilities with loan against import, trust receipts, clean import loan, and advances to us against purchase orders. HSBC charges an interest rate of 1.5% per annum over LIBOR or HIBOR, as applicable, for credit related to the release of goods immediately on the Group’s documentary credit. LIBOR was 2.56% and HIBOR was 1.75% at March 31, 2019. HSBC charges a commission of: i) 0.25% for the first $50,000, ii) 0.125% for the balance in excess of $50,000 and up to $100,000 and iii) 0.0625% for balance in excess of $100,000 and an interest rate of 1.5% per annum over LIBOR or HIBOR, as applicable, for credit related to trust receipts whereby HSBC has title to the goods or merchandise released immediately to us. HSBC has approved certain of the Group’s suppliers that are eligible to use clean import loans. HSBC charges a commission of: i) 0.25% for the first $50,000, ii) 0.125% for the balance in excess of $50,000 and up to $100,000 and iii) 0.0625% for balance in excess of $100,000 and an interest of 1.5% per annum over LIBOR or HIBOR, as applicable, for credit services related to clean import loans or release of the goods or merchandise based on evidence of delivery or invoice. HSBC will advance up to 70% of the purchase order value in the Group’s favor. HSBC charges a handling fee of 0.25% and an interest rate of 1.5% per annum over LIBOR or HIBOR, as applicable, for credit services related to advances. Previously, the HSBC the Facility was collateralized by the guarantees of us, Jerash Garments, Treasure Success and the personal guarantees of Mr. Choi and Mr. Ng Tsze Lun. Jerash Garments is also required to maintain an account at HSBC for receiving payments from VF Sourcing Asia S.A.R.L. and its related companies. In addition, to secure the Facility Letter, the Group had granted HSBC a charge of $3,000,000 over the Company’s deposits. This charge was accounted for as restricted cash in our balance sheet at March 31, 2018. Following the effectiveness of the 2018 Facility Letter, the security collateral of $3,000,000 was released. The Group anticipates that the personal guarantees of Mr. Choi and Mr. Ng will be released during calendar year 2019. The HSBC Facility is subject to review at any time. HSBC has discretion on whether to renew the HSBC Facility prior to expiration and the Group is currently negotiating an extension of the Facility Letter on similar terms. As of March 31, 2019, $274,980 was outstanding under the Facility Letter. Borrowings under the Facility Letter are due within 120 days of each borrowing date or upon demand by HSBC. HSBC Factoring Agreement On June 5, 2017, Treasure Success entered into an Offer Letter - Invoice Discounting / Factoring Agreement and on August 21, 2017, Treasure Success entered into the Invoice Discounting/Factoring Agreement (together, the “2017 Factoring Agreement”) with HSBC for certain debt purchase services related to the Group’s accounts receivables. On June 14, 2018, Treasure Success and Jerash Garments entered into another Offer Letter - Invoice Discounting / Factoring Agreement with HSBC (the “2018 Factoring Agreement, and together with the 2017 Factoring Agreement, the “HSBC Factoring Agreement”), which amends the 2017 Factoring Agreement. The HSBC Factoring Agreement is effective through May 1, 2019. The Group anticipates amending the HSBC Factoring Agreement to extend the term of the facility with substantially similar terms and that the Group will continue to be able to use the borrowings under the HSBC Factoring Agreement through any negotiation period. Under the current terms of the HSBC Factoring Agreement, the Group may borrow up to $12,000,000. In exchange for advances on eligible invoices from HSBC for the Group’s approved customers, HSBC charges a fee to advance such payments at a discounting charge of 1.5% per annum over 2-month LIBOR or HIBOR, as applicable. Such fee accrues on a daily basis on the amount of funds in use. HSBC has final determination of the percentage amount available for prepayment from each of the Group’s approved customers. The Group may not prepay an amount from a customer in excess of 85% of the funds available for borrowing. As of March 31, 2019, $85,421 was outstanding under the Factoring Agreement. HSBC also provides credit protection and debt services related to each of the Group’s preapproved customers. For any approved debts or collections assigned to HSBC, HSBC charges a flat fee of 0.35% on the face value of the invoice for such debt or collection. The Group may assign debtor payments that are to be paid to HSBC within 90 days, defined as the maximum terms of payment. The Group may receive advances on invoices that are due within 30 days of the delivery of the Group’s goods, defined as the maximum invoicing period. The advances made by HSBC are collateralized by the guarantees of us, Jerash Garments, Treasure Success and the personal guarantees of Mr. Choi and Mr. Ng Tsze Lun. If the Group fails to pay any sum due to HSBC, HSBC may charge a default interest at the rate of 8.5% per annum over the best lending rate quoted by HSBC on such defaulted amount. In addition, to secure the Factoring Agreement, the Group had granted HSBC a charge of $3,000,000 over the Group’s deposits. Following the effectiveness of the 2018 Factoring Agreement, the security collateral of $3,000,000 was released as of January 22, 2019. The Group anticipates that the personal guarantees of Mr. Choi and Mr. Ng will be released during calendar year 2019. The HSBC Factoring Agreement is subject to the review by HSBC at any time and HSBC has discretion on whether to renew the HSBC Factoring Agreement. Either party may terminate the agreement subject to a 30-day notice period. SCBHK Facility Letter Pursuant to the SCBHK facility letter dated June 15, 2018 and issued to Treasure Success International Limited by SCBHK, on January 31, 2019, SCBHK offered to provide an import facility of up to $3.0 million to Treasure Success. The SCBHK facility covers import invoice financing and pre-shipment financing under export orders with a combined limit of $3 million. SCBHK charges interest at 1.3% per annum over SCBHK’s cost of funds. In consideration for arranging the SCBHK facility, Treasure Success paid SCBHK HKD50,000. The Company was informed by SCBHK on January 31, 2019 that the SCBHK facility has been activated. As of March 31, 2019, there was an outstanding amount of $288,310 in import invoice financing. Years ended March 31, 2019 and 2018 The following table sets forth a summary of the Group’s cash flows for the fiscal years ended March 31, 2018 and 2019. (All amounts in thousands of U.S. dollars) Operating Activities Net cash provided by operating activities was approximately $9.8 million in fiscal 2019, compared to net cash provided by operating activities of approximately $5.2 million in fiscal 2018. The increase in net cash provided by operating activities was primarily attributable to the following factors: · Accounts payable decreased by approximately $1.4 million in fiscal 2019, compared to a decrease of accounts payable of approximately $5.5 million in fiscal 2018, due to improvement on credit terms of certain suppliers. · Accounts receivable decreased by approximately $1.2 million in fiscal 2019, compared to an increase of approximately $2.5 million in fiscal 2018, due to higher proportion of contract orders in the fourth quarter of 2019 which normally are settled within 30 days. Investing Activities Net cash used in investing activities was approximately $1.6 million and $0.5 million for the years ended March 31, 2019 and 2018, respectively. The increase in net cash used in investing activities was mainly attributable to a deposit relating to the Paramount acquisition, as further discussed in Item 2. Properties above. Financing Activities Net cash provided by financing activities was approximately $7.5 million for the year ended March 31, 2019 compared to $3.4 million in fiscal 2018. The cash inflow resulted from the net effect of the net proceeds from the initial public offering (“IPO”) of the Company’s stock on Nasdaq of approximately $8.9 million, and $1.1 million of dividend paid, and $0.3 million, net, for repaying short-term loans under the HSBC Facility Letter and processing import invoice financing under the SBCHK facility. Non-cash Financing Activities The Group had non-cash financing activities related to the IPO in fiscal 2019. Expense recognized for warrants issued to the underwriters in connection with the IPO was $160,732. There was also a prepaid stock issuance cost of $308,179 netted with proceeds from the IPO. There was an aggregate of non-cash financing activities of $401,031 in connection with the private placement in fiscal 2018. Statutory Reserves In accordance with the Corporate Law in Jordan, Jerash Holdings’ subsidiaries in Jordan are required to make appropriations to certain reserve funds, based on net income determined in accordance with generally accepted accounting principles of Jordan. Appropriations to the statutory reserve are required to be 10% of net income until the reserve is equal to 100% of the entity’s share capital. This reserve is not available for dividend distribution. The statutory reserve was $71,699 and $212,739 in fiscal 2018 and 2019, respectively. The following table provides the amount of the Group’s statutory reserves, the amount of restricted net assets, consolidated net assets, and the amount of restricted net assets as a percentage of consolidated net assets, as of March 31, 2018 and 2019. (All amounts, other than percentages, in thousands of U.S. dollars) Total restricted net assets accounted for approximately 0.42% of the Group’s consolidated net assets as of March 31, 2019. As the Group’s subsidiaries in Jordan are only required to set aside 10% of net profits to fund the statutory reserves, it has reached the maximum amount. We believe the potential impact of such restricted net assets on our liquidity is limited. Capital Expenditures We had capital expenditures of approximately $0.8 million and $0.9 million in fiscal 2019 and 2018, respectively, for purchases of equipment in connection with our business activities and to increase capacity. Additions in plant and machinery amounted to approximately $0.6 million and $0.6 million in fiscal 2019 and 2018, respectively, and additions to leasehold improvements amounted to approximately $0.1 million and $0.2 million in fiscal 2019 and 2018, respectively. In 2015, we commenced a project to build a 4,800 square foot workshop in the Tafilah Governorate of Jordan, which was initially intended to be used as a sewing workshop for Jerash Garments, has been changed to become a dormitory. This dormitory is expected to be operational in September 2019 and is expected to house workers for the 54,000 square foot workshop in Al-Hasa County. In 2018, the Group commenced another project to build a 54,000 square foot workshop in Al-Hasa County in the Tafilah Governorate of Jordan, which is expected to be completed in September 2019. Provided that we satisfy certain employment requirements over certain time periods, we do not anticipate incurring any significant costs for the project, which is being constructed in conjunction with the Jordanian Ministry of Labor and the Jordanian Education and Training Department. In the event we breach our agreement with these government agencies, we will have to pay such agencies JOD250,000 or $353,000. See Item 2. Properties above for more information regarding this workshop. On December 11, 2018, the Company entered into an agreement through Jerash Garments to acquire all of the stock of Paramount, an existing garment manufacturing business, in order to operate its fourth manufacturing facility in Al Tajamouat Industrial City in Amman, Jordan. The Group paid approximately $980,000 as of the closing date of the transaction on June 18, 2019. The Group projected that there will be an aggregate of approximately $15 million of capital expenditures in both the fiscal years ending March 31, 2020 and 2021 for further enhancement of production capacity to meet future sales growth. We expect that our capital expenditures will increase in the future as our business continues to develop and expand. The Group has used cash generated from our subsidiaries’ operations to fund our capital commitments in the past and anticipate using such funds and proceeds received from our IPO to fund capital expenditure commitments in the future. Off-balance Sheet Commitments and Arrangements We have not entered into any other financial guarantees or other commitments to guarantee the payment obligations of any third parties. In addition, the Group has not entered into any derivative contracts that are indexed to our own shares and classified as shareholders’ equity, or that are not reflected in the Group’s consolidated financial statements. For Management’s Discussion and Analysis of the fiscal years ended March 31, 2018 and 2017, please see our Annual Report on Form 10-K for the year ended March 31, 2018, filed with the SEC on June 28, 2018. Critical Accounting Policies We prepare our financial statements in conformity with U.S. GAAP, which require us to make judgments, estimates and assumptions that affect our reported amount of assets, liabilities, revenue, costs and expenses, and any related disclosures. Although there were no material changes made to the accounting estimates and assumptions in the past two years, we continually evaluate these estimates and assumptions based on the most recently available information, our own historical experience and various other assumptions that we believe to be reasonable under the circumstances. Since the use of estimates is an integral component of the financial reporting process, actual results could differ from our expectations as a result of changes in our estimates. We believe that certain accounting policies involve a higher degree of judgment and complexity in their application and require us to make significant accounting estimates. The policies that we believe are the most critical to understanding and evaluating our consolidated financial condition and results of operations are summarized in Note 2- Summary of Significant Accounting Policies in the notes to our audited financial statements. Recent Accounting Pronouncements See Note 3 - Recent Accounting Pronouncements in the notes to our audited financial statements for a discussion of recent accounting pronouncements.
-0.024996
-0.024886
0
<s>[INST] EXECUTIVE OVERVIEW Overview Jerash Holdings is a holding company organized as a corporation in Delaware in January 2016 with nominal or no assets or operations. Through our wholly owned operating subsidiaries, the Group is principally engaged in the manufacturing and exporting of customized, readymade sport and outerwear from knitted fabric produced in the Group’s facilities in Jordan. The Group is an approved manufacturer by many wellknown brands and retailers, such as Walmart, Costco, Hanes, Columbia, VF Corporation (which owns brands such as The North Face, Timberland, Jansport, etc.), and PVH Corp. (which owns brands such as Calvin Klein, Tommy Hilfiger, IZOD, Speedo, etc.). Our production facilities are made up of four factory units and three warehouses and currently employ approximately 3,600 people. Our employees include local Jordanian workers as well as migrant workers from Bangladesh, Sri Lanka, India, Myanmar and Nepal. The total annual capacity at the Group’s facilities is approximately 8.0 million pieces (average for product categories including tshirts, polos and jackets). Merger On May 11, 2017, we implemented a merger (the “Merger”) via two transactions, the first being an equity contribution whereby the shareholders of Global Trend, contributed 100% of the outstanding capital stock of Global Trend to Jerash Holdings in exchange for an aggregate of 8,787,500 shares of common stock of Jerash Holdings with Global Trend becoming the whollyowned subsidiary of Jerash Holdings. In the second transaction, Global Trend merged with and into Jerash Holdings with Jerash Holdings being the surviving entity, as a result of which Jerash Holdings became the direct parent of Global Trend’s wholly owned operating subsidiaries, Jerash Garments and Treasure Success. Accounting Treatment of Merger For accounting purposes, Global Trend is recognized as the accounting acquirer, and Jerash Holdings is the legal acquirer or accounting acquiree. As such, following the Merger, the historical financial statements of Global Trend are treated as the historical financial statements of the combined company. Accordingly, the financial information in this Annual Report on Form 10K prior to the Merger, including management’s discussion and analysis of financial condition and results of operations and the consolidated financial statements and the related notes thereto appearing elsewhere in this filing, reflect the consolidated financial statements of Global Trend, its subsidiaries and its affiliate, which includes as a variable interest entity Victory Apparel Jordan Company Limited (“Victory Apparel”). Victory Apparel was incorporated in Jordan in 2005 and it is a wholly owned subsidiary of Wealth Choice Limited (“WCL”). WCL acquired Global Trend and Jerash Garments from two thirdparty individuals on March 21, 2012. On March 31, 2006, Victory Apparel purchased all of the property and equipment of Jerash Garments at an industrial building in Al Tajamouat Industrial City purchased by Jerash Garments on July 31, 2000. The land and building were not registered in Victory Apparel’s name, and Jerash Garments continued to hold the land and building in its name in trust for Victory Apparel. The declaration of trust was never registered with the Land Registry of Jordan, and on June 30, 2016, Victory Apparel and Jerash Garments dissolved the sale agreement, resulting in the property and equipment being owned free and clear by Jerash Garments. Victory Apparel does not currently have any material assets or operations of its own, and Mr. Choi and Mr. Lee, the Group’s significant stockholders who together indirectly own 100% of Victory Apparel through WCL, intend to dissolve the entity. Seasonality of Sales A significant portion of our revenues are received during the first six months of our fiscal year. The majority of our VF Corporation orders are derived from winter season fashions, the sales of which occur in Spring and Summer and are merchandized by VF Corporation during the Autumn months (September through November). As such, the second half of our fiscal years reflect lower sales in anticipation of the [/INST] Negative. </s>
2,019
5,142
1,327,607
First Western Financial 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 audited consolidated financial statements and the accompanying notes included elsewhere in this Annual Report on Form 10-K. The following discussion contains “forward-looking statements” that reflect our future plans, estimates, beliefs and expected performance. We caution that assumptions, expectations, projections, intentions or beliefs about future events may, and often do, vary from actual results and the differences can be material. See “Cautionary Statement Regarding Forward-Looking Statements.” Also, see the risk factors and other cautionary statements described under the heading “Item 1A - Risk Factors” included in Item 1A of this Annual Report on Form 10-K. We do not undertake any obligation to publicly update any forward-looking statements except as otherwise required by applicable law. Company Overview We are a financial holding company founded in 2002 and headquartered in Denver, Colorado. We provide a fully integrated suite of wealth management services to our clients including banking, trust and investment management products and services. Our mission is to be the best private bank for the Western wealth management client. We target entrepreneurs, professionals and high-net worth individuals, typically with $1.0 million-plus in liquid net worth, and their related philanthropic and business organizations, which we refer to as the “Western wealth management client”. We believe that the Western wealth management client shares our entrepreneurial spirit and values our sophisticated, high-touch wealth management services that are tailored to meet their specific needs. We partner with our clients to solve their unique financial needs through our expert integrated services provided in a team approach. We offer our services through a branded network of boutique private trust bank offices, which we believe are strategically located in affluent and high-growth markets in locations across Colorado, Arizona, Wyoming and California. Our profit centers, which are comprised of private bankers, lenders, wealth planners and portfolio managers, under the leadership of a local chairman and/or president, are also supported centrally by teams providing management services such as operations, risk management, credit administration, technology support, human capital and accounting/finance services, which we refer to as support centers. From 2004, when we opened our first profit center, until December 31, 2018, we have expanded our footprint into nine full service profit centers, two mortgage loan production offices, two trust offices, and one registered investment advisor located across four states. As of and for the year ended December 31, 2018, we had $1.1 billion in total assets, $57.6 million in total revenues and provided fiduciary and advisory services on $5.2 billion of assets under management (“AUM”). Primary Factors Used to Evaluate the Results of Operations As a financial institution, we manage and evaluate various aspects of both our results of operations and our financial condition. We evaluate the comparative levels and trends of the line items in our consolidated balance sheet and income statement as well as various financial ratios that are commonly used in our industry. The primary factors we use to evaluate our results of operations include net interest income, non-interest income and non-interest expense. Net Interest Income Net interest income represents interest income less interest expense. We generate interest income on interest-earning assets, primarily loans and available-for-sale securities. We incur interest expense on interest-bearing liabilities, primarily interest-bearing deposits and borrowings. To evaluate net interest income, we measure and monitor: (i) yields on loans, available-for-sale securities and other interest-earning assets; (ii) the costs of deposits and other funding sources; (iii) the rates incurred on borrowings and other interest-bearing liabilities; and (iv) the regulatory risk weighting associated with the assets. Interest income is primarily impacted by loan growth and loan repayments, along with changes in interest rates on the loans. Interest expense is primarily impacted by changes in deposit balances along with the volume and type of interest-bearing liabilities. Net interest income is primarily impacted by changes in market interest rates, the slope of the yield curve, and interest we earn on interest-earning assets or pay on interest-bearing liabilities. Non-Interest Income Non-interest income primarily consists of the following: · Trust and investment management fees-fees and other sources of income charged to clients for managing their trust and investment assets, providing financial planning consulting services, 401(k) and retirement advisory consulting services, and other wealth management services. Trust and investment management fees are primarily impacted by rates charged and increases and decreases in AUM. AUM is primarily impacted by opening and closing of client advisory and trust accounts, contributions and withdrawals, and the fluctuation in market values. · Net gain on mortgage loans sold-gain on originating and selling mortgages, origination fees, and borrower credits, less commissions to loan originators, lender credits, document review and other costs specific to originating and selling the loan. The market adjustments for interest rate lock commitments and gains and losses incurred on the mandatory trading of loans are also included in this line item. Net mortgage gains are primarily impacted by the amount of loans sold, the type of loans sold and market conditions. · Bank fees-income generated through bank-related service charges such as: electronic transfer fees, treasury management fees, bill pay fees, and other banking fees. Banking fees are primarily impacted by the level of business activities and cash movement activities of our clients. · Risk management and insurance fees-commissions earned on insurance policies we have placed for clients through our client risk management team who incorporate insurance services, primarily life insurance, to support our clients' wealth planning needs. Our insurance revenues are primarily impacted by the type and volume of policies placed for our clients. · Income on company-owned life insurance-income earned on the growth of the cash surrender value of life insurance policies we hold on certain key associates. The income on the increase in the cash surrender value is non-taxable income. Non-Interest Expense Non-interest expense is comprised primarily of the following: · Salaries and employee benefits-all forms of compensation-related expenses including salary, incentive compensation, payroll-related taxes, stock-based compensation, benefit plans, health insurance, 401(k) plan match costs and other benefit-related expenses. Salaries and employee benefit costs are primarily impacted by changes in headcount and fluctuations in benefits costs. · Occupancy and equipment-costs related to leasing our office space, depreciation charges for the furniture, fixtures and equipment, amortization of leasehold improvements, utilities and other occupancy-related expenses. Occupancy and equipment costs are primarily impacted by the number of locations we occupy. · Professional services-costs related to legal, accounting, tax, consulting, personnel recruiting, insurance and other outsourcing arrangements. Professional services costs are primarily impacted by corporate activities requiring specialized services. FDIC insurance expense is also included in this line and represents the assessments that we pay to the FDIC for deposit insurance. · Technology and information systems-costs related to software and information technology services to support office activities and internal networks. Technology and information system costs are primarily impacted by the number of locations we occupy, the number of associates we have and the level of service we require from our third-party technology vendors. · Data processing-costs related to processing fees paid to our third-party data processing system providers relating to our core private trust banking platform. Data processing costs are primarily impacted by the number of loan, deposit and trust accounts we have and the level of transactions processed for our clients. · Marketing-costs related to promoting our business through advertising, promotions, charitable events, sponsorships, donations and other marketing-related expenses. Marketing costs are primarily impacted by the levels of advertising programs and other marketing activities and events held throughout the year. · Amortization of other intangible assets-primarily represents the amortization of intangible assets, including client lists and other similar items recognized in connection with acquisitions. · Total loss on sales/provision for other real estate owned-represents the change in the holding value, or in the reserve balance on other real estate owned, or OREO, properties representing a change in the carrying value of the asset. · Other-includes costs related to operational expenses associated with office supplies, postage, travel expenses, meals and entertainment, dues and memberships, costs to maintain or prepare OREO for sale, director compensation and travel, and other general corporate expenses that do not fit within one of the specific non-interest expense lines described above. Other operational expenses are generally impacted by our business activities and needs. Operating Segments We measure the overall profitability of operating segments based on income before income tax. We believe this is a more useful measurement as our wealth management products and services are fully integrated with our private trust bank. We allocate costs to our segments, which consist primarily of compensation and overhead expense directly attributable to the products and services within the wealth management, capital management and mortgage segments. We measure the profitability of each segment based on a post-allocation basis, as we believe it better approximates the operating cash flows generated by our reportable operating segments. A description of each segment is provided in Note 17 - Segment Reporting of the accompanying Notes to the Consolidated Financial Statements. Primary Factors Used to Evaluate our Balance Sheet The primary factors we use to evaluate our balance sheet include asset and liability levels, asset quality, capital, liquidity, and potential profit production from assets. We manage our asset levels to ensure our lending initiatives are efficiently and profitably supported and to ensure we have the necessary liquidity and capital to meet the required regulatory capital ratios. Funding needs are evaluated and forecasted by communicating with clients, reviewing loan maturity and draw expectations, and projecting new loan opportunities. We manage the diversification and quality of our assets based upon factors that include the level, distribution, severity and trend of problem assets such as those determined to be classified, delinquent, nonaccrual, non performing or restructured; the adequacy of our allowance for loan losses; the diversification and quality of loan and investment portfolios; the extent of counterparty risks, credit risk concentrations, and other factors. We manage our liquidity based upon factors that include the level and quality of capital and our overall financial condition, the trend and volume of problem assets, our balance sheet risk exposure, the level of deposits as a percentage of total loans, the amount of non-deposit funding used to fund assets, the availability of unused funding sources and off-balance sheet obligations, the availability of assets to be readily converted into cash without undue loss, the amount of cash and liquid securities we hold, and other factors. Financial institution regulators have established guidelines for minimum capital ratios for banks and bank holding companies. In 2015, we adopted the new Basel III regulatory capital framework as approved by federal banking agencies, within which we are subject to a multi-year phase-in period. The adoption of this framework modified the calculation of the various capital ratios, added a new ratio, Common Equity Tier (“CET”) 1, and revised the adequately and well capitalized thresholds. In addition, Basel III established a new capital conservation buffer of 2.5% of risk-weighted assets, which was phased in over a four-year period beginning January 1, 2016. At December 31, 2018, our capital ratios exceeded the current well capitalized regulatory requirements established under Basel III. Results of Operations Overview The year ended December 31, 2018 compared with the year ended December 31, 2017. Subsequent to paying dividends to preferred shareholders, we reported income available to common shareholders of $4.3 million for the year ended December 31, 2018, compared to a loss available to common shareholders for December 31, 2017 of $0.3 million, a $4.5 million, or 1,692.9% increase. For the year ended December 31, 2018, our income before income tax was $7.4 million, a $2.4 million, or 48.2%, increase from December 31, 2017. For the year ended December 31, 2018, compared to the year ended December 31, 2017, income before income tax increased primarily as a result of a $3.0 million, or 11.1%, increase in net interest income, partially offset by a decrease of $0.5 million, or 1.9%, in non-interest income. The decrease in non-interest income was primarily the result of a decrease in a one-time legal fee gain on settlement and the remaining components of non-interest income partially offset by a $172.0 million increase in mortgage loans funded, which resulted in a $1.1 million increase in net gain on mortgage loans sold during the year ended December 31, 2018, compared to December 31, 2017. For the year ended December 31, 2018, net income was $5.6 million, which is an increase over 2017 of $3.6 million, or 179.1%. Net Interest Income The year ended December 31, 2018 compared with the year ended December 31, 2017. For the year ended December 31, 2018, compared to the year ended December 31, 2017, net interest income, before the provision for loan losses, increased $3.0 million, or 11.1%, to $30.6 million. This increase was partially attributable to a $108.4 million increase in average outstanding loan balances compared to December 31, 2017, along with an increase in our average yield on loans to 4.36% for the year ended December 31, 2018 from 4.11% for the year ended December 31, 2017. For the year ended December 31, 2018, our net interest margin was 3.27% and our net interest spread was 2.97%. For the year ended December 31, 2017, our net interest margin was 3.15% and our net interest spread was 2.91%. The increase in average loans outstanding for the year ended December 31, 2018 compared to the same periods in 2017 was primarily due to growth in our 1-4 family residential, owner occupied CRE, and commercial and industrial loans. Net interest income is also impacted by changes in the amount and type of interest-earning assets and interest-bearing liabilities. To evaluate net interest income, we measure and monitor the yields on our loans and other interest-earning assets and the costs of our deposits and other funding sources. Interest income on our available-for-sale securities portfolio decreased as a result of lower average investment balances maintained for year ended December 31, 2018 compared to the same periods in 2017. Our average available-for-sale securities balance during the year ended December 31, 2018 was $49.0 million, a decrease of $45.2 million from ended the year ended December 31, 2017. The decrease was primarily a result of sales of securities in 2017 to support funding and liquidity needs with the growth in loans outstanding. Interest expense on deposits increased during the year ended December 31, 2018 compared to the same period in 2017, driven primarily by a rising rate environment, which resulted in increases in rates on depository accounts, as well as the impact of an increase in average interest-bearing deposit accounts of $60.5 million for the year ended December 31, 2018, respectively, when compared to the same period in 2017. The following tables present an analysis of net interest income and net interest margin for the periods presented, using average balances for each major category of interest-earning assets and interest-bearing liabilities, the interest earned or paid and the average rate earned or paid on those assets or liabilities. (1) Average balance represents daily averages, unless otherwise noted. (2) Available-for-sale securities represents monthly averages. (3) Non-performing loans are included in the respective average loan balances. Income, if any, on such loans is recognized on a cash basis. (4) Promissory notes from related parties were reclassed to loans during 2018, due to a change in composition of related parties. (5) Tax-equivalent yield adjustments are immaterial. (6) Mortgage loans held-for-sale are separated from the interest-earning assets above, as these loans are held for a short period of time until sold in the secondary market and are not held for investment purposes, with interest income recognized in the net gain on mortgage loans sold line in the income statement. These balances are excluded from the margin calculations in these tables. (7) Net interest spread is the average yield on interest-earning assets (excluding mortgage loans held-for-sale) minus the average rate on interest-bearing liabilities. (8) Net interest income is the difference between income earned on interest-earning assets, which does not include interest earned on mortgage loans held-for-sale, and expense paid on interest-bearing liabilities. (9) Net interest margin is equal to net interest income divided by average interest-earning assets (excluding mortgage loans held-for-sale) The following tables present the dollar amount of changes in interest income and interest expense for the periods presented, for each component of interest-earning assets and interest-bearing liabilities (excluding mortgage loans held-for-sale) and distinguishes between changes attributable to volume and interest rates. Changes attributable to both rate and volume that cannot be separated have been allocated to volume. Non-Interest Income The year ended December 31, 2018 compared with the year ended December 31, 2017. For the year ended December 31, 2018 compared to the year ended December 31, 2017, non-interest income decreased $0.5 million, or 1.9%, to $27.2 million. The decrease in non-interest income was primarily the result of a decrease in a one-time legal fee gain on settlement and the remaining components of non-interest income partially offset by a $172.0 million increase in mortgage loans funded, which resulted in a $1.1 million increase in net gain on mortgage loans sold during the year ended December 31, 2018 compared to December 31, 2017. The table below presents the significant categories of our non-interest income for the year ended December 31, 2018 and 2017. Trust and investment management fees- For the year ended December 31, 2018 compared to the same period in 2017, our trust and investment management fees within our capital management segment decreased by $1.6 million, or 32.9%, while trust and investment management fees in the wealth management segment increased by $1.4 million, or 9.4%. Net gain on mortgage loans sold- For the year ended December 31, 2018 compared to the year ended December 31, 2017, our net gain on mortgage loans sold increased by $1.1 million, or 31.4%, to $4.6 million. For the year ended December 31, 2018 and 2017, our average net gain on sale was 94 and 119 basis points, respectively, on loans sold. The net gain on sales of loans will fluctuate with the amount and type of loans sold and market conditions. The increase in gain on mortgage loans sold for the year ended December 31, 2018 compared to 2017 was primarily related to an increase in origination volume in 2018 compared to 2017. The decline in margin is primarily related to competitive pricing year over year. Risk management and insurance fees- Risk management fees include fees earned by our risk management product group as a result of assisting clients with obtaining life insurance policies, and fees from the trailing annuity revenue streams. During the years ended December 31, 2018 and December 31, 2017, we recognized $1.3 million each year of risk management fees. The size and number of client policies placed was comparable year over year. Provision for Credit Losses For the year ended December 31, 2018, our provision for credit loss was $0.2 million, as result of an increase to our specific reserve, partially offset by a reduction in our loan loss factors applied to our non-individually evaluated loan pools as a result of lower charge-offs over the corresponding look-back period utilized in our provision calculation. We have a dedicated problem loan resolution team comprised of associates from our credit, senior leadership, risk and accounting teams that meets frequently to minimize losses by ensuring that watch list and problem credits are identified early and actively worked in order to identify potential losses in a timely manner and proactively manage the corresponding accounts. Non-Interest Expense The table below presents the significant categories of our non-interest expense for the periods noted: The increase in non-interest expense of 1.4% to $50.2 million for the year ended December 31, 2018, was primarily due to an increase in expenses related to salaries and employee benefits resulting from the asset purchase of EMC Holdings, LLC, (“EMC”) in September 2017, as well as increases in equity compensation and health insurance premiums. Data processing-The increase in data processing costs is primarily related to third-party data processing and infrastructure costs driven by loan, deposit, and trust accounts in 2018 compared to 2017. Income Tax During the year ended December 31, 2018, the Company recorded an income tax provision of $1.8 million, reflecting an effective tax rate 23.9%. During the year ended December 31, 2017, the Company recorded an income tax provision of $3.0 million, reflecting an effective tax rate of 59.6%. The decrease in the effective tax rate for the year ended December 31, 2018 was primarily due to the change in corporate tax rates in December 2017 as a result of the passing of the Tax Cuts and Jobs Act of 2017, (the “Tax Reform Act”). Segment Reporting We have three reportable operating segments: Wealth Management, Capital Management and Mortgage. Our Wealth Management segment consists of operations relating to our fully integrated wealth management business. Services provided by our wealth management segment include deposit, loan, insurance, and trust and investment management advisory products and services. Our Capital Management segment consists of operations relating to our institutional investment management services over proprietary fixed income, high yield and equity strategies, including acting as the advisor of three owned, managed and rated proprietary mutual funds. Capital Management products and services are financial in nature, with revenues generally based on a percentage of assets under management or paid premiums. Our Mortgage segment consists of operations relating to the origination and sale of residential mortgage loans. Mortgage products and services are financial in nature, with gains and fees recognized net of expenses, upon the sale of mortgage loans to third parties. Services provided by our Mortgage segment include soliciting, originating and selling mortgage loans into the secondary market. Mortgage loans originated and held for investment purposes are recorded in the Wealth Management segment, as this segment provides ongoing services to our clients. The following table presents key metrics related to our segments: (1) Net interest income plus non-interest income. The tables below present selected financial metrics of each segment as of and for the periods presented: Wealth Management The Wealth Management segment reported income before income tax of $9.4 million for the year ended December 31, 2018, compared to $6.3 million, for the same period in 2017. The increase is primarily related to increases in the average volume of interest-earning assets and yield for the year ended December 31, 2018 compared to the same period in 2017. During the year ended December 31, 2018 average loans increased $108.4 million and the yield on total interest-earning assets increased to 4.15% from 3.81% compared to the same period in 2017. The increase in non-interest income of $0.3 million for the year ended December 31, 2018 is primarily due to an increase in trust and investment management fees of $1.4 million, partially offset by a decrease in the remaining components of non-interest income compared to the same period in 2017. The increase in other non-interest expense of $1.9 million during the year ended December 31, 2018, compared to the same period in 2017, is primarily due to an increase in salaries and benefits related to health insurance premiums in 2018, stock-based compensation expense related to awards granted to associates in 2017 and an increase in audit and internet technology infrastructure costs in 2018 compared to 2017. Capital Management The Capital Management segment reported a loss before income tax of $0.7 million for the year ended December 31, 2018, compared to a loss of $0.9 million, for the same period in 2017. The decrease in non-interest income was partially offset by a gain on legal settlement of $0.8 million recorded in 2017. The decrease in other non-interest expense during the year ended December 31, 2018 was the result of a reduction in salaries expense, office capacity, and professional fees compared to the same period in 2017. Mortgage The Mortgage segment reported a loss before income tax of $1.2 million for the year ended December 31, 2018, compared to $0.4 million for the same period in 2017. The overall increase in non-interest income and non-interest expense is related to an increase in the origination of mortgage loans sold and EMC mortgage operations that began in September 2017. We continue to work on operational changes to improve profitability in the Mortgage segment. Additionally, during the year ended December 31, 2018, we incurred $0.3 million of compensation expenses related to the purchase accounting treatment of the stock and cash consideration paid to the sole member of EMC and we recorded $0.2 million of amortization expense related to the sole member’s covenant not to compete for the year ended December 31, 2018, compared to the same period in 2017. Financial Condition The table below presents our condensed consolidated balance sheets as of the dates presented: Cash and cash equivalents increased by $63.9 million, or 672.0%, to $73.4 million at December 31, 2018 compared to December 31, 2017. During the same period, investments declined by $8.7 million, or 16.3%, to $44.9 million at December 31, 2018. The increase in cash and cash equivalents was primarily due to an increase in deposits at December 31, 2018 compared to December 31, 2017. We continue to manage our balance sheet in an effort to ensure available cash is actively invested for optimal earnings. Total loans increased by $80.3 million, or 9.9%, to $894.0 million at December 31, 2018 compared to December 31, 2017. The increase was primarily due to continued organic growth in our market areas and growth in our residential mortgage and construction loans. Mortgage loans held for sale decreased $8.1 million, or 35.3%, to $14.8 million at December 31, 2018 compared to December 31, 2017. This was primarily due to an increase in loans sold in 2018 compared to 2017. Promissory notes from related parties decreased $5.8 million at December 31, 2018 compared to December 31, 2017, due to the redemption of one of the notes for $3.7 million in June 2018. The remaining note of $2.1 million was reclassified into the loans, net line item of the consolidated balance sheet, as the borrower is no longer a related party. Goodwill and intangible assets, net decreased by $0.8 million at December 31, 2018 compared to December 31, 2017 due to amortization on our intangible assets. Our annual goodwill impairment assessment date for the Company’s reporting units is October 31. Goodwill impairment testing may begin with an assessment of qualitative factors to determine whether certain circumstances or events exist that lead to a determination that the fair value of goodwill is less than the carrying value. This qualitative assessment includes various factors that could affect the reporting unit’s fair value as well as mitigating events or conditions. The assessment of each reporting unit will compare the aggregate fair value to its carrying value, along with several valuation assumptions and methods in order to determine if any impairment was triggered as of the measurement date. As of October 31, 2018 and December 31, 2018, the Company’s enterprise market capitalization was trading below book value. We completed a "step 1" goodwill impairment test as of these dates and, based on the results of our assessment, we believe there are no reporting units at risk of failing "step 1" of the goodwill impairment test. To estimate the fair value of our reporting units, we use an income approach, specifically a discounted cash flow methodology, and a market approach. The discounted cash flow methodology includes assumptions for forecasted revenues, growth rates, discount rates, and market multiples, which all require significant judgment and estimates by management and are inherently uncertain. As required, these assumptions, judgments, and estimates are updated during our annual impairment testing in October and subsequently in December. If management determines these assumptions, judgments and estimates have substantially and negatively changed, they may be updated prior to the annual testing date. Other assets decreased by $6.2 million, or 20.0%, to $24.8 million at December 31, 2018 compared to December 31, 2017. This was primarily related to the settlement of investment security transactions in January 2018 that were executed in December 2017. Total deposits increased $121.6 million, or 14.9%, to $937.8 million at December 31, 2018 compared to December 31, 2017. Total interest-bearing deposits increased $117.5 million, or 19.0%, to $734.9 million and noninterest-bearing deposits increased $4.2 million, or 2.1%, to $202.9 million, during this period. Money market deposit accounts increased $158.5 million, or 47.9%, to $489.5 million at December 31, 2018 compared to December 31, 2017. Time deposit accounts decreased $31.5 million, or 15.0%, to $178.7 million at December 31, 2018 compared to December 31, 2017. Negotiable order of withdrawal (“NOW”) accounts decreased $9.4 million, or 12.7%, to $64.9 million at December 31, 2018, compared to December 31, 2017. This increase in money market deposit accounts was primarily due to transferring cash balances to manage liquidity. The decrease in time deposit accounts was primarily due to the maturity of $35.4 million of public deposits during the year ended December 31, 2018. Total borrowings decreased $20.4 million, or 48.7%, to $21.6 million at December 31, 2018 compared to December 31, 2017. The decrease was attributable to a $10.0 million decrease in fixed maturity Federal Home Loan bank (“FHLB”), $3.6 million decrease in our FHLB line of credit, and a $6.9 million decrease due to the redemption of our Subordinated Notes due 2020 at December 31, 2018 compared to December 31, 2017. Total shareholders' equity increased $15.0 million, or 14.8%, to $116.9 million at December 31, 2018, compared to December 31, 2017. The increase is primarily due to the sale of common stock of $34.5 million, $1.9 million of stock-based compensation charges, and net income of $5.6 million. These increases were partially offset by the redemption of preferred stock of $25.0 million, payment of $1.4 million of dividends on our preferred stock, a $0.4 million increase in the unrealized loss on our available-for-sale investments, and $0.2 million of share awards settled. Assets Under Management *Trust & investment management fees divided by period-end balance. Assets under management decreased $139.0 million and increased $448.0 million, or 2.6% and 9.1%, to $5.2 billion and $5.4 billion for the year ended December 31, 2018 and 2017, respectively. The decrease in 2018 was primarily attributable to closed accounts within one profit center due to attrition associated with the relationship of a prior president. The increase in 2017 is primarily due to market gains. Available-for-sale securities Investments we intend to hold for an indefinite period of time, but not necessarily to maturity, are classified as available-for-sale and are recorded at fair value using current market information from a pricing service, with unrealized gains and losses excluded from earnings and reported in other comprehensive income (loss), net of tax. All our investments in securities were classified as available-for-sale for the periods presented below. The carrying values of our investment securities classified as available-for-sale are adjusted for unrealized gain or loss, and any gain or loss is reported on an after-tax basis as a component of other comprehensive income in shareholders' equity. The following table summarizes the amortized cost and estimated fair value of our investment securities as of December 31, 2018: The following table summarizes the amortized cost and estimated fair value of our investment securities as of December 31, 2017: The following tables represent the book value of our contractual maturities and weighted average yield for our investment securities as of the dates presented. Contractual maturities may differ from expected maturities because issuers can have the right to call or prepay obligations without penalties. Our investments are taxable securities. Weighted average yields are not presented on a taxable equivalent basis. 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. Loan Portfolio Our primary source of interest income is derived through interest earned on loans to high net worth individuals and their related commercial interests. Our senior lending and credit team consists of seasoned, experienced personnel and we believe that our officers are well versed in the types of lending in which we are engaged. Underwriting policies and decisions are managed centrally and the approval process is tiered based on loan size, making the process consistent, efficient and effective. The management team and credit culture demands prudent, practical, and conservative approaches to all credit requests in compliance with the loan policy guidelines to ensure strong credit underwriting practices. In addition to originating loans for our own portfolio, we conduct mortgage banking activities in which we originate and sell, servicing-released, whole loans in the secondary market. Our mortgage banking loan sales activities are primarily directed at originating single family mortgages that are priced and underwritten to conform to previously agreed criteria before loan funding and are delivered to the investor shortly after funding. The level of future loan originations, loan sales and loan repayments depends on overall credit availability, the interest rate environment, the strength of the general economy, local real estate markets and the housing industry, and conditions in the secondary loan sale market. The amount of gain or loss on the sale of loans is primarily driven by market conditions and changes in interest rates, as well as our pricing and asset liability management strategies. As of December 31, 2018 and December 31, 2017, we had mortgage loans held for sale of $14.8 million and $22.9 million, respectively, in residential mortgage loans we originated. The following table summarizes our loan portfolio by type of loan as of the dates indicated, in thousands: (1) Loans held for investment exclude deferred costs, net of $1.2 million, $1.0 million, $0.8 million, $0.6 million, and $0.1 million as of December 31, 2018, 2017, 2016, 2015, and 2014, respectively. · Cash, Securities and Other-consists of consumer and commercial purpose loans that are primarily secured by securities managed and under custody with us, cash on deposit with us or life insurance policies. In addition, loans in this portfolio are collateralized with other sources of consumer collateral and an immaterial amount of each loan may be unsecured. This segment of our portfolio is affected by a variety of local and national economic factors affecting borrowers' employment prospects, income levels, and overall economic sentiment. · Construction and Development-consists of loans to finance the construction of residential and non-residential properties. These loans are dependent on the strength of the industries of the related borrowers and the risks consistent with construction projects. · 1-4 Family Residential-consists of loans and home equity lines of credit secured by 1-4 family residential properties. These loans typically enable borrowers to purchase or refinance existing homes, most of which serve as the primary residence of the owner. In addition, some borrowers secure a commercial purpose loan with owner occupied or non-owner occupied 1-4 family residential properties. Loans in this segment are dependent on the industries tied to these loans as well as the national and local economies, and local residential and commercial real estate markets. · Commercial Real Estate, Owner Occupied and Non-Owner Occupied-consists of commercial loans collateralized by real estate. These loans may be collateralized by owner occupied or non-owner occupied real estate, as well as multi-family residential real estate. These loans are dependent on the strength of the industries of the related borrowers and the success of their businesses. · Commercial and Industrial-consists of commercial and industrial loans, including working capital lines of credit, permanent working capital term loans, business asset loans, acquisition, expansion and development loans, and other loan products, primarily in our target markets. This portfolio primarily consists of term loans and lines of credit which are dependent on the strength of the industries of the related borrowers and the success of their businesses. The contractual maturity ranges of loans in our loan portfolio and the amount of such loans with fixed and floating interest rates in each maturity range, excluding deferred loan fees, as of the date indicated are summarized in the following tables: Non-Performing Assets Non-performing assets include non-accrual loans, loans past due 90 days or more and still accruing interest, troubled debt restructurings (“TDRs”) still accruing interest, and other real estate owned (“OREO”). The accrual of interest on loans is discontinued at the time the loan becomes 90 or more days delinquent unless the loan is well secured and in the process of collection. Past due status is based on the contractual terms of the loan. In all cases, loans are placed on non-accrual status or charged off if collection of interest or principal is considered doubtful. OREO represents assets acquired through, or in lieu of, foreclosure. The amounts reported as OREO are supported by recent appraisals, with the appraised values adjusted, where applicable, for expected transaction fees likely to be incurred upon sale of the property. We incur recurring expenses relating to OREO in the form of maintenance, taxes, insurance and legal fees, among others, until the OREO parcel is disposed. While disposition efforts with respect to our OREO are generally ongoing, if these properties are appraised at lower-than-expected values or if we are unable to sell the properties at the prices for which we expect to be able to sell them, we may incur additional losses. For the year ended December 31, 2018 and 2017, the amount of lost interest for non-accrual loans was $0.4 million and $0.1 million, respectively. We had $19.7 million in non-performing assets as of December 31, 2018 compared to $4.9 million as of December 31, 2017. The $14.8 million increase in our non-performing assets was primarily related to an $11.3 million Cash, Securities, and Other loan that was classified as a non-accrual TDR in 2018. The remainder of the increase was related to a Commercial and Industrial loan that was classified as a TDR and was still accruing interest at December 31, 2018. The following table presents information regarding non-performing loans as of the dates indicated: (1) Excludes mortgage loans held for sale of $14.8 million, $22.9 million, $8.1 million, $19.9 million, and $0 million as of December 31, 2018, 2017, 2016, 2015, and 2014, respectively. Potential Problem Loans We categorize loans into risk categories based on relevant information about the ability of the borrowers to service their debt, such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. We analyze loans individually by classifying the loans by credit risk on a quarterly basis, which are segregated into the following definitions for risk ratings: Special Mention-Loans categorized as special mention have a potential weakness or borrowing relationships that require more than the usual amount of management attention. Adverse industry conditions, deteriorating financial conditions, declining trends, management problems, documentation deficiencies or other similar weaknesses may be evident. Ability to meet current payment schedules may be questionable, even though interest and principal are still being paid as agreed. The asset has potential weaknesses that may result in deteriorating repayment prospects if left uncorrected. Loans in this risk grade are not considered adversely classified. Substandard-Substandard loans are considered “classified” and are inadequately protected by the current net worth and paying capacity of the obligor or by the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardizes the liquidation of the debt. They are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected. Loans in this category may be placed on non-accrual status and may individually be evaluated for impairment if indicators of impairment exist. Doubtful-Loans graded Doubtful are considered "classified" and 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 known facts, conditions and values, highly questionable and improbable. However, the amount or certainty of eventual loss is not known because of specific pending factors. Loans not meeting any of the three criteria above are considered to be pass-rated loans. As of December 31, 2018 and December 31, 2017 non-performing loans of $19.1 million and $4.2 million, respectively, were included in the substandard category in the table below. The following tables present, by class and by credit quality indicator, the recorded investment in our loans as of the dates indicated: Allowance for Loan Losses The allowance for loan losses is established through a provision for credit losses, which is a noncash charge to earnings. Loan losses are charged against the allowance when management believes that a loan balance is confirmed uncollectable. Subsequent recoveries, if any, are credited to the allowance for loan losses. The allowance for loan losses is evaluated on a regular basis by management and is based upon management's periodic review of the collectability of the loans in light of historical experience, the nature and dollar volume of the loan portfolio, adverse situations that may affect the borrower's ability to repay, the estimated value of any underlying collateral and prevailing economic conditions. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management's judgment, should be charged off. The following table presents summary information regarding our allowance for loan losses for the periods indicated: (1) Average balances are average daily balances. (2) Excludes average outstanding balances of mortgage loans held for sale of $21.8 million, $12.7 million, $19.0 million, $8.8 million, and $0 million for the years ended for December 31, 2018, 2017, 2016, 2015, and 2014, respectively. (3) Excludes mortgage loans held for sale of $14.8 million, $22.9 million, $8.1 million, $19.9 million, and $0 million as of December 31, 2018, 2017, 2016, 2015, and 2014, respectively. (4) The ratio of net charge-offs to average loans is negligible or immaterial. The following tables represent the allocation of the allowance for loan losses among loan categories and other summary information. The allocation for loan losses by category should neither be interpreted as an indication of future charge-offs, nor as an indication that charge-offs in future periods will necessarily occur in these amounts or in the indicated proportions. The allocation of a portion of the allowance for loan losses to one category of loans does not preclude its availability to absorb losses in other categories. (1) Represents the percentage of loans to total loans in the respective category. Deferred Tax Assets Deferred tax assets represent the differences in timing of when items are recognized for GAAP purposes as opposed to tax purposes, as well as our net operating losses. As a result of book and tax basis differences, our deferred tax assets for the year ended December 31, 2018 decreased $1.7 million from December 31, 2017 to $4.3 million. Deposits Our deposit products include money market accounts, time-deposit accounts (typically certificates of deposit), NOW accounts (checking accounts), and saving accounts. Our accounts are federally insured by the FDIC up to the legal maximum. Total deposits increased by $121.6 million, or 14.9%, to $937.8 million at December 31, 2018 from December 31, 2017. Total average deposits the year ended December 31, 2018 were $847.7 million, an increase of $67.8 million, or 8.7%, compared to $779.9 million as of December 31, 2017. The increases are primarily due to our general deposit growth initiatives, the cross-selling of products, the skills of our sales and service team, as well as additional deposits added from our trust and investment management relationships for which we also provide deposit products. The increase in average rates in 2018 and 2017 was driven primarily by an increase in market rates and competition. The following table presents the average balances and average rates paid on deposits for the periods below: Average noninterest-bearing deposits to average total deposits was 25.1% and 26.4% for the year ended December 31, 2018 and 2017, respectively. Our average cost of funds was 0.90% and 0.67% during the year ended December 31, 2018 and 2017, respectively. The increase in our cost of funds for 2018 from 2017 was primarily due to an increase in average rates on interest-bearing deposits to 1.03% during the year ended December 31, 2018 compared to 0.66% in 2017. This increase is primarily due to the impact of a rising rate environment. Total money market accounts as of December 31, 2018 were $489.5 million, an increase of $158.5 million, or 47.9%, compared to $331.0 million as of December 31, 2017. This increase was primarily due to transferring cash balances to manage liquidity. Total time deposits as of December 31, 2018 were $178.7 million, a decrease of $31.5 million, or 15.0%, over December 31, 2017. The decrease in time deposit accounts was primarily due to the maturity of $35.4 million of public deposits during the year ended December 31, 2018. The following table represents the amount of certificates of deposit by time remaining until maturity as of December 31, 2018: Borrowings We have short-term and long-term borrowing sources available to supplement deposits and meet our liquidity needs. As of December 31, 2018 and December 31, 2017, borrowings totaled $21.6 million and $42.0 million, respectively. During the year ended December 31, 2018, we redeemed our subordinated notes due 2020 with proceeds from our initial public offering. The table below presents balances of each of the borrowing facilities as of the dates indicated: FHLB Topeka. We have a blanket pledge and security agreement with FHLB Topeka that requires certain loans and securities to be pledged as collateral for any outstanding borrowings under the agreement. The collateral pledged as of December 31, 2018 and December 31, 2017 amounted to $475.4 million and $361.7 million, respectively. Based on this collateral and the Company’s holdings of FHLB Topeka stock, the Company was eligible to borrow an additional $305.0 million at December 31, 2018. As of December 31, 2018 we had three unsecured federal funds lines of credit of $10.0 million, $13.0 million and $25.0 million, respectively, available to us under such federal funds lines. As of December 31, 2017, we had two unsecured federal funds lines of credit of $13.0 million and $25.0 million, respectively, available to us under such federal funds lines. As of December 31, 2018 and December 31, 2017, there were no amounts drawn on any of the federal funds lines. Our borrowing facilities include various financial and other covenants, including, but not limited to, a requirement that the Bank maintains regulatory capital that is deemed "well capitalized" by federal banking agencies. As of December 31, 2018 and December 31, 2017, the Company was in compliance with the covenant requirements. Liquidity and Capital Resources Liquidity resources primarily include interest-bearing and noninterest-bearing deposits which primarily contribute to our ability to raise funds to support asset growth, acquisitions, and meet deposit withdrawals and other payment obligations. Access to purchased funds primarily include the ability to borrow from FHLB Topeka and from correspondent banks. The following table illustrates, during the periods presented, the composition of our funding sources and the average assets in which those funds are invested as a percentage of average total assets for the period indicated. Our primary source of funds is interest-bearing and noninterest-bearing deposits, and our primary use of funds is loans. We do not expect a change in the primary source or use of our funds in the foreseeable future. Capital Resources Total shareholders' equity increased $15.0 million, or 14.8%, to $116.9 million at December 31, 2018 compared to December 31, 2017. The increase is primarily due to the sale of common stock of $34.5 million, $1.9 million of stock-based compensation charges, and net income of $5.6 million. These increases were partially offset by the redemption of preferred stock of $25.0 million, payment of $1.4 million of dividends on our preferred stock, a $0.4 million increase in the unrealized loss on our available-for-sale investments, and $0.2 million of share awards settled. We are subject to various regulatory capital adequacy requirements at a consolidated level and the bank level. These requirements are administered by 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 direct material effect on our consolidated financial statements. Under capital adequacy guidelines and, additionally for banks, 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 practices. Capital levels are viewed as important indicators of an institution's financial soundness by banking regulators. Generally, FDIC-insured depository institutions and their holding companies are required to maintain minimum capital relative to the amount and types of assets they hold. As of December 31, 2018 and December 31, 2017, respectively, our holding company and Bank were in compliance with all applicable regulatory capital requirements, and the Bank was classified as "well capitalized," for purposes of the prompt corrective action regulations. As we continue to grow our operations and maintain capital requirements, our regulatory capital levels may decrease depending on our level of earnings. We continue to monitor growth and control our capital activities in order to remain in compliance with all applicable regulatory capital standards. The following table presents our regulatory capital ratios for the dates noted. Contractual Obligations and Off-Balance Sheet Arrangements We enter into credit-related financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. Commitments may expire without being utilized. Our exposure to credit loss is represented by the contractual amount of these commitments, although material losses are not anticipated. We follow the same credit policies in making commitments as we do for on-balance sheet instruments. The following table presents future contractual obligations to make future payments for the periods indicated (amounts in thousands): (1) Reflects a contractual maturity date of December 31, 2026. The following tables present financial instruments whose contract amounts represent credit risk, as of the dates indicated. We may enter into contracts for services in the conduct of ordinary business operations, which may require payment for services to be provided in the future and may contain penalty clauses for early termination of the contracts. We do not believe these off-balance sheet arrangements have or are reasonably likely to have a material effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources. However, there can be no assurance that such arrangements will not have an effect on future operations. Critical Accounting Policies Our accounting policies and procedures are described in Note 1 - Organization and Summary of Significant Accounting Policies in the accompanying Notes to the Consolidated Financial Statements
-0.005296
-0.005163
0
<s>[INST] Company Overview We are a financial holding company founded in 2002 and headquartered in Denver, Colorado. We provide a fully integrated suite of wealth management services to our clients including banking, trust and investment management products and services. Our mission is to be the best private bank for the Western wealth management client. We target entrepreneurs, professionals and highnet worth individuals, typically with $1.0 millionplus in liquid net worth, and their related philanthropic and business organizations, which we refer to as the “Western wealth management client”. We believe that the Western wealth management client shares our entrepreneurial spirit and values our sophisticated, hightouch wealth management services that are tailored to meet their specific needs. We partner with our clients to solve their unique financial needs through our expert integrated services provided in a team approach. We offer our services through a branded network of boutique private trust bank offices, which we believe are strategically located in affluent and highgrowth markets in locations across Colorado, Arizona, Wyoming and California. Our profit centers, which are comprised of private bankers, lenders, wealth planners and portfolio managers, under the leadership of a local chairman and/or president, are also supported centrally by teams providing management services such as operations, risk management, credit administration, technology support, human capital and accounting/finance services, which we refer to as support centers. From 2004, when we opened our first profit center, until December 31, 2018, we have expanded our footprint into nine full service profit centers, two mortgage loan production offices, two trust offices, and one registered investment advisor located across four states. As of and for the year ended December 31, 2018, we had $1.1 billion in total assets, $57.6 million in total revenues and provided fiduciary and advisory services on $5.2 billion of assets under management (“AUM”). Primary Factors Used to Evaluate the Results of Operations As a financial institution, we manage and evaluate various aspects of both our results of operations and our financial condition. We evaluate the comparative levels and trends of the line items in our consolidated balance sheet and income statement as well as various financial ratios that are commonly used in our industry. The primary factors we use to evaluate our results of operations include net interest income, noninterest income and noninterest expense. Net Interest Income Net interest income represents interest income less interest expense. We generate interest income on interestearning assets, primarily loans and availableforsale securities. We incur interest expense on interestbearing liabilities, primarily interestbearing deposits and borrowings. To evaluate net interest income, we measure and monitor: (i) yields on loans, availableforsale securities and other interestearning assets; (ii) the costs of deposits and other funding sources; (iii) the rates incurred on borrowings and other interestbearing liabilities; and (iv) the regulatory risk weighting associated with the assets. Interest income is primarily impacted by loan growth and loan repayments, along with changes in interest rates on the loans. Interest expense is primarily impacted by changes in deposit balances along with the volume and type of interestbearing liabilities. Net interest income is primarily impacted by changes in market interest rates, the slope of the yield curve, and interest we earn on interestearning assets or pay on interestbearing liabilities. NonInterest Income Noninterest income primarily consists of the following: · Trust and investment management feesfees and other sources of income charged to clients for managing their trust and investment assets, providing financial planning consulting services, 401(k) and retirement advisory consulting services, and other wealth management services. Trust and investment management fees are primarily impacted by rates charged and increases and decreases in AUM. AUM is primarily impacted by opening and closing of client advisory and trust accounts, contributions and withdrawals, and the fluctuation in market values. · Net gain on mortgage loans soldgain on originating and selling mortgages, origination fees, and borrower credits, less commissions to loan originators, lender credits, document review and other costs specific to originating and selling the loan. The market adjustments for interest rate lock commitments and gains and losses incurred on the mandatory trading [/INST] Negative. </s>
2,019
8,462
1,327,607
First Western Financial Inc
2020-03-12
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 our audited consolidated financial statements and the accompanying notes included elsewhere in this Annual Report on Form 10-K. The following discussion contains "forward-looking statements" that reflect our future plans, estimates, beliefs and expected performance. We caution that assumptions, expectations, projections, intentions or beliefs about future events may, and often do, vary from actual results and the differences can be material. See "Cautionary Statement Regarding Forward-Looking Statements." Also, see the risk factors and other cautionary statements described under the heading "Item 1A - Risk Factors" included in Item 1A of this Annual Report on Form 10-K. We do not undertake any obligation to publicly update any forward-looking statements except as otherwise required by applicable law. Company Overview We are a financial holding company founded in 2002 and headquartered in Denver, Colorado. We provide a fully integrated suite of wealth management services to our clients including banking, trust and investment management products and services. Our mission is to be the best private bank for the Western wealth management client. We target entrepreneurs, professionals and high-net worth individuals, typically with $1.0 million-plus in liquid net worth, and their related philanthropic and business organizations, which we refer to as the "Western wealth management client." We believe that the Western wealth management client shares our entrepreneurial spirit and values our sophisticated, high-touch wealth management services that are tailored to meet their specific needs. We partner with our clients to solve their unique financial needs through our expert integrated services provided in a team approach. We offer our services through a branded network of boutique private trust bank offices, which we believe are strategically located in affluent and high-growth markets in locations across Colorado, Arizona, Wyoming and California. Our profit centers, which are comprised of private bankers, lenders, wealth planners and portfolio managers, under the leadership of a local chairman and/or president, are also supported centrally by teams providing management services such as operations, risk management, credit administration, marketing, technology support, human capital and accounting/finance services, which we refer to as support centers. From 2004, when we opened our first profit center, until December 31, 2019, we have expanded our footprint into nine full service profit centers, three mortgage loan production offices, two trust offices, and one registered investment advisor located across four states. As of and for the year ended December 31, 2019, we had $1.3 billion in total assets, $64.0 million in total revenues and provided fiduciary and advisory services on $6.2 billion of assets under management ("AUM"). Primary Factors Used to Evaluate the Results of Operations As a financial institution, we manage and evaluate various aspects of both our results of operations and our financial condition. We evaluate the comparative levels and trends of the line items in our consolidated balance sheet and income statement as well as various financial ratios that are commonly used in our industry. The primary factors we use to evaluate our results of operations include net interest income, non-interest income and non-interest expense. Net Interest Income Net interest income represents interest income less interest expense. We generate interest income on interest-earning assets, primarily loans and available-for-sale securities. We incur interest expense on interest-bearing liabilities, primarily interest-bearing deposits and borrowings. To evaluate net interest income, we measure and monitor: (i) yields on loans, available-for-sale securities and other interest-earning assets; (ii) the costs of deposits and other funding sources; (iii) the rates incurred on borrowings and other interest-bearing liabilities; and (iv) the regulatory risk weighting associated with the assets. Interest income is primarily impacted by loan growth and loan repayments, along with changes in interest rates on the loans. Interest expense is primarily impacted by changes in deposit balances along with the volume and type of interest-bearing liabilities. Net interest income is primarily impacted by changes in market interest rates, the slope of the yield curve, and interest we earn on interest-earning assets or pay on interest-bearing liabilities. Non-Interest Income Non-interest income primarily consists of the following: · Trust and investment management fees-fees and other sources of income charged to clients for managing their trust and investment assets, providing financial planning consulting services, 401(k) and retirement advisory consulting services, and other wealth management services. Trust and investment management fees are primarily impacted by rates charged and increases and decreases in AUM. AUM is primarily impacted by opening and closing of client advisory and trust accounts, contributions and withdrawals, and the fluctuation in market values. · Net gain on mortgage loans sold-gain on originating and selling mortgages, origination fees, and borrower credits, less commissions to loan originators, lender credits, document review and other costs specific to originating and selling the loan. The market adjustments for interest rate lock commitments and gains and losses incurred on the mandatory trading of loans are also included in this line item. Net mortgage gains are primarily impacted by the amount of loans sold, the type of loans sold and market conditions. · Bank fees-income generated through bank-related service charges such as: electronic transfer fees, treasury management fees, bill pay fees, and other banking fees. Banking fees are primarily impacted by the level of business activities and cash movement activities of our clients. · Risk management and insurance fees-commissions earned on insurance policies we have placed for clients through our client risk management team who incorporate insurance services, primarily life insurance, to support our clients’ wealth planning needs. Our insurance revenues are primarily impacted by the type and volume of policies placed for our clients. · Income on company-owned life insurance-income earned on the growth of the cash surrender value of life insurance policies we hold on certain key associates. The income on the increase in the cash surrender value is non-taxable income. · Net gain on sale of securities/assets-gain on sale of available-for-sale securities and other assets sold. Net gain on sale of securities/assets are primarily impacted by the amount of securities/assets sold, the type of securities/assets sold and market conditions. Non-Interest Expense Non-interest expense is comprised primarily of the following: · Salaries and employee benefits-all forms of compensation-related expenses including salary, incentive compensation, payroll-related taxes, stock-based compensation, benefit plans, health insurance, 401(k) plan match costs and other benefit-related expenses. Salaries and employee benefit costs are primarily impacted by changes in headcount and fluctuations in benefits costs. · Occupancy and equipment-costs related to leasing our office space, depreciation charges for the furniture, fixtures and equipment, amortization of leasehold improvements, utilities and other occupancy-related expenses. Occupancy and equipment costs are primarily impacted by the number of locations we occupy. · Professional services-costs related to legal, accounting, tax, consulting, personnel recruiting, insurance and other outsourcing arrangements. Professional services costs are primarily impacted by corporate activities requiring specialized services. FDIC insurance expense is also included in this line and represents the assessments that we pay to the FDIC for deposit insurance. · Technology and information systems-costs related to software and information technology services to support office activities and internal networks. Technology and information system costs are primarily impacted by the number of locations we occupy, the number of associates we have and the level of service we require from our third-party technology vendors. · Data processing-costs related to processing fees paid to our third-party data processing system providers relating to our core private trust banking platform. Data processing costs are primarily impacted by the number of loan, deposit and trust accounts we have and the level of transactions processed for our clients. · Marketing-costs related to promoting our business through advertising, promotions, charitable events, sponsorships, donations and other marketing-related expenses. Marketing costs are primarily impacted by the levels of advertising programs and other marketing activities and events held throughout the year. · Amortization of other intangible assets-primarily represents the amortization of intangible assets, including client lists and other similar items recognized in connection with acquisitions. · Goodwill impairment-represents the result of goodwill impairment testing. Testing for impairment occurs annually or following a triggering event. Triggering events can include adverse changes in the general condition of the economy, increased competitive environment, more-likely-than-not expectation of selling or disposing a segment, legal implications, and changes in key personnel. · Other-includes costs related to operational expenses associated with office supplies, postage, travel expenses, meals and entertainment, dues and memberships, costs to maintain or prepare OREO for sale, director compensation and travel, and other general corporate expenses that do not fit within one of the specific non-interest expense lines described above. Other operational expenses are generally impacted by our business activities and needs. Operating Segments We measure the overall profitability of operating segments based on income before income tax. We believe this is a more useful measurement as our wealth management products and services are fully integrated with our private trust bank. We allocate costs to our segments, which consist primarily of compensation and overhead expense directly attributable to the products and services within the wealth management, capital management and mortgage segments. We measure the profitability of each segment based on a post-allocation basis, as we believe it better approximates the operating cash flows generated by our reportable operating segments. A description of each segment is provided in Note 19 - Segment Reporting of the accompanying Notes to the Consolidated Financial Statements. Primary Factors Used to Evaluate our Balance Sheet The primary factors we use to evaluate our balance sheet include asset and liability levels, asset quality, capital, liquidity, and potential profit production from assets. We manage our asset levels to ensure our lending initiatives are efficiently and profitably supported and to ensure we have the necessary liquidity and capital to meet the required regulatory capital ratios. Funding needs are evaluated and forecasted by communicating with clients, reviewing loan maturity and draw expectations, and projecting new loan opportunities. We manage the diversification and quality of our assets based upon factors that include the level, distribution, severity and trend of problem assets such as those determined to be classified, delinquent, nonaccrual, non performing or restructured; the adequacy of our allowance for loan losses; the diversification and quality of loan and investment portfolios; the extent of counterparty risks, credit risk concentrations, and other factors. We manage our liquidity based upon factors that include the level and quality of capital and our overall financial condition, the trend and volume of problem assets, our balance sheet risk exposure, the level of deposits as a percentage of total loans, the amount of non-deposit funding used to fund assets, the availability of unused funding sources and off-balance sheet obligations, the availability of assets to be readily converted into cash without undue loss, the amount of cash and liquid securities we hold, and other factors. Financial institution regulators have established guidelines for minimum capital ratios for banks and bank holding companies. In 2015, we adopted the Basel III regulatory capital framework. At December 31, 2019, the Bank’s capital ratios exceeded the current well capitalized regulatory requirements established under Basel III. Results of Operations Overview The year ended December 31, 2019 compared with the year ended December 31, 2018. For the year ended December 31, 2019, we reported income available to common shareholders of $8.0 million, compared to income available to common shareholders for December 31, 2018 of $4.3 million, a $3.7 million, or 87.6% increase. For the year ended December 31, 2019, our income before income tax was $10.2 million, a $2.8 million, or 37.3%, increase from December 31, 2018. For the year ended December 31, 2019, compared to the year ended December 31, 2018, income before income tax increased primarily as a result of a $1.4 million, or 4.7%, increase in net interest income and an increase of $5.4 million, or 19.9%, in non-interest income. The increase in non-interest income was primarily the result of a $252.2 million increase in mortgage loans funded, which resulted in a $6.0 million increase in net gain on mortgage loans sold during the year ended December 31, 2019 compared to December 31, 2018. The increase in income before income taxes was partially offset by an increase of $3.6 million, or 7.2%, in non-interest expense, which was primarily due to an increase in expenses related to salaries and employee benefits along with a goodwill impairment charge recorded in the amount of $1.6 million during the second quarter of 2019. For the year ended December 31, 2019, net income was $8.0 million, which is an increase over 2018 of $2.4 million, or 41.8%. Net Interest Income The year ended December 31, 2019 compared with the year ended December 31, 2018. For the year ended December 31, 2019, compared to the year ended December 31, 2018, net interest income, before the provision for loan losses, increased $1.4 million, or 4.7%, to $32.1 million. This increase was partially attributable to a $87.6 million increase in average outstanding loan balances compared to December 31, 2018, along with an increase in our average yield on loans to 4.49% for the year ended December 31, 2019 from 4.36% for the year ended December 31, 2018. For the year ended December 31, 2019, our net interest margin was 2.99% and our net interest spread was 2.62%. For the year ended December 31, 2018, our net interest margin was 3.27% and our net interest spread was 2.97%. The increase in average loans outstanding for the year ended December 31, 2019 compared to the same periods in 2018 was primarily due to growth in our 1-4 family residential, cash, securities and other, owner occupied CRE, and commercial and industrial loans. Net interest income is also impacted by changes in the amount and type of interest-earning assets and interest-bearing liabilities. To evaluate net interest income, we measure and monitor the yields on our loans and other interest-earning assets and the costs of our deposits and other funding sources. Interest income on our available-for-sale securities portfolio increased as a result of higher average investment balances maintained for the year ended December 31, 2019 compared to the same period in 2018. Our average available-for-sale securities balance during the year ended December 31, 2019 was $53.1 million, an increase of $4.1 million from the year ended December 31, 2018. Interest expense on deposits increased during the year ended December 31, 2019 compared to the same period in 2018, driven primarily by a 50 bps increase in the average rate on interest bearing deposits due to competitive pressures on new and existing deposit accounts, as well as the impact of an increase in average interest-bearing deposit accounts of $164.2 million for the year ended December 31, 2019 when compared to the same period in 2018. The following tables present an analysis of net interest income and net interest margin for the periods presented, using average balances for each major category of interest-earning assets and interest-bearing liabilities, the interest earned or paid and the average rate earned or paid on those assets or liabilities. (1) Average balance represents daily averages, unless otherwise noted. (2) Available-for-sale securities represents monthly averages. (3) Non-performing loans are included in the respective average loan balances. Income, if any, on such loans is recognized on a cash basis. (4) Promissory notes from related parties were reclassed to loans during the year ended December 31, 2018. (5) Tax-equivalent yield adjustments are immaterial. (6) Mortgage loans held-for-sale are separated from the interest-earning assets above, as these loans are held for a short period of time until sold in the secondary market and are not held for investment purposes, with interest income recognized in the net gain on mortgage loans sold line in the income statement. These balances are excluded from the margin calculations in these tables. (7) Net interest spread is the average yield on interest-earning assets (excluding mortgage loans held-for-sale) minus the average rate on interest-bearing liabilities. (8) Net interest income is the difference between income earned on interest-earning assets, which does not include interest earned on mortgage loans held-for-sale, and expense paid on interest-bearing liabilities. (9) Net interest margin is equal to net interest income divided by average interest-earning assets (excluding mortgage loans held-for-sale). The following tables present the dollar amount of changes in interest income and interest expense for the periods presented, for each component of interest-earning assets and interest-bearing liabilities (excluding mortgage loans held-for-sale) and distinguishes between changes attributable to volume and interest rates. Changes attributable to both rate and volume that cannot be separated have been allocated to volume. Non-Interest Income The year ended December 31, 2019 compared with the year ended December 31, 2018. For the year ended December 31, 2019 compared to the year ended December 31, 2018, non-interest income increased $5.4 million, or 19.9%, to $32.6 million. The increase in non-interest income was primarily a result of a $252.2 million increase in mortgage loans funded, which resulted in a $6.0 million increase in net gain on mortgage loans sold during the year ended December 31, 2019 compared to December 31, 2018. The table below presents the significant categories of our non-interest income for the year ended December 31, 2019 and 2018. ________________ *Not meaningful Trust and investment management fees- For the year ended December 31, 2019 compared to the same period in 2018, our trust and investment management fees within our capital management segment decreased by $0.2 million, or 5.9%. The decrease in trust and investment management fees was a result of the sale of our third party administration business and lower yields on assets under management within our capital management segment. Net gain on mortgage loans sold- For the year ended December 31, 2019 compared to the year ended December 31, 2018, our net gain on mortgage loans sold increased by $6.0 million, or 132.1%, to $10.6 million. For the year ended December 31, 2019 and 2018, our origination volume of mortgage loans sold was $640.6 million and $388.3 million, respectively. The net gain on sales of loans will fluctuate with the amount and type of loans sold and market conditions. The increase in gain on mortgage loans sold for the year ended December 31, 2019 compared to 2018 was primarily related to the increase in origination volume in 2019 compared to 2018. The increase in origination volume in 2019 was primarily related to a strong residential real estate market in our footprint, lower market rates and management’s commitment and ability to capitalize on the mortgage environment. Bank fees- For the year ended December 31, 2019 compared to the same period in 2018, our bank fees decreased by $0.6 million or 33.3% primarily as a result of lower net fees on treasury management accounts and lower fees generated from correspondent bank stock. Provision for Loan Losses For the year ended December 31, 2019, our provision for loan loss was $0.7 million, the majority of the increase was to our general reserve, resulting from loan growth as well as an increase in our loan loss factors applied to our non-individually evaluated loan pools as a result of a charge off occurring during the year. We have a dedicated problem loan resolution team comprised of associates from our credit, senior leadership, risk and accounting teams that meets frequently to minimize losses by ensuring that watch list and problem credits are identified early and actively worked in order to identify potential losses in a timely manner and proactively manage the corresponding accounts. Non-Interest Expense The year ended December 31, 2019 compared with the year ended December 31, 2018. The increase in non-interest expense of 7.2% to $53.8 million for the year ended December 31, 2019, was primarily due to an increase in expenses related to salaries and employee benefits along with a goodwill impairment charge recorded in the amount of $1.6 million during the second quarter of 2019. The table below presents the significant categories of our non-interest expense for the periods noted: * Not meaningful Salaries and employee benefits-The increase in salaries and employee benefits of $2.0 million or 6.8%, was primarily due to an increase in equity compensation and increased earnings which triggered vesting of stock related earnout resulting from the asset purchase of EMC Holdings, LLC, ("EMC"), and additional equity granted in conjunction with company compensation practices, as well as an increase in salaries and benefits primarily related to an increase in headcount. Occupancy and equipment-The decrease in occupancy and equipment of $0.3 million, or 5.0%, was primarily due to lower depreciation expense and costs associated with maintenance and repairs. Data processing-The increase in data processing costs of $0.4 million, or 14.2%, is primarily related to third-party data processing and infrastructure costs driven by higher loan, deposit, and trust accounts in 2019 compared to 2018. Amortization of other intangible assets-The decrease in amortization of other intangible assets of $0.5 million, or 55.0%, was primarily due to certain intangibles becoming fully amortized during the year ended December 31, 2019. Goodwill impairment-The increase was due to a goodwill impairment charge of $1.6 million related to the Capital Management segment during the second quarter of 2019. See Note 7 - Goodwill and Other Intangible Assets. Other-The increase in other non-interest expense was primarily related to increases in publications and subscriptions, dues and memberships and armored car services and other immaterial net increases. Income Tax During the year ended December 31, 2019, the Company recorded an income tax provision of $2.2 million, reflecting an effective tax rate 21.4%. During the year ended December 31, 2018, the Company recorded an income tax provision of $1.8 million, reflecting an effective tax rate of 23.9%. The decline in the effective tax rate was primarily attributable to tax-planning strategies driven by the impact of research and development tax credits. Segment Reporting We have three reportable operating segments: Wealth Management, Capital Management and Mortgage. Our Wealth Management segment consists of operations relating to the Company’s fully integrated wealth management products and services. Services provided include deposit, loan, insurance, and trust and investment management advisory products and services. Our Capital Management segment consists of operations relating to the Company’s institutional investment management services over proprietary fixed income, high yield, and equity strategies, including acting as the advisor of three owned, managed, and rated proprietary mutual funds. Capital Management products and services are financial in nature, with revenues generally based on a percentage of assets under management or paid premiums. Our Mortgage segment consists of operations relating to the Company’s residential mortgage service offerings. Mortgage products and services are financial in nature for which premiums are recognized, net of expenses, upon the sale of mortgage loans to third parties. Services provided by our Mortgage segment include soliciting, originating and selling mortgage loans into the secondary market. Mortgage loans originated and held for investment purposes are recorded in the Wealth Management segment, as this segment provides ongoing services to our clients. The following table presents key metrics related to our segments: (1) Net interest income after provision plus non-interest income. The tables below present selected financial metrics of each segment as of and for the periods presented: Wealth Management The Wealth Management segment reported income before income tax of $7.7 million for the year ended December 31, 2019, compared to $9.4 million, for the same period in 2018. The decrease was primarily driven by increases in interest and non-interest expense, a slight decrease in non-interest income offset by an increase in interest income. The $4.8 million increase in interest expense is primarily due to a 50 bps increase in the average rate on interest bearing deposits due to competitive pressures on new and existing deposit accounts, as well as the impact of an increase in average interest-bearing deposit accounts of $164.2 million for the year ended December 31, 2019 when compared to the same period in 2018. The increase in other non-interest expense of $2.3 million during the year ended December 31, 2019, is primarily due to an increase in employee compensation and benefits, professional fees and technology related expenses. The decrease in non-interest income of $0.4 million for the year ended December 31, 2019 is primarily due to a $0.6 million reduction in bank fees. This was offset by an increase in total interest income of $6.3 million that was primarily related to increases in the average volume of interest-earning assets and yield for the year ended December 31, 2019 compared to the same period in 2018. During the year ended December 31, 2019, average loans increased $87.6 million and the yield on total interest-earning assets increased to 4.21% from 4.15% as compared to the same period in 2018. Capital Management * Not meaningful (1) Includes goodwill impairment charge of $1.6 million in the second quarter of 2019. The Capital Management segment reported a loss before income tax of $1.5 million for the year ended December 31, 2019, compared to a loss of $0.7 million, for the same period in 2018. The increase in other non-interest expense during the year ended December 31, 2019 was primarily driven by a goodwill impairment charge of $1.6 million in the second quarter offset partially by a decrease in operating expenses related to an effort to align the cost structure of the segment with its revenues. Mortgage The Mortgage segment reported income before income tax of $4.0 million for the year ended December 31, 2019, compared to a loss of $1.2 million for the same period in 2018. The overall increase in non-interest income and non-interest expense is related to an increase in the origination volume of mortgage loans sold. During the year ended December 31, 2019, the origination of mortgage loans sold amounted to $640.6 million, compared with $388.3 million in the prior year period. The growth in mortgage origination is due to favorable housing and interest rate market conditions as well as a strategic move to increase origination volume by mortgage loan originations during the year. Financial Condition The table below presents our condensed consolidated balance sheets as of the dates presented: * Not meaningful Cash and cash equivalents increased by $5.3 million, or 7.2%, to $78.6 million at December 31, 2019 compared to December 31, 2018. During the same period, investments increased by $15.2 million, or 34.8%, to $58.9 million at December 31, 2019. The increase in cash and cash equivalents was primarily due to an increase in deposits at December 31, 2019 compared to December 31, 2018. We continue to manage our balance sheet in an effort to ensure available cash is actively invested for optimal earnings. Total loans increased by $104.0 million, or 11.6%, to $998.0 million at December 31, 2019 compared to December 31, 2018. The increase was primarily due to continued organic growth in our market areas and growth in our residential mortgage and construction loans. Mortgage loans held for sale increased $33.5 million, or 225.7%, to $48.3 million at December 31, 2019 compared to December 31, 2018. This was primarily due to an increase in origination volume in 2019 compared to 2018. Goodwill and other intangible assets, net decreased by $5.5 million at December 31, 2019 compared to December 31, 2018 due to amortization on our intangible assets, goodwill impairment of $1.6 million and the reclass of $3.6 million of goodwill to intangibles held for sale (see Note 7 - Goodwill and Other Intangible Assets). Other assets increased by $11.3 million, or 43.6%, to $37.3 million at December 31, 2019 compared to December 31, 2018. This was primarily related to the recognition of a right-of-use asset and related lease liability upon adoption of ASU 2016-02 as of January 1, 2019. Total deposits increased $149.0 million, or 15.9%, to $1.1 billion at December 31, 2019 compared to December 31, 2018. Total interest-bearing deposits increased $111.8 million, or 15.2%, to $846.7 million and noninterest-bearing deposits increased $37.2 million, or 18.3%, to $240.1 million, during this period. Money market deposit accounts increased $126.1 million, or 25.8%, to $615.6 million at December 31, 2019 compared to December 31, 2018. Time deposit accounts decreased $43.8 million, or 24.5%, to $134.9 million at December 31, 2018. Negotiable order of withdrawal ("NOW") accounts increased $27.1 million, or 41.7%, to $91.9 million compared to December 31, 2018. This increase in money market deposit and NOW accounts was primarily due to continued organic growth in our market areas and a mix shift from less liquid products. The decrease in time deposit accounts was primarily due to a shift in client preference towards more liquid deposit products. Total borrowings decreased $5.0 million, or 23.2%, to $16.6 million at December 31, 2019 compared to December 31, 2018. The decrease was attributable to a $5.0 million decrease in borrowings on our Federal Home Loan bank ("FHLB") line of credit. A FHLB line of credit in the amount of $5.0 million that matured on August 2, 2019 was not renewed. Total shareholders’ equity increased $10.8 million, or 9.2%, to $127.7 million at December 31, 2019. The increase is primarily due to net income of $8.0 million, $2.3 million of stock-based compensation charges, and other comprehensive income, net of tax of $1.4 million. These increases were partially offset by stock repurchases of $0.7 million and $0.1 million of share awards settled. Assets Under Management *Trust & investment management fees divided by period-end balance. (1)AUM reported for the current period are one quarter in arrears. Assets under management increased $953.0 million, or 18.2%, to $6.2 billion for the year ended December 31, 2019. Assets under management decreased $139.0 million, or 2.6%, to $5.2 billion for the year December 31, 2018. The increase in 2019 is primarily due to market gains. The decrease in 2018 was primarily attributable to closed accounts within one profit center due to attrition associated with the relationship of a prior president. Available-for-sale securities Investments we intend to hold for an indefinite period of time, but not necessarily to maturity, are classified as available-for-sale and are recorded at fair value using current market information from a pricing service, with unrealized gains and losses excluded from earnings and reported in other comprehensive income (loss), net of tax. All our investments in securities were classified as available-for-sale for the periods presented below. The carrying values of our investment securities classified as available-for-sale are adjusted for unrealized gain or loss, and any gain or loss is reported on an after-tax basis as a component of other comprehensive income in shareholders’ equity. The following table summarizes the amortized cost and estimated fair value of our investment securities as of December 31, 2019: The following table summarizes the amortized cost and estimated fair value of our investment securities as of December 31, 2018: The following tables represent the book value of our contractual maturities and weighted average yield for our investment securities as of the dates presented. Contractual maturities may differ from expected maturities because issuers can have the right to call or prepay obligations without penalties. Our investments are taxable securities. Weighted average yields are not presented on a taxable equivalent basis. 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. Loan Portfolio Our primary source of interest income is derived through interest earned on loans to high net worth individuals and their related commercial interests. Our senior lending and credit team consists of seasoned, experienced personnel and we believe that our officers are well versed in the types of lending in which we are engaged. Underwriting policies and decisions are managed centrally and the approval process is tiered based on loan size, making the process consistent, efficient and effective. The management team and credit culture demands prudent, practical, and conservative approaches to all credit requests in compliance with the loan policy guidelines to ensure strong credit underwriting practices. In addition to originating loans for our own portfolio, we conduct mortgage banking activities in which we originate and sell, servicing-released, whole loans in the secondary market. Our mortgage banking loan sales activities are primarily directed at originating single family mortgages that are priced and underwritten to conform to previously agreed criteria before loan funding and are delivered to the investor shortly after funding. The level of future loan originations, loan sales and loan repayments depends on overall credit availability, the interest rate environment, the strength of the general economy, local real estate markets and the housing industry, and conditions in the secondary loan sale market. The amount of gain or loss on the sale of loans is primarily driven by market conditions and changes in interest rates, as well as our pricing and asset liability management strategies. As of December 31, 2019 and December 31, 2018, we had mortgage loans held for sale of $48.3 million and $14.8 million, respectively, in residential mortgage loans we originated. The following table summarizes our loan portfolio by type of loan as of the dates indicated, in thousands: (1) Loans held for investment exclude deferred costs, net of $1.4 million, $1.2 million, $1.0 million, $0.8 million and $0.6 million as of December 31, 2019, 2018, 2017, 2016 and 2015, respectively. · Cash, Securities and Other-consists of consumer and commercial purpose loans that are primarily secured by securities managed and under custody with us, cash on deposit with us or life insurance policies. In addition, loans in this portfolio are collateralized with other sources of consumer collateral and an immaterial amount of each loan may be unsecured. This segment of our portfolio is affected by a variety of local and national economic factors affecting borrowers’ employment prospects, income levels, and overall economic sentiment. · Construction and Development-consists of loans to finance the construction of residential and non-residential properties. These loans are dependent on the strength of the industries of the related borrowers and the risks consistent with construction projects. · 1-4 Family Residential-consists of loans and home equity lines of credit secured by 1-4 family residential properties. These loans typically enable borrowers to purchase or refinance existing homes, most of which serve as the primary residence of the owner. In addition, some borrowers secure a commercial purpose loan with owner occupied or non-owner occupied 1-4 family residential properties. Loans in this segment are dependent on the industries tied to these loans as well as the national and local economies, and local residential and commercial real estate markets. · Commercial Real Estate, Owner Occupied and Non-Owner Occupied-consists of commercial loans collateralized by real estate. These loans may be collateralized by owner occupied or non-owner occupied real estate, as well as multi-family residential real estate. These loans are dependent on the strength of the industries of the related borrowers and the success of their businesses. · Commercial and Industrial-consists of commercial and industrial loans, including working capital lines of credit, permanent working capital term loans, business asset loans, acquisition, expansion and development loans, and other loan products, primarily in our target markets. This portfolio primarily consists of term loans and lines of credit which are dependent on the strength of the industries of the related borrowers and the success of their businesses. The contractual maturity ranges of loans in our loan portfolio and the amount of such loans with fixed and floating interest rates in each maturity range, excluding deferred loan fees, as of the date indicated are summarized in the following tables: Non-Performing Assets Non-performing assets include non-accrual loans, troubled debt restructurings ("TDRs"), loans past due 90 days or more and still accruing interest, TDRs still accruing interest, and other real estate owned ("OREO"). The accrual of interest on loans is discontinued at the time the loan becomes 90 or more days delinquent unless the loan is well secured and in the process of collection. Past due status is based on the contractual terms of the loan. In all cases, loans are placed on non-accrual status or charged off if collection of interest or principal is considered doubtful. OREO represents assets acquired through, or in lieu of, foreclosure. The amounts reported as OREO are supported by recent appraisals, with the appraised values adjusted, where applicable, for expected transaction fees likely to be incurred upon sale of the property. We incur recurring expenses relating to OREO in the form of maintenance, taxes, insurance and legal fees, among others, until the OREO parcel is disposed. While disposition efforts with respect to our OREO are generally ongoing, if these properties are appraised at lower-than-expected values or if we are unable to sell the properties at the prices for which we expect to be able to sell them, we may incur additional losses. The amount of lost interest for non-accrual loans was $0.4 million for each of the years ended December 31, 2019 and 2018. We had $12.9 million in non-performing assets as of December 31, 2019 compared to $19.7 million as of December 31, 2018. The $6.8 million decrease in our non-performing assets was primarily related to an $11.3 million Cash, Securities, and Other loan that was classified as a non-accrual TDR in 2018 that was paid down to $2.8 million in 2019. This decrease was partially offset by the addition of two Commercial and Industrial loans that were classified as TDRs and were not accruing interest at December 31, 2019. The following table presents information regarding non-performing loans as of the dates indicated: (1) All non-accrual loans in 2019 and 2018 are TDRs. See Note 5 - Loans and the Allowance for Loan Losses to the consolidated financial statements. (2) Excludes mortgage loans held for sale of $48.3 million, $14.8 million, $22.9 million, $8.1 million and $19.9 million as of December 31, 2019, 2018, 2017, 2016, and 2015, respectively. Potential Problem Loans We categorize loans into risk categories based on relevant information about the ability of the borrowers to service their debt, such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. We analyze loans individually by classifying the loans by credit risk on a quarterly basis, which are segregated into the following definitions for risk ratings: Special Mention- Loans categorized as special mention have a potential weakness or borrowing relationships that require more than the usual amount of management attention. Adverse industry conditions, deteriorating financial conditions, declining trends, management problems, documentation deficiencies or other similar weaknesses may be evident. Ability to meet current payment schedules may be questionable, even though interest and principal are still being paid as agreed. The asset has potential weaknesses that may result in deteriorating repayment prospects if left uncorrected. Loans in this risk grade are not considered adversely classified. Substandard-Substandard loans are considered "classified" and are inadequately protected by the current net worth and paying capacity of the obligor or by the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardizes the liquidation of the debt. They are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected. Loans in this category may be placed on non-accrual status and may individually be evaluated for impairment if indicators of impairment exist. Doubtful-Loans graded Doubtful are considered "classified" and 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 known facts, conditions and values, highly questionable and improbable. However, the amount or certainty of eventual loss is not known because of specific pending factors. Loans not meeting any of the three criteria above are considered to be pass-rated loans. As of December 31, 2019 and December 31, 2018 non-performing loans of $12.3 million and $19.1 million, respectively, were included in the substandard category in the table below. The following tables present, by class and by credit quality indicator, the recorded investment in our loans as of the dates indicated: Allowance for Loan Losses The allowance for loan losses is established through a provision for loan losses, which is a noncash charge to earnings. Loan losses are charged against the allowance when management believes that a loan balance is confirmed uncollectable. Subsequent recoveries, if any, are credited to the allowance for loan losses. The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and dollar volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral and prevailing economic conditions. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off. The following table presents summary information regarding our allowance for loan losses for the periods indicated: (1) Average balances are average daily balances. (2) Excludes average outstanding balances of mortgage loans held for sale of $39.4 million, $21.8 million, $12.7 million, $19.0 million and $8.8 million for the years ended for December 31, 2019, 2018, 2017, 2016 and 2015, respectively. (3) Excludes mortgage loans held for sale of $48.3 million, $14.8 million, $22.9 million, $8.1 million, and $19.9 million as of December 31, 2019, 2018, 2017, 2016 and 2015, respectively. (4) The ratio of net charge-offs to average loans is negligible or immaterial. The following tables represent the allocation of the allowance for loan losses among loan categories and other summary information. The allocation for loan losses by category should neither be interpreted as an indication of future charge-offs, nor as an indication that charge-offs in future periods will necessarily occur in these amounts or in the indicated proportions. The allocation of a portion of the allowance for loan losses to one category of loans does not preclude its availability to absorb losses in other categories. (1) Represents the percentage of loans to total loans in the respective category. Deferred Tax Assets, Net Deferred tax assets, net represent the differences in timing of when items are recognized for GAAP purposes and when they are recognized for tax purposes, as well as our net operating losses. As a result of book and tax basis differences, our deferred tax assets, net for year ended December 31, 2019 increased $0.7 million from December 31, 2018. Deposits Our deposit products include money market accounts, time-deposit accounts (typically certificates of deposit), NOW accounts (checking accounts), and saving accounts. Our accounts are federally insured by the FDIC up to the legal maximum. Total deposits increased by $149.0 million, or 15.9%, to $1.1 billion at December 31, 2019 from December 31, 2018. Total average deposits for the year ended December 31, 2019 were $1.02 billion, an increase of $173.4 million, or 20.5%, compared to $847.7 million as of December 31, 2018. The increases are primarily due to our general deposit growth initiatives, the cross-selling of products, the skills of our sales and service team, as well as additional deposits added from our trust and investment management relationships for which we also provide deposit products. The increase in average rates in 2019 was driven primarily by competitive pressures on new and existing deposit accounts. The following table presents the average balances and average rates paid on deposits for the periods below: Average noninterest-bearing deposits to average total deposits was 21.7% and 25.1% for the year ended December 31, 2019 and 2018, respectively. Our average cost of funds was 1.25% and 0.90% during the year ended December 31, 2019 and 2018, respectively. The increase in our cost of funds for 2019 from 2018 was primarily due to an increase in average rates on interest-bearing deposits to 1.53% during the year ended December 31, 2019 compared to 1.03% in 2018. This increase is primarily due to competitive pressures on new and existing deposit accounts. Total money market accounts as of December 31, 2019 were $615.6 million, an increase of $126.1 million, or 25.8%, compared to $489.5 million as of December 31, 2018. This increase was primarily due to continued growth in our market areas and a mix shift from less liquid products. Negotiable order of withdrawal accounts increased $27.1 million, or 41.7%, to $91.9 million compared to December 31, 2018. This increase in money market deposit and NOW accounts was primarily due to continued organic growth in our market areas and a mix shift from less liquid products. Total time deposits as of December 31, 2019 were $134.9 million, a decrease of $43.8 million, or 24.5%, compared to December 31, 2018. The decrease in time deposit accounts was primarily due to a shift in client preference towards more liquid products. The following table represents the amount of certificates of deposit by time remaining until maturity as of December 31, 2019: Borrowings We have short-term and long-term borrowing sources available to supplement deposits and meet our liquidity needs. As of December 31, 2019 and December 31, 2018, borrowings totaled $16.6 million and $21.6 million, respectively. During the year ended December 31, 2018, we redeemed our subordinated notes due 2020 with proceeds from our initial public offering. The table below presents balances of each of the borrowing facilities as of the dates indicated: FHLB Topeka. We have a blanket pledge and security agreement with FHLB Topeka that requires certain loans and securities to be pledged as collateral for any outstanding borrowings under the agreement. The collateral pledged as of December 31, 2019 and December 31, 2018 amounted to $515.5 million and $475.4 million, respectively. Based on this collateral and the Company’s holdings of FHLB Topeka stock, the Company was eligible to borrow an additional $349.9 million at December 31, 2019. As of December 31, 2019, the Bank had borrowing capacity associated with three unsecured federal funds lines of credit up to $10.0 million, $19.0 million, and $25.0 million. As of December 31, 2018, the Bank had borrowing capacity associated with three unsecured federal funds lines of credit up to $10.0 million, $13.0 million, and $25.0 million. As of December 31, 2019 and December 31, 2018, there were no amounts drawn on any of the federal funds lines. Our borrowing facilities include various financial and other covenants, including, but not limited to, a requirement that the Bank maintains regulatory capital that is deemed "well capitalized" by federal banking agencies. As of December 31, 2019 and December 31, 2018, the Company was in compliance with the covenant requirements. Liquidity and Capital Resources Liquidity resources primarily include interest-bearing and noninterest-bearing deposits which primarily contribute to our ability to raise funds to support asset growth, acquisitions, and meet deposit withdrawals and other payment obligations. Access to purchased funds primarily include the ability to borrow from FHLB Topeka and from correspondent banks. The following table illustrates, during the periods presented, the composition of our funding sources and the average assets in which those funds are invested as a percentage of average total assets for the period indicated. Our primary source of funds is interest-bearing and noninterest-bearing deposits, and our primary use of funds is loans. We do not expect a change in the primary source or use of our funds in the foreseeable future. Capital Resources Total shareholders’ equity increased $10.8 million, or 9.2%, to $127.7 million at December 31, 2019 compared to December 31, 2018. The increase is primarily due to net income of $8.0 million, $2.3 million of stock-based compensation charges, and other comprehensive income, net of tax of $1.4. These increases were partially offset by stock repurchases of $0.7 million and $0.1 million of share awards settled. We are subject to various regulatory capital adequacy requirements at a consolidated level and the bank level. These requirements are administered by 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 direct material effect on our consolidated financial statements. Under capital adequacy guidelines and, additionally for banks, 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 practices. Capital levels are viewed as important indicators of an institution’s financial soundness by banking regulators. Generally, FDIC-insured depository institutions and their holding companies are required to maintain minimum capital relative to the amount and types of assets they hold. As of December 31, 2019 and December 31, 2018, respectively, our holding company and Bank were in compliance with all applicable regulatory capital requirements, and the Bank was classified as "well capitalized," for purposes of the prompt corrective action regulations. As we continue to grow our operations and maintain capital requirements, our regulatory capital levels may decrease depending on our level of earnings. We continue to monitor growth and control our capital activities in order to remain in compliance with all applicable regulatory capital standards. The following table presents our regulatory capital ratios for the dates noted. Contractual Obligations and Off-Balance Sheet Arrangements We enter into credit-related financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. Commitments may expire without being utilized. Our exposure to loan loss is represented by the contractual amount of these commitments, although material losses are not anticipated. We follow the same credit policies in making commitments as we do for on-balance sheet instruments. The following table presents future contractual obligations to make future payments for the periods indicated (amounts in thousands). (1) Reflects a contractual maturity date of December 31, 2026. The following tables present financial instruments whose contract amounts represent credit risk, as of the dates indicated. We may enter into contracts for services in the conduct of ordinary business operations, which may require payment for services to be provided in the future and may contain penalty clauses for early termination of the contracts. We do not believe these off-balance sheet arrangements have or are reasonably likely to have a material effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources. However, there can be no assurance that such arrangements will not have an effect on future operations. Critical Accounting Policies Our accounting policies and procedures are described in Note 1 - Organization and Summary of Significant Accounting Policies in the accompanying Notes to the Consolidated Financial Statements.
-0.075864
-0.075386
0
<s>[INST] Company Overview We are a financial holding company founded in 2002 and headquartered in Denver, Colorado. We provide a fully integrated suite of wealth management services to our clients including banking, trust and investment management products and services. Our mission is to be the best private bank for the Western wealth management client. We target entrepreneurs, professionals and highnet worth individuals, typically with $1.0 millionplus in liquid net worth, and their related philanthropic and business organizations, which we refer to as the "Western wealth management client." We believe that the Western wealth management client shares our entrepreneurial spirit and values our sophisticated, hightouch wealth management services that are tailored to meet their specific needs. We partner with our clients to solve their unique financial needs through our expert integrated services provided in a team approach. We offer our services through a branded network of boutique private trust bank offices, which we believe are strategically located in affluent and highgrowth markets in locations across Colorado, Arizona, Wyoming and California. Our profit centers, which are comprised of private bankers, lenders, wealth planners and portfolio managers, under the leadership of a local chairman and/or president, are also supported centrally by teams providing management services such as operations, risk management, credit administration, marketing, technology support, human capital and accounting/finance services, which we refer to as support centers. From 2004, when we opened our first profit center, until December 31, 2019, we have expanded our footprint into nine full service profit centers, three mortgage loan production offices, two trust offices, and one registered investment advisor located across four states. As of and for the year ended December 31, 2019, we had $1.3 billion in total assets, $64.0 million in total revenues and provided fiduciary and advisory services on $6.2 billion of assets under management ("AUM"). Primary Factors Used to Evaluate the Results of Operations As a financial institution, we manage and evaluate various aspects of both our results of operations and our financial condition. We evaluate the comparative levels and trends of the line items in our consolidated balance sheet and income statement as well as various financial ratios that are commonly used in our industry. The primary factors we use to evaluate our results of operations include net interest income, noninterest income and noninterest expense. Net Interest Income Net interest income represents interest income less interest expense. We generate interest income on interestearning assets, primarily loans and availableforsale securities. We incur interest expense on interestbearing liabilities, primarily interestbearing deposits and borrowings. To evaluate net interest income, we measure and monitor: (i) yields on loans, availableforsale securities and other interestearning assets; (ii) the costs of deposits and other funding sources; (iii) the rates incurred on borrowings and other interestbearing liabilities; and (iv) the regulatory risk weighting associated with the assets. Interest income is primarily impacted by loan growth and loan repayments, along with changes in interest rates on the loans. Interest expense is primarily impacted by changes in deposit balances along with the volume and type of interestbearing liabilities. Net interest income is primarily impacted by changes in market interest rates, the slope of the yield curve, and interest we earn on interestearning assets or pay on interestbearing liabilities. NonInterest Income Noninterest income primarily consists of the following: · Trust and investment management feesfees and other sources of income charged to clients for managing their trust and investment assets, providing financial planning consulting services, 401(k) and retirement advisory consulting services, and other wealth management services. Trust and investment management fees are primarily impacted by rates charged and increases and decreases in AUM. AUM is primarily impacted by opening and closing of client advisory and trust accounts, contributions and withdrawals, and the fluctuation in market values. · Net gain on mortgage loans soldgain on originating and selling mortgages, origination fees, and borrower credits, less commissions to loan originators, lender credits, document review and other costs specific to originating and selling the loan. The market adjustments for interest rate lock commitments and gains and losses incurred on the mandatory trad [/INST] Negative. </s>
2,020
8,406
1,726,173
Biglari Holdings Inc.
2019-02-25
2018-12-31
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (dollars in thousands except per share data) Biglari Holdings Inc. is a holding company owning subsidiaries engaged in a number of diverse business activities, including media, property and casualty insurance, and restaurants. The Company’s largest operating subsidiaries are involved in the franchising and operating of restaurants. Biglari Holdings is founded and led by Sardar Biglari, Chairman and Chief Executive Officer of Biglari Holdings and its major operating subsidiaries. The Company’s long-term objective is to maximize per-share intrinsic value. All major operating, investment, and capital allocation decisions are made for the Company and its subsidiaries by Mr. Biglari. As of December 31, 2018, Mr. Biglari’s beneficial ownership was approximately 56.9% of the Company’s outstanding Class A common stock and 54.3% of the Company’s outstanding Class B common stock. Issuance of Dual Class Common Stock On March 5, 2018, the Company entered into an agreement with its predecessor registrant, now known as OBH Inc. (the “Predecessor”), and BH Merger Company, a wholly owned subsidiary of the Company. Pursuant to the agreement on April 30, 2018, BH Merger Company merged with and into the Predecessor, with the Predecessor continuing as the surviving corporation and a wholly owned subsidiary of the Company. As a result of the April 30, 2018 transaction, the Company has two classes of common stock, designated Class A common stock and Class B common stock. A share of Class B common stock has economic rights equivalent to 1/5th of a share of Class A common stock; however, Class B common stock has no voting rights. Upon completion of the transaction, every ten (10) shares of common stock outstanding on April 30, 2018 converted into (i) ten (10) shares of Class B common stock and (ii) one (1) share of Class A common stock. Since May 1, 2018, the shares of the Company’s Class A common stock have traded on the New York Stock Exchange (“NYSE”) under the ticker symbol “BH.A” and the shares of the Company’s Class B common stock have traded on the NYSE under the ticker symbol “BH”. Net earnings attributable to Biglari Holdings shareholders are disaggregated in the table that follows. Amounts are recorded after deducting income taxes. The following discussion should be read in conjunction with Item 1, Business and our Consolidated Financial Statements and the notes thereto included in this Form 10-K. The following discussion should also be read in conjunction with the “Cautionary Note Regarding Forward-Looking Statements” and the risks and uncertainties described in Item 1A, Risk Factors set forth above. Management’s Discussion and Analysis (continued) Restaurants Our restaurant businesses, which include Steak n Shake and Western Sizzlin, comprise 685 company-operated and franchise restaurants as of December 31, 2018. The term “same-store sales” refers to the sales of company-operated units open at least 18 months at the beginning of the current period and have remained open through the end of the period. Same-store traffic measures the number of patrons who walk through the same units. Restaurant operations for 2018, 2017 and 2016 are summarized below. Cost of food, restaurant operating costs and rent expense are expressed as a percentage of net sales. General and administrative, marketing, other expenses and depreciation and amortization are expressed as a percentage of total revenue. Management’s Discussion and Analysis (continued) Net sales during 2018 were $740,922 representing a decrease of $40,934 when compared to 2017. The decreased performance of our restaurant operations in 2018 was largely driven by Steak n Shake’s same-store sales, which decreased 5.1% whereas customer traffic decreased by 7.0%. Net sales during 2017 were $781,856 representing a decrease of $13,466 when compared to 2016. The decreased performance of our restaurant operations in 2017 was largely driven by Steak n Shake’s same-store sales. In 2017, Steak n Shake’s same-store sales decreased by 1.8% compared to 2016. In 2018, franchise royalties and fees increased $10,225 or 49.2%. During 2018, Steak n Shake opened 33 franchise units and closed 20. Western Sizzlin opened one franchise unit and closed four. The increase in franchise royalties and fees was primarily due to the adoption of new ASC 606 accounting guidance for revenue recognition. Franchise marketing contributions are now reflected in revenue with a corresponding increase in marketing expense. As a result, franchise revenue increased by $9,417 or 45.3% during 2018. Franchise royalties and fees during 2017 increased $1,979 compared to 2016. In 2017 Steak n Shake opened 40 franchise units and closed thirteen. During the same period, six Western Sizzlin franchise units closed. The increase in franchise fees and royalties during 2017 are primarily attributable to new Steak n Shake franchise units, which opened in 2017 and 2016. Cost of food in 2018 was $223,273 or 30.1% of net sales, compared with $238,143 or 30.5% of net sales in 2017 and $221,657 or 27.9% of net sales in 2016. The increase as a percent of net sales during 2018 and 2017 compared to 2016 was attributable to increased commodity costs. Restaurant operating costs during 2018 were $393,348 or 53.1% of net sales, compared to $404,373 or 51.7% of net sales in 2017 and $395,262 or 49.7% of net sales in 2016. Total costs as a percent of net sales during 2018 and 2017 increased compared to the respective prior years principally due to higher wages. Selling, general and administrative expenses during 2018 were $120,807 or 15.6% of total revenues. General and administrative expenses decreased by $2,843 during 2018 compared to 2017, primarily because of decreased personnel costs. Marketing expense increased by $5,474 in 2018 compared to 2017 primarily due to the adoption of new accounting guidance. New ASC 606 accounting guidance requires the Company to recognize franchise fees as revenue and reflect advertising expenditures made on behalf of the franchisees as marketing expense. The new guidance increased marketing expenses by $9,689 during 2018. Other expenses increased by $4,049 during 2018 compared to 2017. The increase in other expenses was primarily due to asset impairments of $5,677. Selling, general and administrative expenses during 2017 were $114,127 or 14.1% of total revenues. General and administrative expenses increased by $1,081 during 2017 compared to 2016, primarily because of increased recruiting. Marketing expense decreased by $1,735 in 2017 compared to 2016 because of a decrease in promotions. Interest on obligations under leases was $8,207 during 2018, versus $9,082 during 2017 and $9,475 during 2016. The year over year decrease in interest expense is primarily attributable to the maturity and retirement of lease obligations. The total obligations under leases outstanding at December 31, 2018 were $64,200, compared to $80,752 at December 31, 2017 and $89,498 at December 31, 2016. Management’s Discussion and Analysis (continued) Insurance First Guard is a direct underwriter of commercial truck insurance, selling physical damage and nontrucking liability insurance to truckers. Earnings of our insurance business are summarized below. First Guard’s insurance products are marketed primarily through direct response methods via the Internet or by telephone. First Guard’s cost-efficient direct response marketing methods enable it to be a low-cost trucking insurer. In 2018, premiums earned increased $2,223 or 9.2% compared to 2017. Premiums earned during 2017 increased $1,845 or 8.2% compared to 2016. Pre-tax underwriting gain during 2018 was $5,634, an increase of $1,116 (24.7%) compared to 2017. Pre-tax underwriting gain during 2017 was $4,518, a decrease of $395 (8.0%) compared to 2016. We strive to generate pre-tax underwriting profits every year. Insurance premiums and other on the statement of earnings includes premiums earned, investment income and commissions, which are included in other income in the above table. Management’s Discussion and Analysis (continued) Media and Licensing Maxim’s business lies principally in media and licensing. Earnings of our media operations are summarized below. We acquired Maxim with the idea of transforming its business model. The magazine developed the Maxim brand, a franchise we are utilizing to generate nonmagazine revenue, notably through licensing, a cash-generating business related to consumer products, services, and events. We have taken the risk on the belief that the probability for gain in value more than justifies the risk of loss. Investment Partnership Gains Earnings from our investments in partnerships are summarized below. Investment partnership gains include gains and losses from changes in market values of investments held by the investment partnerships and dividends earned by the partnerships. The volatility of the gains and losses during the various years is attributable to changes in market values of investments. Dividend income has a lower effective tax rate than income from changes in market values. The investments held by the investment partnerships are largely concentrated in the common stock of one investee, Cracker Barrel Old Country Store, Inc. The investment partnerships hold the Company’s common stock as investments. The Company’s pro-rata share of its common stock held by the investment partnerships is recorded as treasury stock even though these shares are legally outstanding. Gains and losses on Company common stock included in the earnings of the partnerships are eliminated. Management’s Discussion and Analysis (continued) Interest Expense The Company’s interest expense is summarized below. The outstanding balance on Steak n Shake’s credit facility on December 31, 2018 was $183,698 compared to $185,898 on December 31, 2017. The decrease in the outstanding balance was due to debt payments of $2,200 during 2018. The interest rate was 6.28% and 5.32% as of December 31, 2018 and 2017, respectively. Interest expense during 2018 increased by $637 compared to 2017, primarily due to higher interest rates during 2018. Interest expense during 2017 decreased by $410 compared to 2016, primarily due to lower debt during 2017. Income Taxes Consolidated income tax was a benefit of $2,637 in 2018 versus a benefit of $62,961 in 2017 and an expense of $46,812 in 2016. The income tax benefit of $2,637 was primarily from the use of employment tax credits generated by restaurant operations. The 2017 Tax Cuts and Jobs Act reduces the U.S. statutory corporate tax rate from 35% to 21% for our tax years beginning in 2018, which resulted in the re-measurement of the federal portion of our deferred tax assets and liabilities as of December 31, 2017. The change in the tax rate resulted in a onetime deferred tax benefit of $51,707 during 2017. The deferred income tax benefit is derived from a re-measurement in deferred tax balances to the new statutory rate applicable to unrealized gains on marketable securities held by the Company and in the investment partnerships. Corporate Corporate expenses exclude the activities in the restaurant, insurance, media and other companies. Corporate net losses during 2018 were $8,661 versus net earnings of $32,072 during 2017 and net losses of $6,387 during 2016. In 2017, an increase in shareholders’ equity was derived from a re-measurement in deferred tax liability to the new statutory rate applicable to unrealized gains on marketable securities. The majority of the Company’s deferred tax liabilities associated with unrealized gains on marketable securities are held in the corporate account. Financial Condition Our consolidated shareholders’ equity on December 31, 2018 was $570,455, a decrease of $873 compared to the December 31, 2017 balance. Shareholders’ equity increased by $19,392 in net income and was offset by an increase in treasury stock of $19,292. The increase in treasury stock was primarily a result of recording our proportionate interest in shares of the Company’s stock purchased during 2018 by The Lion Fund II, L.P. under a Rule 10b5-1 trading plan. The shares purchased by the investment partnership are legally outstanding but under accounting convention the Company’s proportional ownership of the shares is reflected as treasury shares in the consolidated financial statements. Consolidated cash and investments are summarized below. Unrealized gains/losses of Biglari Holdings’ stock held by the investment partnerships are eliminated in the Company’s consolidated financial results. Management’s Discussion and Analysis (continued) Liquidity Our balance sheet continues to maintain significant liquidity. Consolidated cash flow activities are summarized below. In 2018, cash from operating activities decreased by $5,102 compared to 2017 and by $42,671 compared to 2016. Net earnings (excluding non-cash items) were $3,061 during 2018, $3,316 during 2017 and $28,780 during 2016. The decrease in net earnings during 2018 and 2017 compared to 2016 was primarily due to decreases in restaurant net earnings. Distributions from investment partnerships were $29,660 during 2018, $9,395 during 2017 and $26,265 during 2016. Changes in working capital accounts were a decrease of $12,043 during 2018, and increases during 2017 and 2016 of $13,069 and $8,304, respectively. The decrease of working capital accounts during 2018 was primarily tied to the payment of the 2017 CEO incentive fee of $7,353. And the accrual of the 2017 CEO incentive fee increased working capital accounts during 2017. Net cash used in investing activities increased during 2018 by $13,742 compared to 2017, and decreased by $3,505 compared to 2016. Capital expenditures during 2018 were $7,259 and $6,630 higher than capital expenditures during 2017 and 2016, respectively. Purchases of investments, net of redemptions of fixed maturity securities during 2018 were $9,273 and $6,385 higher than purchases of investments during 2017 and 2016, respectively. Distributions from investment partnerships of $39,040 during 2018 were reinvested into the investment partnerships during 2018. During 2018, 2017 and 2016 we incurred debt payments of $7,579, $23,030 and $15,295, respectively. Debt obligations were reduced in 2018 because of additional principal payments on long-term debt during 2017 and 2016. We intend to meet the working capital needs of our operating subsidiaries principally through anticipated cash flows generated from operations, cash on hand, existing credit facilities, and the sale of excess properties and investments. We continually review available financing alternatives. Steak n Shake Credit Facility On March 19, 2014, Steak n Shake and its subsidiaries entered into a credit agreement which provided for a senior secured term loan facility in an aggregate principal amount of $220,000 and a senior secured revolving credit facility in an aggregate principal amount of up to $30,000. On October 27, 2017, Steak n Shake determined to end the use of its senior secured revolving credit facility. In 2017, Steak n Shake deposited cash to satisfy required collateral for casualty insurance previously collateralized by letters of credit issued through the revolving credit facility. The deposits are recorded in other assets under restricted cash in the consolidated balance sheets. The term loan is scheduled to mature on March 19, 2021. It amortizes at an annual rate of 1.0% in equal quarterly installments, beginning June 30, 2014, at 0.25% of the original principal amount of the term loan, subject to mandatory prepayments from excess cash flow, asset sales and other events described in the credit agreement. The balance will be due at maturity. Steak n Shake has the right to request an incremental term loan facility from participating lenders and/or eligible assignees at any time, up to an aggregate total principal amount not to exceed $70,000 if certain customary conditions within the credit agreement are met. Borrowings bear interest at a rate per annum equal to a base rate or a Eurodollar rate (minimum of 1%) plus an applicable margin. Interest on the term loan is based on a Eurodollar rate plus an applicable margin of 3.75% or on the prime rate plus an applicable margin of 2.75%. The interest rate on the term loan was 6.28% and 5.32% as of December 31, 2018 and 2017, respectively. The credit agreement includes customary affirmative and negative covenants and events of default. As of December 31, 2018, we were in compliance with all covenants. Steak n Shake’s credit facility contains restrictions on its ability to pay dividends to Biglari Holdings. Management’s Discussion and Analysis (continued) The term loan is secured by first priority security interests in substantially all the assets of Steak n Shake. Disruptions in debt capital markets that restrict access to funding when needed could adversely affect the results of operations, liquidity and capital resources of Steak n Shake. Biglari Holdings is not a guarantor under the credit facility. As of December 31, 2018, $183,698 was outstanding under the term loan. Western Sizzlin Revolver As of December 31, 2018, Western Sizzlin had no debt outstanding under the revolver. Critical Accounting Policies Management’s discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. Certain accounting policies require management to make estimates and judgments concerning transactions that will be settled several years in the future. Amounts recognized in our consolidated financial statements from such estimates are necessarily based on numerous assumptions involving varying and potentially significant degrees of judgment and uncertainty. Accordingly, the amounts currently reflected in our consolidated financial statements will likely increase or decrease in the future as additional information becomes available. We believe the following critical accounting policies represent our more significant judgments and estimates used in preparation of our consolidated financial statements. Given the current composition of our business, we do not believe that any accounting policies related to our insurance or media businesses were critical to the preparation of our consolidated financial statements as of and for the year ended December 31, 2018. Consolidation The consolidated financial statements include the accounts of (i) Biglari Holdings Inc., and (ii) the wholly owned subsidiaries of Biglari Holdings Inc. in which control can be exercised. In evaluating whether we have a controlling interest in entities in which we would consolidate, we consider the following: (1) for voting interest entities, we consolidate those entities in which we own a majority of the voting interests; and (2) for limited partnership entities, we consolidate those entities if we are the general partner of such entities and for which no substantive removal rights exist. The analysis as to whether to consolidate an entity is subject to a significant amount of judgment. Some of the criteria considered include the determination as to the degree of control over an entity by its various equity holders and the design of the entity. All intercompany accounts and transactions are eliminated in consolidation. Our interests in the investment partnerships are accounted for as equity method investments because of our retained limited partner interest in the investment partnerships. The Company records gains from investment partnerships (inclusive of the investment partnerships’ unrealized gains and losses on their securities) in the consolidated statement of earnings based on our proportional ownership interest in the investment partnerships. Impairment of Long-lived Assets We review company-operated restaurants for impairment on a restaurant-by-restaurant basis when events or circumstances indicate a possible impairment. We test for impairment by comparing the carrying value of the asset to the undiscounted future cash flows expected to be generated by the asset. If the total estimated future cash flows are less than the carrying amount of the asset, the carrying value is written down to the estimated fair value, and a loss is recognized in earnings. The future cash flows expected to be generated by an asset requires significant judgment regarding future performance of the asset, fair market value if the asset were to be sold, and other financial and economic assumptions. Insurance Reserves We currently self-insure a significant portion of expected losses under our workers’ compensation, general liability, directors’ and officers’ liability, and auto liability insurance programs. For certain programs, we purchase reinsurance for individual and aggregate claims that exceed predetermined limits. We record a liability for all unresolved claims and our estimates of incurred but not reported (“IBNR”) claims at the anticipated cost to us. The liability estimate is based on information received from insurance companies, combined with management’s judgments regarding frequency and severity of claims, claims development history, and settlement practices. Significant judgment is required to estimate IBNR claims as parties have yet to assert a claim, and therefore the degree to which injuries have been incurred and the related costs have not yet been determined. Additionally, estimates about future costs involve significant judgment regarding legislation, case jurisdictions, and other matters. Management’s Discussion and Analysis (continued) Income Taxes We record deferred tax assets or liabilities based on differences between financial reporting and tax basis of assets and liabilities using currently enacted rates and laws that will be in effect when the differences are expected to reverse. We record deferred tax assets to the extent we believe there will be sufficient future taxable income to utilize those assets prior to their expiration. To the extent deferred tax assets would be unable to be utilized; we would record a valuation allowance against the unrealizable amount and record that amount as a charge against earnings. Due to changing tax laws and state income tax rates, significant judgment is required to estimate the effective tax rate expected to apply to tax differences that are expected to reverse in the future. We must also make estimates about the sufficiency of taxable income in future periods to offset any deductions related to deferred tax assets currently recorded. As of December 31, 2018, a change of one percentage point in an enacted tax rate would have an impact of approximately $3,800 on net earnings. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate resolution. Goodwill and Other Intangible Assets We are required to assess goodwill and any indefinite-lived intangible assets for impairment annually, or more frequently if circumstances indicate impairment may have occurred. Goodwill impairment occurs when the estimated fair value of goodwill is less than its carrying value. The valuation methodology and underlying financial information included in our determination of fair value require significant management judgments. We use both market and income approaches to derive fair value. The judgments in these two approaches include, but are not limited to, comparable market multiples, long-term projections of future financial performance, and the selection of appropriate discount rates used to determine the present value of future cash flows. Changes in such estimates or the application of alternative assumptions could produce significantly different results. Leases Restaurant operations lease certain properties under operating leases. Many of these lease agreements contain rent holidays, rent escalation clauses and/or contingent rent provisions. Rent expense is recognized on a straight-line basis over the expected lease term, including cancelable option periods when failure to exercise such options would result in an economic penalty. We use a time period for straight-line rent expense calculation that equals or exceeds the time period used for depreciation. In addition, the rent commencement date of the lease term is the earlier of the date when they become legally obligated for the rent payments or the date when they take access to the grounds for build out. Accounting for leases involves significant management judgment. Management’s Discussion and Analysis (continued) Contractual Obligations Our significant contractual obligations and commitments as of December 31, 2018 are shown in the following table. ________________ (1) Includes principal and interest and assumes payoff of indebtedness at maturity date. (2) Includes outstanding borrowings under the Credit Facility. (3) Excludes amounts to be paid for contingent rents. Includes amounts to be paid for subleased properties. (4) Includes agreements to purchase goods or services that are enforceable and legally binding on us and that specify all significant terms. Excludes agreements that are cancelable without penalty. (5) Includes liabilities for Non-Qualified Deferred Compensation Plan. Excludes our unrecognized tax benefits of $341 as of December 31, 2018 because we cannot make a reliable estimate of the timing of cash payments. Off-Balance Sheet Arrangements We have no off-balance sheet arrangements other than operating leases entered into in the normal course of business. Recently Issued Accounting Pronouncements For detailed information regarding recently issued accounting pronouncements and the expected impact on our consolidated financial statements, see Note 1, “Summary of Significant Accounting Policies” in the accompanying notes to consolidated financial statements included in Part II, Item 8 of this report on Form 10-K. Cautionary Note Regarding Forward-Looking Statements This report includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. In general, forward-looking statements include estimates of future revenues, cash flows, capital expenditures, or other financial items, and assumptions underlying any of the foregoing. Forward-looking statements reflect management’s current expectations regarding future events and use words such as “anticipate,” “believe,” “expect,” “may,” and other similar terminology. A forward-looking statement is neither a prediction nor a guarantee of future events or circumstances, and those future events or circumstances may not occur. Investors should not place undue reliance on the forward-looking statements, which speak only as of the date of this report. These forward-looking statements are all based on currently available operating, financial, and competitive information and are subject to various risks and uncertainties. Our actual future results and trends may differ materially depending on a variety of factors, many beyond our control, including, but not limited to, the risks and uncertainties described in Item 1A, Risk Factors set forth above. We undertake no obligation to publicly update or revise them, except as may be required by law.
-0.005744
-0.005627
0
<s>[INST] Biglari Holdings Inc. is a holding company owning subsidiaries engaged in a number of diverse business activities, including media, property and casualty insurance, and restaurants. The Company’s largest operating subsidiaries are involved in the franchising and operating of restaurants. Biglari Holdings is founded and led by Sardar Biglari, Chairman and Chief Executive Officer of Biglari Holdings and its major operating subsidiaries. The Company’s longterm objective is to maximize pershare intrinsic value. All major operating, investment, and capital allocation decisions are made for the Company and its subsidiaries by Mr. Biglari. As of December 31, 2018, Mr. Biglari’s beneficial ownership was approximately 56.9% of the Company’s outstanding Class A common stock and 54.3% of the Company’s outstanding Class B common stock. Issuance of Dual Class Common Stock On March 5, 2018, the Company entered into an agreement with its predecessor registrant, now known as OBH Inc. (the “Predecessor”), and BH Merger Company, a wholly owned subsidiary of the Company. Pursuant to the agreement on April 30, 2018, BH Merger Company merged with and into the Predecessor, with the Predecessor continuing as the surviving corporation and a wholly owned subsidiary of the Company. As a result of the April 30, 2018 transaction, the Company has two classes of common stock, designated Class A common stock and Class B common stock. A share of Class B common stock has economic rights equivalent to 1/5th of a share of Class A common stock; however, Class B common stock has no voting rights. Upon completion of the transaction, every ten (10) shares of common stock outstanding on April 30, 2018 converted into (i) ten (10) shares of Class B common stock and (ii) one (1) share of Class A common stock. Since May 1, 2018, the shares of the Company’s Class A common stock have traded on the New York Stock Exchange (“NYSE”) under the ticker symbol “BH.A” and the shares of the Company’s Class B common stock have traded on the NYSE under the ticker symbol “BH”. Net earnings attributable to Biglari Holdings shareholders are disaggregated in the table that follows. Amounts are recorded after deducting income taxes. The following discussion should be read in conjunction with Item 1, Business and our Consolidated Financial Statements and the notes thereto included in this Form 10K. The following discussion should also be read in conjunction with the “Cautionary Note Regarding ForwardLooking Statements” and the risks and uncertainties described in Item 1A, Risk Factors set forth above. Management’s Discussion and Analysis (continued) Restaurants Our restaurant businesses, which include Steak n Shake and Western Sizzlin, comprise 685 companyoperated and franchise restaurants as of December 31, 2018. The term “samestore sales” refers to the sales of companyoperated units open at least 18 months at the beginning of the current period and have remained open through the end of the period. Samestore traffic measures the number of patrons who walk through the same units. Restaurant operations for 2018, 2017 and 2016 are summarized below. Cost of food, restaurant operating costs and rent expense are expressed as a percentage of net sales. General and administrative, marketing, other expenses and depreciation and amortization are expressed as a percentage of total revenue. Management’s Discussion and Analysis (continued) Net sales during 2018 were $740,922 representing a decrease of $40,934 when compared to 2017. The decreased performance of our restaurant operations in 2018 was largely driven by Steak n Shake’s samestore sales, which decreased 5.1% whereas customer traffic decreased by 7.0%. Net sales during 2017 were $781,856 representing a decrease of $13,466 [/INST] Negative. </s>
2,019
4,196
1,726,173
Biglari Holdings Inc.
2020-02-24
2019-12-31
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (dollars in thousands except per share data) Biglari Holdings Inc. is a holding company owning subsidiaries engaged in a number of diverse business activities, including property and casualty insurance, media and licensing, restaurants, and oil and gas. The Company’s largest operating subsidiaries are involved in the franchising and operating of restaurants. Biglari Holdings is founded and led by Sardar Biglari, Chairman and Chief Executive Officer of Biglari Holdings. The Company’s long-term objective is to maximize per-share intrinsic value. All major investment and capital allocation decisions are made for the Company and its subsidiaries by Mr. Biglari. As of December 31, 2019, Mr. Biglari’s beneficial ownership was approximately 64.4% of the Company’s outstanding Class A common stock and 55.4% of the Company’s outstanding Class B common stock. Business Acquisition On September 9, 2019, a wholly-owned subsidiary of the Company, Southern Oil Company, acquired the stock of Southern Oil of Louisiana Inc. (collectively “Southern Oil”) for $51,505 in cash. Southern Oil primarily operates oil and natural gas properties offshore in the shallow waters of the Gulf of Mexico. The Company’s financial results include the results of Southern Oil from the acquisition date to the end of the year. Net earnings attributable to Biglari Holdings shareholders are disaggregated in the table that follows. Amounts are recorded after deducting income taxes. The following discussion should be read in conjunction with Item 1, Business and our Consolidated Financial Statements and the notes thereto included in this Form 10-K. The following discussion should also be read in conjunction with the “Cautionary Note Regarding Forward-Looking Statements” and the risks and uncertainties described in Item 1A, Risk Factors set forth above. Our Management Discussion and Analysis 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 “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 the year ended December 31, 2018 filed with the SEC on February 25, 2019. Management’s Discussion and Analysis (continued) Restaurants Our restaurant businesses, which include Steak n Shake and Western Sizzlin, comprise 662 company-operated and franchise restaurants as of December 31, 2019. As of December 31, 2019, 107 of the 368 Steak n Shake company-operated stores were temporarily closed. We anticipate re-opening the temporarily closed stores as franchise partner or company-operated counter service units. The term “same-store sales” refers to the sales of company-operated units that have been open at least 18 months at the beginning of the current period and have remained open through the end of the period. Same-store traffic measures the number of patrons who walk through the same units. Restaurant operations for 2019, 2018 and 2017 are summarized below. Cost of food, restaurant operating costs and rent expense are expressed as a percentage of net sales. General and administrative, marketing, other expenses, impairments and depreciation and amortization are expressed as a percentage of total revenue. Management’s Discussion and Analysis (continued) Net sales during 2019 were $578,164 representing a decrease of $162,758 when compared to 2018. The decreased performance of our restaurant operations in 2019 was driven by a decline in Steak n Shake’s same-store sales of $35,250 and the balance of the decrease was attributable to the closure of stores. Same-store sales decreased 6.9% whereas customer traffic decreased by 11.2%. Franchise royalties and fees in 2019 were $27,189 compared to $30,998 in 2018. The decrease in franchise royalties and fees during 2019 compared to 2018 was attributable to decreases in marketing fees of $1,858 and forfeited development fees of $1,698. During 2019, Steak n Shake opened 29 franchise units and closed 29. Western Sizzlin did not open any new franchise units and closed seven. The cost of food in 2019 was $176,346 or 30.5% of net sales, compared with $223,273 or 30.1% of net sales in 2018. Restaurant operating costs during 2019 were $307,337 or 53.2% of net sales, compared to $393,348 or 53.1% of net sales in 2018. The decrease in cost of food and restaurant operating costs during 2019 compared to 2018 was attributable to lower net sales resulting from store closures and decreased same-store sales. Selling, general and administrative expenses during 2019 were $88,914 or 14.6% of total revenues compared to $115,130 or 14.8% of total revenues during 2018. General and administrative expenses decreased by $9,999 during 2019 compared to 2018, primarily because of decreased personnel costs of $17,918, offset by settlements of class action complaints of $8,350. Marketing expense decreased by $15,587 in 2019 compared to 2018 primarily driven by a reduction in television and print advertising. Asset impairments increased $2,509 during 2019 compared to 2018 primarily due to store closures. Depreciation and amortization expense increased $2,343 during 2019 compared to 2018 primarily as a result of the depreciation of finance lease assets. Interest on obligations under leases was $7,816 during 2019, versus $8,207 during 2018. The year-over-year decrease in interest expense is primarily attributable to the maturity and retirement of lease obligations. The total obligations under leases outstanding on December 31, 2019 were $78,749 compared to $64,200 on December 31, 2018. Insurance First Guard is a direct underwriter of commercial truck insurance, selling physical damage and nontrucking liability insurance to truckers. Earnings of our insurance business are summarized below. First Guard’s insurance products are marketed primarily through direct response methods via the Internet or by telephone. First Guard’s cost-efficient direct response marketing methods enable it to be a low-cost trucking insurer. Management’s Discussion and Analysis (continued) In 2019, premiums earned increased $2,281 or 8.6% compared to 2018. Pre-tax underwriting gain during 2019 was $6,477, an increase of $843 or 15.0% compared to 2018. Insurance premiums and other on the consolidated statement of earnings includes premiums written, investment income and commissions. In the preceding table, investment income and commissions are included in other income. Oil and Gas Southern Oil primarily operates oil and natural gas properties offshore in the shallow waters of the Gulf of Mexico. Southern Oil was acquired on September 9, 2019. The financial results for Southern Oil from the acquisition date to the end of the year are summarized below. Media and Licensing Maxim’s business lies principally in media and licensing. Earnings of our media and licensing operations are summarized below. We acquired Maxim with the idea of transforming its business model. The magazine developed the Maxim brand, a franchise we are utilizing to generate nonmagazine revenue, notably through licensing, a cash-generating business related to consumer products, services, and events. Investment Partnership Gains Earnings from our investments in partnerships are summarized below. Investment partnership gains include gains and losses from changes in the market values of underlying investments and dividends earned by the partnerships. Dividend income has a lower effective tax rate than income from changes in market values. Changes in the market values of investments can be highly volatile. The investments held by the investment partnerships are largely concentrated in the common stock of one investee, Cracker Barrel Old Country Store, Inc. Management’s Discussion and Analysis (continued) The investment partnerships hold the Company’s common stock as investments. The Company’s pro-rata share of its common stock held by the investment partnerships is recorded as treasury stock even though these shares are legally outstanding. Gains and losses on Company common stock included in the earnings of the partnerships are eliminated. Interest Expense The Company’s interest expense is summarized below. Interest expense during 2019 increased by $765 compared to 2018 primarily due to higher average interest rates during 2019. Income Taxes Consolidated income tax expense was $9,761 in 2019 versus a benefit of $2,637 in 2018. Income tax expense increased by $12,398 during 2019 compared to 2018, primarily due to an increase in tax expense for investment partnership gains of $10,189. Corporate Corporate expenses exclude the activities in the restaurant, insurance, media and licensing, oil and gas, and other companies. Corporate net losses of $8,661 during 2019 remained flat compared to 2018. Financial Condition Our consolidated shareholders’ equity on December 31, 2019 was $616,298, an increase of $45,843 compared to the December 31, 2018 balance. The increase was primarily due to net income of $45,380. Consolidated cash and investments are summarized below. Unrealized gains/losses of Biglari Holdings’ stock held by the investment partnerships are eliminated in the Company’s consolidated financial results. Liquidity Our balance sheet continues to maintain significant liquidity. Consolidated cash flow activities are summarized below. In 2019, cash from operating activities increased by $73,005 compared to 2018, primarily because of increased distributions from investment partnerships. Distributions from investment partnerships were $129,329 and $29,660 during 2019 and 2018, respectively. Distributions to partners were higher during 2019 primarily because of tax liabilities from capital gains in the partnerships. Changes in working capital accounts decreased by $2,131 and $12,043 during 2019 and 2018, respectively. The decrease of working capital accounts during 2018 was primarily tied to the payment of the 2017 CEO incentive fee of $7,353. No incentive fees were accrued during 2019 and 2018. Management’s Discussion and Analysis (continued) Net cash used in investing activities increased during 2019 by $44,692 compared to 2018. The purchase price of Southern Oil during 2019, net of cash acquired was $51,062. Capital expenditures during 2019 were $2,386 higher than capital expenditures during 2018. The increase during 2019 compared to 2018 was primarily because of $7,594 in capitalized development costs by Southern Oil, which was offset by decreased capital expenditures by our restaurant businesses of $5,020. Purchases of investments, net of redemptions of fixed maturity securities were $5,818 during 2019 compared to $10,084 during 2018. Distributions from investment partnerships of $40,000 during 2019 and $39,040 during 2018 were reinvested into the investment partnerships in each year. During 2019 and 2018 we incurred debt payments of $8,010 and $7,579, respectively. We intend to meet the working capital needs of our operating subsidiaries principally through anticipated cash flows generated from operations, cash on hand, existing credit facilities, and the sale of excess properties. We continually review available financing alternatives. Steak n Shake Credit Facility On March 19, 2014, Steak n Shake and its subsidiaries entered into a credit agreement which provided for a senior secured term loan facility in an aggregate principal amount of $220,000. The term loan is scheduled to mature on March 19, 2021. As of December 31, 2019, $181,498 was outstanding. The Company is evaluating refinancing options although alternatives may not be available on terms commensurate with its current financing arrangement. Biglari Holdings is not a guarantor under the credit facility. The term loan amortizes in equal quarterly installments at an annual rate of 1.0% of the original principal amount of the term loan, subject to mandatory prepayments from excess cash flow, asset sales and other events described in the credit agreement. The balance will be due at maturity. Borrowings bear interest at a rate per annum equal to a base rate or a Eurodollar rate (minimum of 1%) plus an applicable margin. Interest on the term loan is based on a Eurodollar rate plus an applicable margin of 3.75% or on the prime rate plus an applicable margin of 2.75%. The interest rate on the term loan was 5.55% and 6.28% as of December 31, 2019 and 2018, respectively. The credit agreement includes customary affirmative and negative covenants and events of default. As of December 31, 2019, we were in compliance with all covenants. Steak n Shake’s credit facility contains restrictions on its ability to pay dividends to Biglari Holdings. The term loan is secured by first priority security interests in substantially all the assets of Steak n Shake. Disruptions in debt capital markets that restrict access to funding when needed could adversely affect the results of operations, liquidity and capital resources of Steak n Shake. Western Sizzlin Revolver As of December 31, 2019 and 2018, Western Sizzlin had no debt outstanding under its revolver. Critical Accounting Policies Certain accounting policies require us to make estimates and judgments in determining the amounts reflected in the consolidated financial statements. Such estimates and judgments necessarily involve varying, and possibly significant, degrees of uncertainty. Accordingly, certain amounts currently recorded in the financial statements will likely be adjusted in the future based on new available information and changes in other facts and circumstances. A discussion of our principal accounting policies that required the application of significant judgments as of December 31, 2019 follows. Consolidation The consolidated financial statements include the accounts of Biglari Holdings Inc. and the wholly owned subsidiaries of Biglari Holdings Inc. We consolidate limited partnership entities if we are the general partner of such entities and for which no substantive removal rights exist. The analysis as to whether to consolidate an entity is subject to a significant amount of judgment. All intercompany accounts and transactions are eliminated in consolidation. Management’s Discussion and Analysis (continued) Our interests in the investment partnerships are accounted for as equity method investments because of our retained limited partner interest in the investment partnerships. The Company records gains from investment partnerships (inclusive of the investment partnerships’ unrealized gains and losses on their securities) in the consolidated statement of earnings based on our proportional ownership interest in the investment partnerships. Impairment of Restaurant Long-lived Assets We review company-operated restaurants for impairment on a restaurant-by-restaurant basis when events or circumstances indicate a possible impairment. Assets included in the impairment assessment generally consist of property, equipment and leasehold improvements directly associated with an individual restaurant as well as any related finance or operating lease assets. We test for impairment by comparing the carrying value of the asset to the undiscounted future cash flows expected to be generated by the asset. If the total estimated future cash flows are less than the carrying amount of the asset, the carrying value is written down to the estimated fair value, and a loss is recognized in earnings. The future cash flows expected to be generated by an asset requires significant judgment regarding future performance of the asset, fair market value if the asset were to be sold, and other financial and economic assumptions. Oil and Natural Gas Reserves The estimation of proved reserves, which is based on the requirement of reasonable certainty, is an ongoing process based on rigorous technical evaluations, commercial and market assessments and detailed analysis of well and reservoir information such as flow rates and reservoir pressures. Although we are reasonably confident that proved reserves will be produced, the timing and amount recovered can be affected by a number of factors including, reservoir performance, government policies, and significant changes in long-term oil and natural gas price levels. In addition, proved reserves could be affected by an extended period of low prices which could reduce the level of our partners’ capacity to fund their share of joint projects. Accordingly, reserve estimates are generally different from the quantities of natural gas and oil that are ultimately recovered. We cannot predict the amounts or timing of future reserve revisions. Income Taxes We record deferred tax assets or liabilities based on differences between financial reporting and the tax basis of assets and liabilities using currently enacted rates and laws that will be in effect when the differences are expected to reverse. We record deferred tax assets to the extent we believe there will be sufficient future taxable income to utilize those assets prior to their expiration. To the extent deferred tax assets would be unable to be utilized; we would record a valuation allowance against the unrealizable amount and record that amount as a charge against earnings. Due to changing tax laws and state income tax rates, significant judgment is required to estimate the effective tax rate expected to apply to tax differences that are expected to reverse in the future. We must also make estimates about the sufficiency of taxable income in future periods to offset any deductions related to deferred tax assets currently recorded. Goodwill and Other Intangible Assets We evaluate goodwill and any indefinite-lived intangible assets for impairment annually, or more frequently if circumstances indicate impairment may have occurred. Goodwill impairment occurs when the estimated fair value of goodwill is less than its carrying value. The valuation methodology and underlying financial information included in our determination of fair value require significant management judgments. We use both market and income approaches to derive fair value. The judgments in these two approaches include, but are not limited to, comparable market multiples, long-term projections of future financial performance, and the selection of appropriate discount rates used to determine the present value of future cash flows. Leases We determine whether a contract is or contains a lease at contract inception based on the presence of identified assets and our right to obtain substantially all of the economic benefit from or to direct the use of such assets. When we determine a lease exists, we record a right-of-use asset and corresponding lease liability on our consolidated balance sheets. Right-of-use assets represent our right to use an underlying asset for the lease term. Lease liabilities represent our obligation to make lease payments arising from the lease. Right-of-use assets are recognized at commencement date at the value of the lease liability and are adjusted for any prepayments, lease incentives received, and initial direct costs incurred. Lease liabilities are recognized at the lease commencement date based on the present value of remaining lease payments over the lease term. As the discount rate implicit in the lease is not readily determinable in most of our leases, we use our incremental borrowing rate based on the information available at commencement date in determining the present value of lease payments. Our lease terms include options to extend or terminate the lease when it is reasonably certain that we will exercise that option. We do not record lease contracts with a term of 12 months or less on our consolidated balance sheets. We recognize fixed lease expense for operating leases on a straight-line basis over the lease term. For finance leases, we recognize amortization expense on the right-of-use asset and interest expense on the lease liability over the lease term. Management’s Discussion and Analysis (continued) Contractual Obligations Our significant contractual obligations and commitments as of December 31, 2019 are shown in the following table. ________________ (1) Includes principal and interest and assumes payoff of indebtedness at maturity date. (2) Excludes amounts to be paid for contingent rents. Includes amounts to be paid for subleased properties. (3) Includes agreements to purchase goods or services that are enforceable and legally binding on us and that specify all significant terms. Excludes agreements that are cancelable without penalty. (4) Includes liabilities for Non-Qualified Deferred Compensation Plan. Excludes our unrecognized tax benefits of $348 as of December 31, 2019 because we cannot make a reliable estimate of the timing of cash payments. Off-Balance Sheet Arrangements We have no off-balance sheet arrangements. Recently Issued Accounting Pronouncements For detailed information regarding recently issued accounting pronouncements and the expected impact on our consolidated financial statements, see Note 1, “Summary of Significant Accounting Policies” in the accompanying notes to consolidated financial statements included in Part II, Item 8 of this report on Form 10-K. Cautionary Note Regarding Forward-Looking Statements This report includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. In general, forward-looking statements include estimates of future revenues, cash flows, capital expenditures, or other financial items, and assumptions underlying any of the foregoing. Forward-looking statements reflect management’s current expectations regarding future events and use words such as “anticipate,” “believe,” “expect,” “may,” and other similar terminology. A forward-looking statement is neither a prediction nor a guarantee of future events or circumstances, and those future events or circumstances may not occur. Investors should not place undue reliance on the forward-looking statements, which speak only as of the date of this report. These forward-looking statements are all based on currently available operating, financial, and competitive information and are subject to various risks and uncertainties. Our actual future results and trends may differ materially depending on a variety of factors, many beyond our control, including, but not limited to, the risks and uncertainties described in Item 1A, Risk Factors set forth above. We undertake no obligation to publicly update or revise them, except as may be required by law.
0.069438
0.069569
0
<s>[INST] Biglari Holdings Inc. is a holding company owning subsidiaries engaged in a number of diverse business activities, including property and casualty insurance, media and licensing, restaurants, and oil and gas. The Company’s largest operating subsidiaries are involved in the franchising and operating of restaurants. Biglari Holdings is founded and led by Sardar Biglari, Chairman and Chief Executive Officer of Biglari Holdings. The Company’s longterm objective is to maximize pershare intrinsic value. All major investment and capital allocation decisions are made for the Company and its subsidiaries by Mr. Biglari. As of December 31, 2019, Mr. Biglari’s beneficial ownership was approximately 64.4% of the Company’s outstanding Class A common stock and 55.4% of the Company’s outstanding Class B common stock. Business Acquisition On September 9, 2019, a whollyowned subsidiary of the Company, Southern Oil Company, acquired the stock of Southern Oil of Louisiana Inc. (collectively “Southern Oil”) for $51,505 in cash. Southern Oil primarily operates oil and natural gas properties offshore in the shallow waters of the Gulf of Mexico. The Company’s financial results include the results of Southern Oil from the acquisition date to the end of the year. Net earnings attributable to Biglari Holdings shareholders are disaggregated in the table that follows. Amounts are recorded after deducting income taxes. The following discussion should be read in conjunction with Item 1, Business and our Consolidated Financial Statements and the notes thereto included in this Form 10K. The following discussion should also be read in conjunction with the “Cautionary Note Regarding ForwardLooking Statements” and the risks and uncertainties described in Item 1A, Risk Factors set forth above. Our Management Discussion and Analysis 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 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of our Annual Report on Form 10K for the year ended December 31, 2018 filed with the SEC on February 25, 2019. Management’s Discussion and Analysis (continued) Restaurants Our restaurant businesses, which include Steak n Shake and Western Sizzlin, comprise 662 companyoperated and franchise restaurants as of December 31, 2019. As of December 31, 2019, 107 of the 368 Steak n Shake companyoperated stores were temporarily closed. We anticipate reopening the temporarily closed stores as franchise partner or companyoperated counter service units. The term “samestore sales” refers to the sales of companyoperated units that have been open at least 18 months at the beginning of the current period and have remained open through the end of the period. Samestore traffic measures the number of patrons who walk through the same units. Restaurant operations for 2019, 2018 and 2017 are summarized below. Cost of food, restaurant operating costs and rent expense are expressed as a percentage of net sales. General and administrative, marketing, other expenses, impairments and depreciation and amortization are expressed as a percentage of total revenue. Management’s Discussion and Analysis (continued) Net sales during 2019 were $578,164 representing a decrease of $162,758 when compared to 2018. The decreased performance of our restaurant operations in 2019 was driven by a decline in Steak n Shake’s samestore sales of $35,250 and the balance of the decrease was attributable to the closure of stores. Samestore sales decreased 6.9% whereas customer traffic decreased by 11.2%. Franchise royalties and fees in 20 [/INST] Positive. </s>
2,020
3,389
1,731,831
Eidos Therapeutics, Inc.
2019-04-15
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 “Item 6. Selected Financial Data” and the financial statements and related notes included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements based upon current expectations 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 those discussed in “Item 1A. Risk Factors” and in other parts of this Annual Report. Overview We are a clinical stage biopharmaceutical company focused on addressing the large and growing unmet need in transthyretin, or TTR, amyloidosis, or ATTR. We are advancing our product candidate, AG10, to treat ATTR, a progressive and fatal family of diseases. Our financial information includes allocations of expenses attributable to certain corporate functions that were provided to us by BridgeBio and its affiliates, including expenses attributable to certain executive personnel, facility-related costs, advisory services, insurance costs and other general corporate expenses. These allocations were made based on direct usage or estimates which are considered to be reasonable by our management and in accordance with our services agreement with BridgeBio. We have moved into our own leased facility and expect to reduce the services provided by BridgeBio as we hire additional personnel. Since the commencement of our operations, we have devoted substantially all of our resources to research and development activities in support of our product development efforts, hiring personnel, raising capital to support and expand such activities and general and administrative support for these operations. We have funded our operations to date primarily from the issuance and sale of shares of common stock, redeemable convertible preferred stock and notes convertible into shares of redeemable convertible preferred stock. In April 2016, we entered into a license agreement with the Board of Trustees of the Leland Stanford Junior University, or Stanford, for rights relating to novel transthyretin aggregation inhibitors. Under the license agreement, Stanford has granted us an exclusive worldwide license to make, use and sell products that are covered by the licensed patent rights. In connection with the execution of the license agreement, we paid an upfront license fee in April 2016 and issued Stanford shares of common stock, which were recorded as research and development expense during the year ended December 31, 2016. During the years ended December 31, 2018, 2017 and 2016, we recorded $60,000, $10,000 and $25,000 under the license agreement related to annual maintenance fees, and milestone payments, respectively. We are obligated to make future payments to Stanford upon the achievement of specific intellectual property, clinical and regulatory milestone events, as well as pay royalties in the low single digits on future net sales, if any. In October 2018, the FDA granted orphan drug designation in the United States to AG10 for the treatment of ATTR, and the Committee for Orphan Medicinal Products of the European Medicines Agency, or EMA, adopted a positive opinion for the designation of AG10 as an orphan medicinal product in the European Union, or EU, for the treatment of ATTR. The EMA also granted a product-specific pediatric investigational plan waiver to us for AG10. We have not generated any revenue to date. Since inception, we have incurred significant operating losses. We have incurred net losses of $2.5 million, $11.9 million and $40.7 million during the years ended December 31, 2016, 2017 and 2018, 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 $65.3 million. We expect these losses to increase as we continue our development of, and seek regulatory approvals for our product candidate, AG10, begin to commercialize AG10, if approved, and engage in any other research and development activities. Our net losses may fluctuate significantly from quarter-to-quarter and year-to-year, depending on the timing of our clinical trials and our expenditures on other research and development activities. In June 2018, we completed our initial public offering (IPO) of our common stock pursuant to which we issued 7,187,500 shares of our common stock at a price of $17.00 per share and received $111.0 million in cash, net of underwriting discounts and commissions and offering costs. As of December 31, 2018, we had $157.1 million in cash and cash equivalents. We will need to obtain additional financing in the future and may seek financing through the issuance of our common stock, through other equity or debt financings or through collaborations or partnerships with other companies. The amount and timing of our future funding requirements will depend on many factors, including the pace and results of our clinical development efforts for AG10 and other research and development activities. We may not be able to raise additional capital on terms acceptable to us, or at all, and any failure to raise capital as and when needed would compromise our ability to execute on our business plan and we may have to significantly delay, scale back, or discontinue the development of AG10 or curtail any efforts to expand our product pipeline. We cannot assure you that we will ever be profitable or generate positive cash flow from operating activities Financial operations overview Research and development expense Research and development expense consist primarily of costs incurred for the development of AG10, which include: • employee-related expenses, including salaries, benefits and stock-based compensation; • laboratory, manufacturing and other vendor expenses related to the execution of preclinical studies and clinical trials; • the costs related to the production of clinical supplies and the engagement of consultants and other third-party service providers that conduct research and development activities on our behalf; • fees paid under our license agreement with Stanford; and • facilities and other allocated expenses, expenses for rent, depreciation and amortization, maintenance of facilities 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. Nonrefundable payments made prior to the receipt of goods or services that will be used or rendered for future research and development activities are deferred and capitalized. The capitalized amounts are recognized as expense as the goods are delivered or the related services are performed. The following table summarizes our research and development expenses incurred during the respective periods (in thousands): We expect our research and development expenses to increase substantially for the foreseeable future as we continue to conduct research and development activities related to AG10 and advance AG10 into later stages of clinical development, including our ongoing Phase 2 and Phase 3 clinical trials of AG10 in ATTR-CM and our planned Phase 3 clinical trial of AG10 in ATTR-PN and any subsequent preclinical or clinical development activities. The process of conducting the necessary clinical research to obtain regulatory approval is costly and time-consuming, and the successful development of AG10 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 of our product candidate, if at all. General and administrative expense Our general and administrative expenses consist primarily of personnel costs, allocated facility costs and other expenses for outside professional services, including legal, human resource, audit and accounting 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 Securities and Exchange Commission, or SEC, and listing standards applicable to companies listed on a national securities exchange, 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. Other income (expense), net Other income (expense), net primarily includes gains and losses from the remeasurement of our liabilities related to our redeemable convertible preferred stock tranche liabilities and our redeemable convertible preferred stock warrant liability. We continued to adjust these liabilities for changes in estimated fair value until the settlement of the related redeemable convertible preferred stock tranche liability and redeemable convertible preferred stock warrant liability. At such time, the related redeemable convertible preferred stock tranche liability was reclassified to redeemable convertible preferred stock and we no longer recorded any related periodic fair value adjustments. We continued to record adjustments to the estimated fair value of the redeemable convertible preferred stock warrants until these were net exercised upon the completion of an IPO. Accordingly, the associated warrant liability was revalued and reclassed into equity. Deemed dividend In February 2018, we recognized a deemed dividend of $6.5 million related to the fair value of the redemption feature embedded within the Convertible Promissory Notes payable with stockholders and separately treated as a derivative liability. The charge was recognized in additional paid in capital. Gain on extinguishment of convertible promissory notes In March 2018, upon the conversion of the Convertible Promissory Notes into Series B redeemable convertible stock, we recognized a gain on debt extinguishment. As the Convertible Promissory Notes were issued to stockholders, we treated the gain on debt extinguishment as a capital contribution included in additional paid in capital. Results of Operations Comparison of the years ended December 31, 2018 and December 31, 2017 Research and development expense Research and development expense increased by $19.3 million, or 207%, during the year ended December 31, 2018, compared to the year ended December 31, 2017. The increase was primarily attributable to an increase of $15.2 million in clinical trial related activities and contract manufacturing activities for our clinical trials and drug supply, increased personnel costs of $3.2 million due to a higher headcount, and an increase in stock-based compensation of $0.8 million. General and administrative expense General and administrative expense increased by $6.5 million, or 238%, during the year ended December 31, 2018, compared to the year ended December 31, 2017. The increase was primarily attributable to an increase of $4.3 million in professional service fees and consulting services, primarily for financial, legal and accounting fees and an increase of $1.7 million in personnel-related expenses due to an increase in headcount to support the growth of our operations and an increase in stock-based compensation of $0.6 million. Other income (expense), net Other income (expense), net was an expense of $2.9 million during the year ended December 31, 2018, compared to income of $75,000 during the year ended December 31, 2017. The expense during the year ended December 31, 2018 is primarily from the amortization of the debt discount of $1.0 million related to the convertible promissory note payable which was converted into Series B redeemable convertible preferred stock in March 2018 and the increase to fair value of the redeemable convertible preferred stock warrant liability and tranche liability of $3.2 million, partially offset by the interest income of $1.2 million. The other income during the year ended December 31, 2017 was due to the decrease in fair value of the redeemable convertible preferred stock tranche liability which was remeasured prior to settlement of in March 2017. Deemed dividend In February 2018, we recognized a deemed dividend of $6.5 million related to the fair value of the redemption feature embedded in the Convertible Promissory Notes payable with stockholders and separately treated as a derivative liability. The charge was recognized in additional paid in capital. Gain on extinguishment of convertible promissory notes In March 2018, upon the conversion of the Convertible Promissory Notes into Series B redeemable convertible stock, we recognized a gain on debt extinguishment. As the Convertible Promissory Notes were issued to stockholders, we treated the gain on debt extinguishment as a capital contribution included in additional paid in capital. Comparison of the years ended December 31, 2017 and December 31, 2016 Research and development expense Research and development expense increased by $7.6 million, or 436%, during the year ended December 31, 2017, compared to the year ended December 31, 2016. The increase was related to an increase of $2.5 million primarily in preclinical activities for AG10, an increase of $1.9 million in contract manufacturing activities for AG10 to supply our Phase 1 clinical trial, an increase of $1.7 million in salaries and employee-related expenses due to an increase in headcount, an increase of $1.3 million in clinical research organization and related costs for the Phase 1 clinical trial, which were incurred primarily in the second half of 2017, and an increase in $0.2 million in facility-related costs due to increased costs for our office and lab facilities. General and administrative expense General and administrative expense increased by $2.1 million, or 319%, during the year ended December 31, 2017, compared to the year ended December 31, 2016. The increase was attributable to an increase of $1.2 million in professional service fees, primarily for financial and accounting consulting fees and an increase of $0.9 million in personnel-related expenses due to an increase in headcount to support the growth of our operations. Other income (expense), net Other income (expense), net was $0.2 million expense during the year ended December 31, 2016, compared to $75,000 income the year ended December 31, 2017. The change resulted from the final settlement of the redeemable convertible preferred stock tranche liability in March 2017. We will no longer record any related periodic fair value adjustments for the liability. Critical accounting policies 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 United States generally accepted accounting principles, or U.S. 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 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. We believe that the accounting policies discussed below are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving management’s judgments and estimates. While our significant accounting policies are described in the notes to our financial statements included elsewhere in this Annual Report on Form 10-K, we believe that the following critical accounting policies are most important to understanding and evaluating our reported financial results. Accrued research and development We record accrued expenses for estimated costs of our research and development activities conducted by third-party service providers, which include preclinical studies and clinical trials and contract manufacturing activities. 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 expenses and other current liabilities in the balance sheets and within research and development expense in the statements of operations. These costs are a significant component of our research and development expenses. 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 significant 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, and the number of patients enrolled and the rate of patient enrollment in our clinical trials 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. We record advance payments to service providers as prepaid assets, which are expensed as the contracted services are performed. To date, there have been no material differences from our accrued expenses to actual expenses. Redeemable convertible preferred stock tranche liabilities We determined that our obligations to issue additional shares of redeemable convertible preferred stock upon the achievement of certain milestones or at the option of the respective holders of such shares represent freestanding financial instruments. These instruments are subject to remeasurement with changes in fair value recognized in other income (expense), net in the statements of operations at each balance sheet date and prior to settlement. Redeemable convertible preferred stock warrant liability We issued freestanding warrants to purchase shares of redeemable convertible preferred stock in connection with the issuance of the Convertible Promissory Notes issued to stockholders that was converted into Series B redeemable convertible preferred stock (Series B Preferred Stock). We account for these warrants as a liability in our financial statements because the underlying instrument, Series B Preferred Stock, into which the warrants are exercisable contains redemption provisions that are outside our control. The fair value of the warrants at the issuance date and at March 31, 2018 was determined using a probability-weighted expected return model in combination with an option pricing model. The warrants are remeasured at each financial reporting period prior to the settlement with any changes in fair value being recognized in other income (expense) in the statements of operations. Upon the completion of our IPO in June 2018, the outstanding warrants were net exercised. Embedded derivative liability We determined that the automatic conversion of the convertible promissory notes issued in 2018 into new shares of preferred stock at 70% of the issuance price of such shares upon the closing of a qualified financing is an embedded derivative liability. As this instrument was issued to stockholders, we treated the initial recognition as a deemed dividend included in additional paid in capital. This instrument was subject to remeasurement with changes in fair value recognized in other income (expense), net in the statements of operations. The embedded derivative liability balance was settled upon the conversion of the Convertible Promissory Notes into Series B Preferred Stock in March 2018. Stock-based compensation We recognize compensation costs related to stock options granted to employees and non-employees based on the estimated fair value of the awards on the date of grant. Prior to January 1, 2017, the fair value of the portion of the award that is ultimately expected to vest was recognized as expense over the requisite service periods in our statements of operations. Upon the adoption of ASU 2016-09 on January 1, 2017, we elected to recognize the actual forfeitures by reducing the employee stock-based compensation expense in the same period as the forfeitures occur. 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 period, which is generally the vesting period of the respective awards. 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-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- Since we have only recently become a public company and have only a limited trading history for our common stock, 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. 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 volatility, and expected terms 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 an unrelated third-party valuation firm in accordance with the guidance provide by the American Institute of Certified Public Accountants Practice Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. Given the absence of a public trading market for our common stock prior to our IPO, our board of directors exercised reasonable judgment and considered a number of objective and subjective factors to determine the best estimate of the fair value of our common stock, including our stage of development; progress of our research and development efforts; the rights, preferences and privileges of our redeemable convertible preferred stock relative to those of our common stock; equity market conditions affecting comparable public companies and the lack of marketability of our common stock. Since the completion of our IPO, our board of directors (or a committee thereof) determines the fair value of each share of common stock underlying stock option grants based on the closing price of our common stock on the Nasdaq Global Select Market as reported on the date of grant. Income taxes We use the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on the differences between the financial reporting and the tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. We assess the likelihood that the resulting deferred tax assets will be realized. A valuation allowance is provided when it is more likely than not that some portion or all of a deferred tax asset will not be realized. Due to the net losses incurred and the uncertainty of realizing the deferred tax assets, for all the periods presented, we have a full valuation allowance against our deferred tax assets. As of December 31, 2018, we had federal net operating loss carryforwards of $46.3 million and research and development credits totaling $0.5 million, as well as state net operating loss carryforwards of $47.4 million and state research and development credits of $0.3 million. If not utilized, the federal credits will expire at various dates beginning in 2037. The federal net operating loss carries forward indefinitely, subject to potential limitations as noted below. As of December 31, 2018, we had federal orphan drug credits of $1.5 million available to offset future taxable income. Utilization of the net operating loss carryforwards may be subject to a substantial annual limitation due to the ownership change limitations provided by the Code, and similar state provisions. These ownership change limitations may limit the amount of net operating loss carryforwards and other tax attributes that can be utilized annually to offset future taxable income and tax, respectively. In general, an “ownership change” as defined by Section 382 of the Code results from a transaction or series of transactions over a three-year period resulting in an ownership change of more than 50 percentage points (by value) of the outstanding stock of a company by certain stockholders. The annual limitation may result in the expiration of net operating losses and credits before utilization. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained upon examination by the taxing authorities based on the technical merits of the position. The tax benefit recognized in the financial statements for a particular tax position is based on the largest benefit that is more likely than not to be realized. The amount of unrecognized tax benefits is adjusted as appropriate for changes in facts and circumstances, such as significant amendments to existing tax law, new regulations or interpretations by the taxing authorities, new information obtained during a tax examination, or resolution of an examination. It is our policy to recognize both accrued interest and penalties, if any, related to unrecognized tax benefits in income tax expense. Liquidity and Capital Resources Liquidity and Capital Expenditures Liquidity As of December 31, 2018, we had $157.1 million of cash and cash equivalents and an accumulated deficit of $65.3 million. In June 2018, we completed our IPO of our common stock pursuant to which we issued 7,187,500 shares of our common stock at a price of $17.00 per share and received $111.0 million in cash, net of underwriting discounts and commissions and offering costs paid by us. Our primary uses of cash are 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 and accrued expenses. We believe, based on our current operating plan and expected expenditures, that our existing cash and cash equivalents will be sufficient to meet our anticipated operating and capital expenditure requirements for at least the next 12 months from the filing of this Annual Report on Form 10-K. 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. Our ultimate success depends on the outcome of our research and development activities. We expect to incur additional losses in the future and we anticipate the need to raise additional capital to fully implement our business plan. We expect to further increase our research and development activities, which will increase the amount of cash used during 2019 and beyond. Specifically, we expect continued spending on clinical trials, continued manufacturing activities and higher payroll expenses as we increase our professional and scientific staff and research and development activities and advance AG10 into later-stage clinical development, including our ongoing and planned Phase 3 clinical trials. 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 to private investors. 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. Our future funding requirements will depend on many factors, including the following: • the progress, timing, scope, results and costs of our ongoing and planned clinical trials and other research and development activities related to AG10 and any other product candidates we may identify and pursue, including the ability to enroll patients in a timely manner in our clinical trials; • the costs of obtaining AG10 in amounts sufficient for our ongoing and planned clinical trials and, if approved, for commercialization; • the cost, timing and outcomes of any regulatory approvals for AG10; • our ability to successfully commercialize AG10, if approved; • the extent to which we may acquire or in-license other product candidates and technologies; • our ability to attract, hire and retain qualified personnel; and • the cost of obtaining, maintaining, preparing, filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights related to AG10 and any other product candidates we may identify and pursue. 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, 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, strategic alliances, licensing arrangements and other marketing and distribution arrangements. To the extent that we raise additional capital through collaborations, strategic alliances or licensing arrangements with third parties, we may have to relinquish valuable rights to our product candidates, future revenue streams, research programs or product candidates or to grant licenses on terms that may not be favorable to us. If we do raise additional capital through public or private equity offerings, the ownership interest of our existing stockholders will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect our stockholders’ rights. 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 table summarizes our cash flows for the periods indicated (in thousands): Cash flows from operating activities During the year ended December 31, 2018, cash used in operating activities was $33.1 million and consisted primarily of a net loss of $40.7 million. Our non-cash charges of $6.8 million primary consisted of embedded derivative revaluation of $0.1 million, a cost of $2.6 million related to the revaluation of the convertible redeemable preferred stock warrant liability, $2.5 million for stock-based compensation expense, amortization of debt discount of $1.0 million, and a cost of $0.6 million related to the redeemable convertible preferred stock tranche liability. The change in our net operating assets of $0.8 million was primarily due to an increase in accounts payable and accrued expenses of $3.0 million, as a result of an increase in operating expenses and timing of payments, partially offset by the change in prepaid expenses and other current assets of $2.1 million, due to timing of payments and the timing of activities for which payments were made. During 2017, cash used in operating activities was $9.7 million, which consisted of a net loss of $11.9 million, adjusted by non-cash charges of $1.1 million and a net change of $1.1 million in our net operating assets and liabilities. The non-cash charges are primarily comprised of $1.1 million for stock-based compensation, offset by a gain of $0.1 million for the remeasurement of the redeemable convertible preferred stock tranche liability. The change in our net operating assets and liabilities was primarily due to an increase in accounts payable, accrued expenses and other liabilities and related party payable of $1.9 million as a result of an increase in operating expenses and timing of payments, offset by $0.5 million increase in cash used for prepaid and other current assets related to payments associated with clinical trials and studies and $0.2 million increase in cash used for other assets related to the security deposit for our facility leases. Cash flows from investing activities During 2018, cash used in investing activities was $0.2 million, which consisted of our purchase of property and equipment for our office and employees. During 2017, cash used in investing activities was $0.1 million, which consisted of our purchase of property and equipment for our office and lab facilities. Cash flows from financing activities During the year ended December 31, 2018, cash provided by financing activities was $184.9 million, which consisted of the receipt of funds in connection with our IPO of $111.0 million, the net proceeds from the issuance of Series B redeemable convertible preferred stock of $63.9 million, proceeds from the issuance of convertible promissory notes of $10.0 million, and $0.1 million related to the receipt of funds from the exercise of options. During the year ended December 31, 2017, cash provided by financing activities was $13.0 million, which consisted primarily of net proceeds from the issuance of Series Seed redeemable convertible preferred stock and $0.3 million related to the receipt of funds from the exercise of options. Contractual Obligations and Other Commitments The following table summarizes our contractual obligations as of December 31, 2018 (in thousands): In September 2017, we entered into a one-year operating lease for laboratory facilities in San Francisco, California. In November 2017, we entered into an operating lease for a facility in San Francisco, California, which expires in November 2022. We provided a security deposit of $158,000 as collateral for the lease, which is included in other assets on the balance sheet. Potential Obligations Not Included in the Table Above We enter into agreements in the normal course of business with contract research organizations 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 to 60 days prior written notice. These payments are not included in this table of contractual obligations. Off-Balance Sheet Arrangements We did not have during the periods presented, and we do not have any off-balance sheet arrangements, as defined under SEC rules, including the use of structured finance, special purpose entities or variable interest entities. Recent Accounting Pronouncements Information regarding recent accounting pronouncements applicable to us is included in the notes to our financial statements included elsewhere in this Annual Report.
0.06241
0.062456
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<s>[INST] Overview We are a clinical stage biopharmaceutical company focused on addressing the large and growing unmet need in transthyretin, or TTR, amyloidosis, or ATTR. We are advancing our product candidate, AG10, to treat ATTR, a progressive and fatal family of diseases. Our financial information includes allocations of expenses attributable to certain corporate functions that were provided to us by BridgeBio and its affiliates, including expenses attributable to certain executive personnel, facilityrelated costs, advisory services, insurance costs and other general corporate expenses. These allocations were made based on direct usage or estimates which are considered to be reasonable by our management and in accordance with our services agreement with BridgeBio. We have moved into our own leased facility and expect to reduce the services provided by BridgeBio as we hire additional personnel. Since the commencement of our operations, we have devoted substantially all of our resources to research and development activities in support of our product development efforts, hiring personnel, raising capital to support and expand such activities and general and administrative support for these operations. We have funded our operations to date primarily from the issuance and sale of shares of common stock, redeemable convertible preferred stock and notes convertible into shares of redeemable convertible preferred stock. In April 2016, we entered into a license agreement with the Board of Trustees of the Leland Stanford Junior University, or Stanford, for rights relating to novel transthyretin aggregation inhibitors. Under the license agreement, Stanford has granted us an exclusive worldwide license to make, use and sell products that are covered by the licensed patent rights. In connection with the execution of the license agreement, we paid an upfront license fee in April 2016 and issued Stanford shares of common stock, which were recorded as research and development expense during the year ended December 31, 2016. During the years ended December 31, 2018, 2017 and 2016, we recorded $60,000, $10,000 and $25,000 under the license agreement related to annual maintenance fees, and milestone payments, respectively. We are obligated to make future payments to Stanford upon the achievement of specific intellectual property, clinical and regulatory milestone events, as well as pay royalties in the low single digits on future net sales, if any. In October 2018, the FDA granted orphan drug designation in the United States to AG10 for the treatment of ATTR, and the Committee for Orphan Medicinal Products of the European Medicines Agency, or EMA, adopted a positive opinion for the designation of AG10 as an orphan medicinal product in the European Union, or EU, for the treatment of ATTR. The EMA also granted a productspecific pediatric investigational plan waiver to us for AG10. We have not generated any revenue to date. Since inception, we have incurred significant operating losses. We have incurred net losses of $2.5 million, $11.9 million and $40.7 million during the years ended December 31, 2016, 2017 and 2018, 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 $65.3 million. We expect these losses to increase as we continue our development of, and seek regulatory approvals for our product candidate, AG10, begin to commercialize AG10, if approved, and engage in any other research and development activities. Our net losses may fluctuate significantly from quartertoquarter and yeartoyear, depending on the timing of our clinical trials and our expenditures on other research and development activities. In June 2018, we completed our initial public offering (IPO) of our common stock pursuant to which we issued 7,187,500 shares of our common stock at a price of $17.00 per share and received $111.0 million in cash, net of underwriting discounts and commissions and offering costs. As of December 31, 2018, we had $157.1 million in cash and cash equivalents. We will [/INST] Positive. </s>
2,019
5,661
1,731,831
Eidos Therapeutics, Inc.
2020-02-26
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 “Item 6. Selected Financial Data” and the financial statements and related notes included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements based upon current expectations 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 those discussed in “Item 1A. Risk Factors” and in other parts of this Annual Report. Overview We are a clinical stage biopharmaceutical company focused on addressing the large and growing unmet need in transthyretin, or TTR, amyloidosis, or ATTR. We are advancing our product candidate, AG10, to treat ATTR, a progressive and fatal family of diseases. Our financial information includes allocations of expenses attributable to certain corporate functions that were provided to us by BridgeBio and its affiliates, including expenses attributable to certain executive personnel, facility-related costs, advisory services, insurance costs and other general corporate expenses. These allocations were made based on direct usage or estimates which are considered to be reasonable by our management and in accordance with our services agreement with BridgeBio. We have moved into our own leased premises and expect to reduce the services provided by BridgeBio as we hire additional personnel. Since the commencement of our operations, we have devoted substantially all of our resources to research and development activities in support of our product development efforts, hiring personnel, raising capital to support and expand such activities and general and administrative support for these operations. We have funded our operations to date primarily from the issuance and sale of shares of common stock, redeemable convertible preferred stock and notes convertible into shares of redeemable convertible preferred stock. In April 2016, we entered into a license agreement (the “Stanford License Agreement”) with the Board of Trustees of the Leland Stanford Junior University (“Stanford”) for rights relating to novel transthyretin aggregation inhibitors. Under the Stanford License Agreement, Stanford has granted us an exclusive worldwide license to make, use and sell products that are covered by the licensed patent rights. In connection with the execution of the Stanford License Agreement, we paid an upfront license fee in April 2016 and issued Stanford shares of common stock, which were recorded as research and development expense during the year ended December 31, 2016. During the years ended December 31, 2019, 2018 and 2017, we recorded $210,000, $60,000 and $10,000 under the Stanford License Agreement related to annual maintenance fees, and milestone payments, respectively. We are obligated to make future payments to Stanford upon the achievement of specific intellectual property, clinical and regulatory milestone events, as well as pay royalties in the low single digits on future net sales, if any. In October 2018, the FDA granted orphan drug designation in the United States to AG10 for the treatment of ATTR, and the Committee for Orphan Medicinal Products of the European Medicines Agency, or EMA, adopted a positive opinion for the designation of AG10 as an orphan medicinal product in the European Union, or EU, for the treatment of ATTR. The EMA also granted a product-specific pediatric investigational plan waiver to us for AG10. We have incurred net losses in each year since inception. Our net losses were $37.8 million and $40.7 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had an accumulated deficit of $103.1 million. Substantially all of our net losses have resulted from costs incurred in connection with our research and development programs and from general and administrative costs associated with our operations and exceeded revenues for each fiscal year. We expect to continue to incur significant expenses and increasing operating losses over at least the next several years. We expect these losses to increase as we continue our development of, and seek regulatory approvals for our product candidate, AG10, begin to commercialize AG10, if approved, and engage in any other research and development activities. Our net losses may fluctuate significantly from quarter-to-quarter and year-to-year, depending on the timing of our clinical trials and our expenditures on other research and development activities. In June 2018, we completed our initial public offering (IPO) of our common stock pursuant to which we issued 7,187,500 shares of our common stock at a price of $17.00 per share and received $111.0 million in cash, net of underwriting discounts and commissions and offering costs. On August 2, 2019, we filed a Registration Statement on Form S-3, as amended (the “2019 Shelf”) with the SEC in relation to the registration of common stock, preferred stock, warrants and units of any combination thereof. The Company also simultaneously entered into an Open Market Sale Agreement with Jefferies and SVB Leerink LLC (“Sales Agent”), to provide for the offering, issuance and sale by the Company of up to an aggregate offering price of $100.0 million of its common stock from time to time in “at-the-market” offerings under the 2019 Shelf and subject to the limitations thereof. We will pay to the Sales Agent cash commissions of up to 3.0 percent of the gross proceeds of sales of common stock under the 2019 Sales Agreement. We have issued 385,613 shares under this offering and received $23.9 million of net proceeds as of December 31, 2019. In September 2019, we entered into a license agreement (the “Alexion License Agreement”) with Alexion Pharma International Operations Unlimited Company, a subsidiary of Alexion Pharmaceuticals, Inc. (together, “Alexion”) to develop and commercialize AG10 in Japan. Additionally, in September 2019, we entered into a Stock Purchase Agreement (the “Stock Purchase Agreement”) with Alexion, pursuant to which we sold to Alexion 556,173 shares of our common stock, for aggregate cash proceeds of $25.0 million. Under the terms of the Alexion License Agreement, we granted Alexion an exclusive license to certain of our intellectual property rights to develop, manufacture and commercialize AG10 in Japan. In consideration for the license grant, we received an upfront payment of $25.0 million, with the potential for an additional one-time payment of $30.0 million subject to the achievement of a regulatory milestone. In addition, we are entitled to receive royalties in the low double-digits on net sales by Alexion of AG10 in Japan. The royalty rate is subject to reduction if Alexion is required to obtain intellectual property rights from third parties to develop, manufacture or commercialize AG10 in Japan, or upon the introduction of generic competition into the market. In November 2019, we entered into a Loan and Security Agreement with Silicon Valley Bank and Hercules Capital, Inc. (“SVB and Hercules Loan Agreement”). The SVB and Hercules Loan Agreement provides for up to $55.0 million in term loans to be drawn in three tranches as follows: (i) Tranche A loan of $17.5 million, (ii) Tranche B loan of up to $22.5 million which is available to be drawn until October 31, 2020, and (iii) Tranche C loan of up to $15.0 million available to be drawn upon a clinical trial milestone. The Tranche C loan is available to be drawn until September 30, 2021. The Tranche A loan of $17.5 million was drawn on November 13, 2019 and there have not been any additional draws on the other tranches. The Tranche A loan bears interest at a fixed rate equal to 8.50% per annum that is due and payable monthly. As of December 31, 2019, we had $191.2 million in cash and cash equivalents. We will need to obtain additional financing in the future and may seek financing through the issuance of our common stock, through other equity or debt financings or through collaborations or partnerships with other companies. The amount and timing of our future funding requirements will depend on many factors, including the pace and results of our clinical development efforts for AG10 and other research and development activities. We may not be able to raise additional capital on terms acceptable to us, or at all, and any failure to raise capital as and when needed would compromise our ability to execute on our business plan and we may have to significantly delay, scale back, or discontinue the development of AG10 or curtail any efforts to expand our product pipeline. We cannot assure you that we will ever be profitable or generate positive cash flow from operating activities Financial operations overview Revenue License revenue consists of consideration earned for performance obligations satisfied pursuant to our Alexion License Agreement. We have not generated any revenue from the sale of any drugs, and we do not expect to generate any revenue unless or until we obtain regulatory approval of and commercialize our product candidate. On September 9, 2019, we entered into the Alexion License Agreement. In consideration for the license grant, we received an upfront nonrefundable payment of $25.0 million. Additionally, on September 9, 2019, we entered into a Stock Purchase Agreement with Alexion wherein we agreed to sell to Alexion 556,173 shares of our common stock, par value $0.001 per share, for aggregate cash proceeds of approximately $25.0 million. The discount for lack of marketability (“DLOM”) was applied in accordance with ASC 820 on the date of issuance, and as a result we recorded a premium of $1.7 million in license revenue. Cost of license revenue Cost of license revenue includes sublicensing fees payable to Stanford in the period incurred under the terms of the Stanford License Agreement (see Note 12) corresponding to the recognition of license revenue from Alexion. Cost of license revenue does not include any allocated overhead costs. Research and development expense Research and development expense consists primarily of costs incurred for the development of AG10, which include: • employee-related expenses, including salaries, benefits and stock-based compensation; • laboratory, manufacturing and other vendor expenses related to the execution of preclinical studies and clinical trials; • the costs related to the production of clinical supplies and the engagement of consultants and other third-party service providers that conduct research and development activities on our behalf; • fees paid under our license agreement with Stanford; and • facilities and other allocated expenses, expenses for rent, depreciation and amortization, maintenance of facilities 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. Nonrefundable payments made prior to the receipt of goods or services that will be used or rendered for future research and development activities are deferred and capitalized. The capitalized amounts are recognized as expense as the goods are delivered or the related services are performed. The following table summarizes our research and development expenses incurred during the respective periods (in thousands): We expect our research and development expenses to increase substantially for the foreseeable future as we continue to conduct research and development activities related to AG10 and advance AG10 into later stages of clinical development, including our ongoing and planned Phase 2 and Phase 3 clinical trials of AG10 in ATTR-CM and ATTR-PN and any subsequent preclinical or clinical development activities. The process of conducting the necessary clinical research to obtain regulatory approval is costly and time-consuming, and the successful development of AG10 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 of our product candidate, if at all. General and administrative expense Our general and administrative expenses consist primarily of personnel costs, allocated facility costs and other expenses for outside professional services, including legal, human resource, audit and accounting 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 Securities and Exchange Commission, or SEC, and listing standards applicable to companies listed on a national securities exchange, 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 expense Interest expense consists of cash and non-cash components. The cash component of interest expense is attributable to borrowings under our loan agreements. Refer to Note 5. Debt, for further information on our loan agreements. The non-cash component consists of interest expense recognized from the amortization of debt discounts derived from the debt issuance costs capitalized on our balance sheets. Other income (expense), net Other income (expense), net primarily includes gains and losses from the remeasurement of our liabilities related to our redeemable convertible preferred stock tranche liabilities and our redeemable convertible preferred stock warrant liability. We continued to adjust these liabilities for changes in estimated fair value until the settlement of the related redeemable convertible preferred stock tranche liability and redeemable convertible preferred stock warrant liability. At such time, the related redeemable convertible preferred stock tranche liability was reclassified to redeemable convertible preferred stock and we no longer recorded any related periodic fair value adjustments. We continued to record adjustments to the estimated fair value of the redeemable convertible preferred stock warrants until these were net exercised upon the completion of an IPO. Accordingly, the associated warrant liability was revalued and reclassed into equity. Results of Operations Comparison of the years ended December 31, 2019 and December 31, 2018 License revenue License revenue was $26.7 million for the year ended December 31, 2019, and there was no revenue for the year ended December 31, 2018. The increase in license revenue was entirely attributable to revenue recognition related to the Alexion License Agreement for which performance obligations were satisfied. Cost of license revenue Cost of license revenue was $2.5 million for the year ended December 31, 2019, and there was no cost of license revenue for the year ended December 31, 2018. The increase in cost of license revenue was related to the obligations under the Stanford License Agreement, whereby we are required to pay a portion of license fees received. Research and development expense Research and development expense increased by $18.4 million, or 64%, during the year ended December 31, 2019, compared to the year ended December 31, 2018. The increase was primarily attributable to an increase of $15.4 million in clinical trial related activities and contract manufacturing activities for our clinical trials and drug supply, increased personnel costs of $2.6 million due to a higher headcount, an increase in stock-based compensation of $1.0 million, and an increase in other expenses of $0.3 million, offset by a decrease in nonclinical expense of $0.6 million due to the timing of projects completed in 2018. General and administrative expense General and administrative expense increased by $8.5 million, or 92%, during the year ended December 31, 2019, compared to the year ended December 31, 2018. The increase was primarily attributable to an increase of $2.7 million in professional service fees and consulting services, primarily from one-time charges of $2.0 million related to financial, legal and accounting fees, an increase of $3.0 million in marketing and commercial strategy expense, an increase in stock-based compensation of $1.9 million, an increase in other overhead costs of $0.8 million and an increase of $0.5 million in personnel-related expenses due to an increase in headcount to support the growth of our operations. This was offset by a decrease of $0.3 million in consulting costs. Interest expense Interest expense was $0.3 million for the year ended December 31, 2019, and there was a $1.0 million interest expense for the year ended December 31, 2018. The increase in interest expense for 2019 was related to the obligations under the SVB and Hercules Loan Agreement, whereby we are required to pay interest for money received. The expense during the year ended December 31, 2018 is primarily from the amortization of the debt discount of $1.0 million related to the convertible promissory note payable which was converted into Series B redeemable convertible preferred stock in March 2018. Other income (expense), net Other income (expense), net was an income of $3.0 million during the year ended December 31, 2019, compared to expense of $1.9 million during the year ended December 31, 2018. Other income in 2019 primarily includes interest income due to the interest income related to our higher balance of money market funds. The expense during the year ended December 31, 2018 is due to the increase to fair value of the redeemable convertible preferred stock warrant liability and tranche liability of $3.2 million, partially offset by the interest income of $1.2 million. Deemed dividend In February 2018, we recognized a deemed dividend of $6.5 million related to the fair value of the redemption feature embedded in the Convertible Promissory Notes payable to stockholders and separately treated as a derivative liability. The charge was recognized in additional paid in capital. Gain on extinguishment of convertible promissory notes In March 2018, upon the conversion of the Convertible Promissory Notes into Series B redeemable convertible preferred stock, we recognized a gain on debt extinguishment. As the Convertible Promissory Notes were issued to stockholders, we treated the gain on debt extinguishment as a capital contribution included in additional paid in capital. Comparison of the years ended December 31, 2018 and December 31, 2017 Research and development expense Research and development expense increased by $19.3 million, or 207%, during the year ended December 31, 2018, compared to the year ended December 31, 2017. The increase was primarily attributable to an increase of $15.2 million in clinical trial related activities and contract manufacturing activities for our clinical trials and drug supply, increased personnel costs of $3.2 million due to a higher headcount, and an increase in stock-based compensation of $0.8 million. General and administrative expense General and administrative expense increased by $6.5 million, or 238%, during the year ended December 31, 2018, compared to the year ended December 31, 2017. The increase was primarily attributable to an increase of $4.3 million in professional service fees and consulting services, primarily for financial, legal and accounting fees and an increase of $1.7 million in personnel-related expenses due to an increase in headcount to support the growth of our operations and an increase in stock-based compensation of $0.6 million. Interest expense Interest expense was $1.0 million for the year ended December 31, 2018. The expense during the year ended December 31, 2018 is primarily from the amortization of the debt discount of $1.0 million related to the convertible promissory note payable which was converted into Series B redeemable convertible preferred stock in March 2018. Other income (expense), net Other income (expense), net was an expense of $1.9 million during the year ended December 31, 2018, compared to income of $75,000 during the year ended December 31, 2017. The $1.9 million activity for the year ended December 31, 2018 is due to an increase to fair value of the redeemable convertible preferred stock warrant liability and tranche liability of $3.2 million, partially offset by the interest income of $1.2 million. The other income during the year ended December 31, 2017 was due to the decrease in fair value of the redeemable convertible preferred stock tranche liability which was remeasured prior to settlement in March 2017. Critical accounting policies 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 United States generally accepted accounting principles, or U.S. 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 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. We believe that the accounting policies discussed below are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving management’s judgments and estimates. While our significant accounting policies are described in the notes to our financial statements included elsewhere in this Annual Report on Form 10-K, we believe that the following critical accounting policies are most important to understanding and evaluating our reported financial results. Revenue recognition We recognize revenue in accordance with ASC Topic 606, Revenue from Contracts with Customers (“ASC 606”), when the customer obtains control of promised goods or services, in an amount that reflects the consideration which we expect to receive in exchange for those goods or services. To determine the appropriate revenue recognition for arrangements within the scope of ASC 606, we perform 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) we satisfy our performance obligation. We apply the five-step model to contracts when it is probable that we will collect the consideration we are entitled to in exchange for the goods or services the Company transfers to the customer. At contract inception, once the contract is determined to be within the scope of ASC 606, we assess the goods or services promised within each contract and then identify the performance obligations and assess whether each promised good or service is distinct. We then recognize as revenue the amount of the transaction price that is allocated to the respective performance obligation when (or as) the performance obligation is satisfied. Contract Revenues from License Agreements In the normal course of business, we conduct research and development programs independently pursuant to which we may license certain of our intellectual property rights to third parties. The terms of these arrangements typically include payment to us for a combination of one or more of the following: upfront license fees; development, regulatory and commercial milestone payments; product supply services; and royalties on net sales of licensed products. Upfront license fees: If the license to our intellectual property is determined to be distinct from the other performance obligations identified in the arrangement, we will recognize revenue from upfront license fees allocated to the license when the license is transferred to the licensee and the licensee is able to use and benefit from the license. For licenses that are bundled with other promises, we determine whether the combined performance obligation is satisfied over time or at a point in time. Development, regulatory or commercial milestone payments: At the inception of each arrangement that includes payments based on the achievement of certain development, regulatory and commercial or launch events, we evaluate whether the milestones are considered probable of being achieved 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 milestone value is included in the transaction price. Milestone payments that are not within our or the licensee’s control, such as regulatory approvals, are not considered probable of being achieved until uncertainty associated with the approvals has been resolved. At the end of each subsequent reporting period, we will re-evaluate the probability of achieving such development and regulatory milestones and any related constraint, and if necessary, adjust our estimate of the overall transaction price. Any such adjustments are recorded on a cumulative catch-up basis and recorded as part of contract revenues from collaborations during the period of adjustment. Product supply services: Arrangements that include a promise for the future supply of drug product for either clinical development or commercial supply at the licensee’s discretion are generally considered as options. We will assess if these options provide a material right to the licensee and if so, they are accounted for as separate performance obligations. Sales-based milestone payments and royalties: For arrangements that include sales-based royalties, including milestone payments based on the volume of sales, we will determine whether the license is deemed to be the predominant item to which the royalties or sales-based milestones relate and if such is the case, we will recognize revenue at the later of (i) when the related sales occur, or (ii) when the performance obligation to which some or all of the royalty has been allocated has been satisfied (or partially satisfied). Upfront payments and fees are recorded as deferred revenue when due and payable, and may require deferral of revenue recognition to a future period until we perform our obligations under these arrangements. Amounts payable to us are recorded as accounts receivable when our right to consideration is unconditional. We do not assess whether a contract has a significant financing component if the expectation at contract inception is such that the period between payment by the customer and the transfer of the promised goods or services to the customer will be one year or less. Accrued research and development We record accrued expenses for estimated costs of our research and development activities conducted by third-party service providers, which include preclinical studies and clinical trials and contract manufacturing activities. 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 expenses and other current liabilities in the balance sheets and within research and development expense in the statements of operations. These costs are a significant component of our research and development expenses. 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 significant 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, and the number of patients enrolled and the rate of patient enrollment in our clinical trials 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. We record advance payments to service providers as prepaid assets, which are expensed as the contracted services are performed. To date, there have been no material differences from our accrued expenses to actual expenses. Stock-based compensation We recognize compensation costs related to stock options granted to employees and non-employees based on the estimated fair value of the awards on the date of grant. We elect to recognize the actual forfeitures by reducing the employee stock-based compensation expense in the same period in which the forfeitures occur. 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 period, which is generally the vesting period of the respective awards. 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- The expected term represents the period that the stock-based awards are expected to be outstanding. Since we do not have a long trading history for our common stock, the expected term is estimated based on the average expected term for comparable publicly traded biopharmaceutical companies. The comparable companies were chosen based on their similar size, stage in the life cycle or area of specialty. For non-employees, the term is the remaining contractual term of the option. • Expected volatility- Since we have only recently become a public company and have only a limited trading history for our common stock, 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. 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 volatility, and expected terms 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 an unrelated third-party valuation firm in accordance with the guidance provide by the American Institute of Certified Public Accountants Practice Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. Given the absence of a public trading market for our common stock prior to our IPO, our board of directors exercised reasonable judgment and considered a number of objective and subjective factors to determine the best estimate of the fair value of our common stock, including our stage of development; progress of our research and development efforts; the rights, preferences and privileges of our redeemable convertible preferred stock relative to those of our common stock; equity market conditions affecting comparable public companies and the lack of marketability of our common stock. Since the completion of our IPO, our board of directors (or a committee thereof) determines the fair value of each share of common stock underlying stock option grants based on the closing price of our common stock on the Nasdaq Global Select Market as reported on the date of grant. Liquidity and Capital Resources Liquidity and Capital Expenditures Liquidity As of December 31, 2019, we had $191.2 million of cash and cash equivalents and an accumulated deficit of $103.1 million. In June 2018, we completed our IPO of our common stock pursuant to which we issued 7,187,500 shares of our common stock at a price of $17.00 per share and received $111.0 million in cash, net of underwriting discounts and commissions and offering costs paid by us. On August 2, 2019, we filed the 2019 Shelf with the SEC in relation to the registration of common stock, preferred stock, warrants and units of any combination thereof. We also simultaneously entered into an Open Market Sale Agreement with the Sales Agent, to provide for the offering, issuance and sale by the Company of up to an aggregate offering price of $100.0 million of its common stock from time to time in “at-the-market” offerings under the 2019 Shelf and subject to the limitations thereof. We will pay to the Sales Agent cash commissions of up to 3.0 percent of the gross proceeds of sales of common stock under the 2019 Sales Agreement. We have issued 385,613 shares under this offering and received $23.9 million of net proceeds as of December 31, 2019. On September 9, 2019, we entered into the Alexion License Agreement to develop and commercialize our product candidate, AG10, in Japan. Under the terms of the Alexion License Agreement, the Company has granted Alexion an exclusive license to certain of the Company’s intellectual property rights to develop, manufacture, and commercialize AG10 in Japan. In consideration for the license grant, the Company received an upfront nonrefundable payment of $25.0 million. Under the terms of the Alexion License Agreement, we are entitled to receive an additional one-time nonrefundable payment of $30.0 million subject to the achievement of a regulatory milestone and royalties in the low double-digits on net sales by Alexion of AG10 in Japan. The royalty rate is subject to reduction if Alexion is required to obtain intellectual property rights from third parties to develop, manufacture or commercialize AG10 in Japan, or upon the introduction of generic competition into the market. Additionally, on September 9, 2019, we and Alexion entered into a Stock Purchase Agreement wherein we sold to Alexion 556,173 shares of our common stock, par value $0.001 per share, for aggregate cash proceeds of approximately $25.0 million. Our primary uses of cash are 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 and accrued expenses. We believe, based on our current operating plan and expected expenditures, that our existing cash and cash equivalents will be sufficient to meet our anticipated operating and capital expenditure requirements for at least the next 12 months from the filing of this Annual Report on Form 10-K. 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. Our ultimate success depends on the outcome of our research and development activities. We expect to incur additional losses in the future and we anticipate the need to raise additional capital to fully implement our business plan. We expect to further increase our research and development activities, which will increase the amount of cash used during 2020 and beyond. Specifically, we expect continued spending on clinical trials, continued manufacturing activities and higher payroll expenses as we increase our professional and scientific staff and research and development activities and advance AG10 into later-stage clinical development, including our ongoing and planned Phase 3 clinical trials. 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 to private investors. 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. Our future funding requirements will depend on many factors, including the following: • the progress, timing, scope, results and costs of our ongoing and planned clinical trials and other research and development activities related to AG10 and any other product candidates we may identify and pursue, including the ability to enroll patients in a timely manner in our clinical trials; • the costs of obtaining AG10 in amounts sufficient for our ongoing and planned clinical trials and, if approved, for commercialization; • the cost, timing and outcomes of any regulatory approvals for AG10; • our ability to successfully commercialize AG10, if approved; • the extent to which we may acquire or in-license other product candidates and technologies; • our ability to attract, hire and retain qualified personnel; and • the cost of obtaining, maintaining, preparing, filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights related to AG10 and any other product candidates we may identify and pursue. 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, 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, strategic alliances, licensing arrangements and other marketing and distribution arrangements. To the extent that we raise additional capital through collaborations, strategic alliances or licensing arrangements with third parties, we may have to relinquish valuable rights to our product candidates, future revenue streams, research programs or product candidates or to grant licenses on terms that may not be favorable to us. If we do raise additional capital through public or private equity offerings, the ownership interest of our existing stockholders will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect our stockholders’ rights. 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 table summarizes our cash flows for the periods indicated (in thousands): Cash flows from operating activities During the year ended December 31, 2019, cash used in operating activities was $31.6 million and consisted primarily of a net loss of $37.8 million. Our non-cash charges of $5.6 million primary consisted of $5.4 million for stock-based compensation expense, and amortization of debt discount of $0.1 million. The change in our net operating assets of $0.6 million was primarily due to an increase in accounts payable and accrued expenses of $9.2 million, as a result of an increase in operating expenses and timing of payments, partially offset by the change in prepaid expenses and other assets of $8.6 million, due to timing of payments and the timing of activities for which payments were made. During 2018, cash used in operating activities was $33.3 million and consisted primarily of a net loss of $40.7 million. Our non-cash charges of $6.8 million primary consisted of embedded derivative revaluation of $0.1 million, a cost of $2.6 million related to the revaluation of the convertible redeemable preferred stock warrant liability, $2.5 million for stock-based compensation expense, amortization of debt discount of $1.0 million, and a cost of $0.6 million related to the redeemable convertible preferred stock tranche liability. The change in our net operating assets of $0.6 million was primarily due to an increase in accounts payable and accrued expenses of $2.8 million, as a result of an increase in operating expenses and timing of payments, partially offset by the change in prepaid expenses and other current assets of $2.1 million, due to timing of payments and the timing of activities for which payments were made. During 2017, cash used in operating activities was $9.7 million, which consisted of a net loss of $11.9 million, adjusted by non-cash charges of $1.1 million and a net change of $1.1 million in our net operating assets and liabilities. The non-cash charges are primarily comprised of $1.1 million for stock-based compensation, offset by a gain of $0.1 million for the remeasurement of the redeemable convertible preferred stock tranche liability. The change in our net operating assets and liabilities was primarily due to an increase in accounts payable, accrued expenses and other liabilities and related party payable of $1.9 million as a result of an increase in operating expenses and timing of payments, offset by $0.5 million increase in cash used for prepaid and other current assets related to payments associated with clinical trials and studies and $0.2 million increase in cash used for other assets related to the security deposit for our facility leases. Cash flows from investing activities During 2019, cash used in investing activities was $0.2 million, which consisted of our purchase of property and equipment for our office and employees. During 2018, cash used in investing activities was $0.2 million, which consisted of our purchase of property and equipment for our office and employees. During 2017, cash used in investing activities was $0.1 million, which consisted of our purchase of property and equipment for our office and lab facilities. Cash flows from financing activities During the year ended December 31, 2019, cash provided by financing activities was $65.9 million, which consisted of $23.9 million from proceeds from the issuance of common stock under our at-the-market offering facility, $23.3 million related to the issuance of common stock to Alexion, $17.5 million from proceeds of long term debt, and $1.5 million due to the issuance of common stock and receipt of funds from our employee stock purchase plan and the exercise of common stock options, offset by $0.3 million of deferred financing costs. During the year ended December 31, 2018, cash provided by financing activities was $185.1 million, which consisted of the receipt of funds in connection with our IPO of $111.0 million, the net proceeds from the issuance of Series B redeemable convertible preferred stock of $63.9 million, and proceeds from the issuance of convertible promissory notes of $10.0 million. During the year ended December 31, 2017, cash provided by financing activities was $13.3 million, which consisted of $13.0 million of net proceeds from the issuance of Series Seed redeemable convertible preferred stock and $0.3 million related to the receipt of funds from the exercise of options. Contractual Obligations and Other Commitments The following table summarizes our contractual obligations as of December 31, 2019 (in thousands). The SVB and Hercules Debt includes principal, interest and final payment charge as of December 31, 2019. On March 27, 2019, we entered into an amendment to the lease dated November 14, 2017 and the new lease commenced in August 2019. In connection with the amendment, we lease 10,552 rentable square feet. The amended lease is for 87 months and has $6.4 million of payments under this lease. On November 13, 2019, we entered into the SVB and Hercules Loan Agreement. The SVB and Hercules Loan Agreement provides for up to $55.0 million in term loans to be drawn in three tranches. The Tranche A loan of $17.5 million was drawn on November 13, 2019. There have not been any additional draws on the other tranches as of December 31, 2019. Potential Obligations Not Included in the Table Above We enter into agreements in the normal course of business with contract research organizations 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 to 60 days prior written notice. These payments are not included in this table of contractual obligations. Off-Balance Sheet Arrangements We did not have during the periods presented, and we do not have any off-balance sheet arrangements, as defined under SEC rules, including the use of structured finance, special purpose entities or variable interest entities. Recent Accounting Pronouncements Information regarding recent accounting pronouncements applicable to us is included in the notes to our financial statements included elsewhere in this Annual Report.
0.084593
0.084779
0
<s>[INST] Overview We are a clinical stage biopharmaceutical company focused on addressing the large and growing unmet need in transthyretin, or TTR, amyloidosis, or ATTR. We are advancing our product candidate, AG10, to treat ATTR, a progressive and fatal family of diseases. Our financial information includes allocations of expenses attributable to certain corporate functions that were provided to us by BridgeBio and its affiliates, including expenses attributable to certain executive personnel, facilityrelated costs, advisory services, insurance costs and other general corporate expenses. These allocations were made based on direct usage or estimates which are considered to be reasonable by our management and in accordance with our services agreement with BridgeBio. We have moved into our own leased premises and expect to reduce the services provided by BridgeBio as we hire additional personnel. Since the commencement of our operations, we have devoted substantially all of our resources to research and development activities in support of our product development efforts, hiring personnel, raising capital to support and expand such activities and general and administrative support for these operations. We have funded our operations to date primarily from the issuance and sale of shares of common stock, redeemable convertible preferred stock and notes convertible into shares of redeemable convertible preferred stock. In April 2016, we entered into a license agreement (the “Stanford License Agreement”) with the Board of Trustees of the Leland Stanford Junior University (“Stanford”) for rights relating to novel transthyretin aggregation inhibitors. Under the Stanford License Agreement, Stanford has granted us an exclusive worldwide license to make, use and sell products that are covered by the licensed patent rights. In connection with the execution of the Stanford License Agreement, we paid an upfront license fee in April 2016 and issued Stanford shares of common stock, which were recorded as research and development expense during the year ended December 31, 2016. During the years ended December 31, 2019, 2018 and 2017, we recorded $210,000, $60,000 and $10,000 under the Stanford License Agreement related to annual maintenance fees, and milestone payments, respectively. We are obligated to make future payments to Stanford upon the achievement of specific intellectual property, clinical and regulatory milestone events, as well as pay royalties in the low single digits on future net sales, if any. In October 2018, the FDA granted orphan drug designation in the United States to AG10 for the treatment of ATTR, and the Committee for Orphan Medicinal Products of the European Medicines Agency, or EMA, adopted a positive opinion for the designation of AG10 as an orphan medicinal product in the European Union, or EU, for the treatment of ATTR. The EMA also granted a productspecific pediatric investigational plan waiver to us for AG10. We have incurred net losses in each year since inception. Our net losses were $37.8 million and $40.7 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had an accumulated deficit of $103.1 million. Substantially all of our net losses have resulted from costs incurred in connection with our research and development programs and from general and administrative costs associated with our operations and exceeded revenues for each fiscal year. We expect to continue to incur significant expenses and increasing operating losses over at least the next several years. We expect these losses to increase as we continue our development of, and seek regulatory approvals for our product candidate, AG10, begin to commercialize AG10, if approved, and engage in any other research and development activities. Our net losses may fluctuate significantly from quartertoquarter and yeartoyear, depending on the timing of our clinical trials and our expenditures on other research and development activities. In June 2018, we completed our initial public offering (IPO) of our common stock pursuant to which we issued 7,187,500 shares of our common stock at a price of $17.00 per share and received $111.0 [/INST] Positive. </s>
2,020
7,179
1,720,821
Gores Holdings III, Inc.
2019-03-18
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 on October 23, 2017 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 September 11, 2018. 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 calendar year ended December 31, 2018 and the period from October 23, 2017 (inception) to December 31, 2017, we had a net income/(loss) of $1,736,729 and ($23,684), respectively. 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 September 11, 2020. 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, 2018 and December 31, 2017, we had $856,182 and $109,737, respectively, in cash, and deferred offering costs of $0 and $153,198, 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 November 2017, 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 each of our independent directors. On October 22, 2018, 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 IPO Closing Date. On September 11, 2018, 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 401,100,000, 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 $1,100,000 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 November 3, 2017, our Sponsor loaned us an aggregate of $150,000 by the issuance of an unsecured promissory note for $150,000 to cover expenses related to the Public Offering, and on August 30, 2018, our Sponsor loaned us an additional $150,000 by the issuance of a second unsecured promissory note for $150,000 to cover expenses related to the Public Offering. These Notes were non-interest bearing and payable on the earlier of November 30, 2018 or the completion of the Public Offering. These Notes were repaid in full upon the completion of the Public Offering. As of December 31, 2018 and December 31, 2017, we had cash held outside of the Trust Account of $856,182 and $109,737, respectively, which is available to fund our working capital requirements. As of December 31, 2018 and December 31, 2017, the Company had current liabilities of $687,370 and $261,619, respectively and working capital of $375,661 and $1,316, respectively, largely due to amounts owed to professionals, consultants, advisors and others who are working on seeking a Business Combination. Such work is continuing after December 31, 2018 and amounts 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), as well as the $10,000,000 from its sale of Private Placement Warrants 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 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 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 other than an administrative services agreement to pay a monthly recurring expense 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 stockholders’ equity upon the IPO Closing Date. Accordingly, as of December 31, 2018 and December 31, 2017, offering costs totaling approximately $22,756,432 and $153,198 respectively, (including $22,000,000 in underwriter’s fees), have been charged to stockholders’ equity. As of December 31, 2017, $153,198 was deferred, but it has not been charged to stockholder's equity as the IPO had not closed. Net income/(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. Income taxes Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement 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. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company accounts for uncertainty in income taxes by recognizing the tax benefit from an uncertain tax position only if it is more than likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The Company measures the tax benefits recognized in the financial statements from such a position based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate resolution. The application of income tax law is inherently complex. Laws and regulations in this area are voluminous and are often ambiguous. As such, the Company is required to make many subjective assumptions and judgments regarding income tax exposures. Interpretations of and guidance surrounding income tax law and regulations change over time and may result in changes to the Company's subjective assumptions and judgments, which can materially affect amounts recognized in the balance sheets and statements of income and comprehensive income. The Company recognizes interest and penalties related to uncertain tax positions in other income (expense). No penalties or interest were recorded during the years ended December 31, 2018 and December 31, 2017. 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.
-0.001245
-0.001168
0
<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 October 23, 2017 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 September 11, 2018. 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 calendar year ended December 31, 2018 and the period from October 23, 2017 (inception) to December 31, 2017, we had a net income/(loss) of $1,736,729 and ($23,684), respectively. 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 September 11, 2020. 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, 2018 and December 31, 2017, we had $856,182 and $109,737, respectively, in cash, and deferred offering costs of $0 and $153,198, 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 November 2017, 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 each of our independent directors. On October 22, 2018, 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 IPO Closing Date. On September 11, 2018, 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 [/INST] Negative. </s>
2,019
2,082
1,720,821
PAE Inc
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 the financial condition and results of operations of Gores Holding III, Inc. should be read in conjunction with the audited consolidated 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 Recent Developments PAE Business Combination On the Closing Date, the Company consummated the previously announced business combination pursuant to the Merger Agreement, which provided for the Business Combination. As a result of the First Merger, the Company owns 100% of the outstanding common stock of Shay and each share of common stock of Shay has been cancelled and converted into the right to receive a portion of the consideration payable in connection with the Merger. As a result of the Second Merger, the registrant owns 100% of the outstanding interests in Second Merger Sub. In connection with the Closing, the registrant acquired 100% of the stock of Shay and its subsidiaries and the Shay Stockholders hold a portion of the Class A Common Stock. Additional information regarding the Business Combination and related transactions is set forth in our Current Report on Form 8-K filed with the SEC on February 14, 2020. The Business Combination is a subsequent event that occurred after the periods for which the financial information herein is presented. However, an annual report on Form 10-K, including consolidated financial statements of Gores Holdings III, Inc. for the periods presented herein, is required to be filed with the Securities and Exchange Commission (“SEC”). The Company’s financial statement presentation to be included in quarterly and annual filings with the SEC on Forms 10-Q and 10-K with respect to periods subsequent to the Business Combination will include the consolidated financial statements of Shay and its subsidiaries for periods prior to the completion of the Business Combination and of PAE Incorporated for periods from and after the Closing Date. The financial information included in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” reflects the historical operations of Gores Holdings III, Inc., the legal acquirer, unless otherwise noted. Results of Operations For the calendar years ended December 31, 2019 and 2018, and the period from October 23, 2017 (inception) to December 31, 2017, we had a net income (loss) of $1,458,376, $1,736,729 and $(23,684), respectively. Our activities during these periods mainly consisted of identifying and evaluating prospective acquisition candidates for a Business Combination. We generated $8,488,158, $2,609,060 and $0 in interest income for the calendar years ended December 31, 2019 and 2018 and the period from October 23, 2017 (inception) to December 31, 2017 respectively. As indicated in the accompanying consolidated financial statements, as of December 31, 2019 and 2018, we had $244,960 and $856,182, respectively, in cash. Liquidity and Capital Resources In November 2017, 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 Messrs. Randall Bort, William Patton and Jeffrey Rea, our former independent directors. On October 22, 2018, 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 IPO Closing Date. On September 11, 2018, we consummated our IPO 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 any deferred underwriting commissions (the “Deferred Discount”), which amount became payable upon consummation of the Business Combination) and the estimated offering expenses, the total net proceeds from our IPO and the sale of the Private Placement Warrants were 401,100,000, of which $400,000,000 (or $10.00 per share sold in the IPO) was placed in the Trust Account. The amount of proceeds not deposited in the Trust Account was $1,100,000 at the closing of our IPO. Interest earned on the funds held in the Trust Account may be released to us to fund our regulatory compliance requirements and other costs related thereto (“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 November 3, 2017, our Sponsor loaned us an aggregate of $150,000 by the issuance of an unsecured promissory note for $150,000 to cover expenses related to the IPO, and on August 30, 2018, our Sponsor loaned us an additional $150,000 by the issuance of a second unsecured promissory note for $150,000 to cover expenses related to the IPO (collectively, the “Notes”). These Notes were non-interest bearing and payable on the earlier of November 30, 2018 or the completion of the IPO. These Notes were repaid in full upon the completion of the IPO. As of December 31, 2019 and 2018, we had cash held outside of the Trust Account of $244,960 and $856,182, respectively, which is available to fund our working capital requirements. As of December 31, 2019 and 2018, the Company had current liabilities of $4,517,373 and $687,370, respectively and working capital of ($4,187,865) and $375,661, respectively, largely due to amounts owed to professionals, consultants, advisors and others who were working on seeking a Business Combination. 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 and 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 entered into any non-financial agreements involving assets as of December 31, 2019 and 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, 2019 other than an administrative services agreement to pay a monthly recurring expense of $20,000 to The Gores Group for office space, utilities and secretarial support. The administrative services agreement terminated upon the completion of the Business Combination. 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 became payable to the underwriter from the amounts held in the Trust Account upon completion of the Business Combination, pursuant to the terms of the underwriting agreement. The underwriter was not entitled to any interest accrued on the Deferred Discount.
-0.10323
-0.102985
0
<s>[INST] Overview Recent Developments PAE Business Combination On the Closing Date, the Company consummated the previously announced business combination pursuant to the Merger Agreement, which provided for the Business Combination. As a result of the First Merger, the Company owns 100% of the outstanding common stock of Shay and each share of common stock of Shay has been cancelled and converted into the right to receive a portion of the consideration payable in connection with the Merger. As a result of the Second Merger, the registrant owns 100% of the outstanding interests in Second Merger Sub. In connection with the Closing, the registrant acquired 100% of the stock of Shay and its subsidiaries and the Shay Stockholders hold a portion of the Class A Common Stock. Additional information regarding the Business Combination and related transactions is set forth in our Current Report on Form 8K filed with the SEC on February 14, 2020. The Business Combination is a subsequent event that occurred after the periods for which the financial information herein is presented. However, an annual report on Form 10K, including consolidated financial statements of Gores Holdings III, Inc. for the periods presented herein, is required to be filed with the Securities and Exchange Commission (“SEC”). The Company’s financial statement presentation to be included in quarterly and annual filings with the SEC on Forms 10Q and 10K with respect to periods subsequent to the Business Combination will include the consolidated financial statements of Shay and its subsidiaries for periods prior to the completion of the Business Combination and of PAE Incorporated for periods from and after the Closing Date. The financial information included in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” reflects the historical operations of Gores Holdings III, Inc., the legal acquirer, unless otherwise noted. Results of Operations For the calendar years ended December 31, 2019 and 2018, and the period from October 23, 2017 (inception) to December 31, 2017, we had a net income (loss) of $1,458,376, $1,736,729 and $(23,684), respectively. Our activities during these periods mainly consisted of identifying and evaluating prospective acquisition candidates for a Business Combination. We generated $8,488,158, $2,609,060 and $0 in interest income for the calendar years ended December 31, 2019 and 2018 and the period from October 23, 2017 (inception) to December 31, 2017 respectively. As indicated in the accompanying consolidated financial statements, as of December 31, 2019 and 2018, we had $244,960 and $856,182, respectively, in cash. Liquidity and Capital Resources In November 2017, 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 Messrs. Randall Bort, William Patton and Jeffrey Rea, our former independent directors. On October 22, 2018, 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 IPO Closing Date. On September 11, 2018, we consummated our IPO 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 [/INST] Negative. </s>
2,020
1,245
1,690,585
Magenta Therapeutics, Inc.
2019-03-19
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 appearing at the end of this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10-K, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties. As a result of many factors, including those factors set forth in the “Risk Factors” section of this Annual Report on Form 10-K, our actual results could 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 clinical-stage biotechnology company developing novel medicines to extend the curative power of stem cell transplant, gene therapy, genome editing and cell therapy to more patients. Transplant is a well-established and often curative medical procedure, and emerging data on stem cell gene therapy, which is stem cell transplant using gene-modified stem cells, suggest the potential for meaningful benefit with this newer form of transplant. Stem cell transplant and stem cell gene therapies use the same widely-adopted decades-old transplant process. As it exists today, stem cell transplant is a large market opportunity, and improvements to the current approaches could enable better stem cell transplant and extend stem cell transplant to more patients. The ability to treat patients with a stem cell transplant is limited by the challenges of obtaining sufficient cells to perform the procedure, the inherent morbidity and mortality of current methods used to prepare patients for transplant, and complications following transplant. At Magenta, we believe we are uniquely positioned to overcome these challenges and to lead a new era in transplant medicine. Our portfolio of product candidates includes biologics, small molecules and a cell therapy designed to address deficiencies in existing approaches and extend the curative power of stem cell transplant, gene therapy, genome editing and cell therapy to more patients across many diseases. Currently, only a fraction of eligible patients with these diseases receive a transplant because the risks and challenges outweigh the potential for a cure. These include diseases where stem cell transplant is a standard of care (e.g., blood cancers such as acute myelogenous leukemia, myelodysplastic syndromes, multiple myeloma, and non-Hodgkin lymphoma), diseases where transplant is performed but limited in use (e.g., hemoglobinopathies such as sickle cell disease and beta-thalassemia), and autoimmune diseases. Emerging clinical data suggest that stem cell transplant may represent a breakthrough approach with curative potential for patients with severe autoimmune diseases. For example, recent results from multiple clinical trials show that patients with autoimmune diseases, including multiple sclerosis and scleroderma, can be cured with a transplant. However, based on our epidemiology analyses, currently only approximately 1 to 2% of eligible patients with multiple sclerosis or scleroderma in the United States and Europe receive a stem cell transplant. To address the major unmet medical needs in the existing stem cell transplant process, we are developing a stem cell biology discovery platform and comprehensive portfolio of novel therapeutics. Our programs will improve stem cell dose (expansion), stem cell collection (mobilization), patient preparation for transplant (conditioning) and potential post-transplant complications to address key limitations of the stem cell transplant process to allow more patients to benefit. Within our expansion program, MGTA-456 is a cell therapy used with curative intent, and it has the potential to allow more patients to have a better chance for a successful stem cell transplant. We are currently studying it in patients with inherited metabolic disorders and patients with blood cancers. Within our mobilization program, MGTA-145 is focused on enabling physicians to more easily harvest a greater number of blood stem cells, known as hematopoietic stem cells or HSCs, from patients and donors to improve patient outcomes and scale the capacity of transplant and apheresis centers. Our targeted transplant conditioning programs, which prepare the patient for transplant, are designed to selectively remove stem and/or immune cells from a patient prior to transplant, and to be far less toxic than the decades-old radiation and chemotherapy-based approaches which are still the only available options. Our post-transplant complications program is designed to target the donor immune cells within the patient that cause Graft vs. Host Disease, or GvHD, which can be a fatal complication of transplant. We intend to become a fully integrated discovery, development and commercial company in the field of transplant medicine. We believe that our product portfolio will offer significant commercial synergies. We are developing our products so that they can each be used individually or in combination with each other. As a result, our portfolio could be utilized in a manner tailored to the patient’s disease, such that a patient may receive more than one Magenta therapy as part of their individual transplant journey. Since our inception in 2015, we have focused substantially all of our efforts and financial resources on organizing and staffing our company, business planning, raising capital, acquiring and developing our technology, identifying potential product candidates, and undertaking preclinical studies, and in the case of MGTA-456, clinical trials. We do not have any products approved for sale and have not generated any revenue from product sales. On June 25, 2018, we completed an initial public offering, or IPO, of our common stock, pursuant to which we issued and sold 6,666,667 shares of common stock at a public offering price of $15.00 per share, resulting in net proceeds of $89.9 million after deducting underwriting discounts and commissions and other offering expenses. Prior to the IPO, we funded our operations primarily with proceeds from the sales of redeemable convertible preferred stock and issuance of convertible notes. 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 product candidates. Our net loss was $57.5 million for the year ended December 31, 2018 and $35.5 million for the year ended December 31, 2017. As of December 31, 2018, we had an accumulated deficit of $102.7 million. We expect to continue to incur significant expenses and increasing operating losses for at least the next several years. We expect our expenses and capital requirements will increase substantially in connection with our ongoing activities, particularly as we: • continue enrollment in our Phase 2 clinical trial of MGTA-456; • prepare for and initiate our preclinical studies and clinical trials of our product candidates; • develop any other future product candidates we may choose to pursue; • continue research and development and drug discovery and initiate additional clinical trials; • seek marketing approval for any of our product candidates that successfully complete clinical development, if any; • maintain compliance with applicable regulatory requirements; • develop and scale up our capabilities to support our ongoing preclinical activities and clinical trials for our product candidates and commercialization of any of our product candidates for which we obtain marketing approval, if any; • maintain, expand, protect and enforce our intellectual property portfolio; • develop and expand our sales, marketing and distribution capabilities for our product candidates for which we obtain marketing approval, if any; and • expand our operational, financial and management systems and increase personnel, including to support our clinical development and commercialization efforts and our operations as a public company. We will not generate revenue from product sales unless and until we successfully complete clinical development and obtain regulatory approval for our product candidates. If we obtain regulatory approval for any of our product candidates, we expect to incur significant expenses related to developing our commercialization capability to support product sales, marketing and distribution. Further, we expect to incur additional costs associated with operating as a public company. As a result, we will need substantial additional funding to support our continuing operations and pursue our growth strategy. Until such time as we can generate significant revenue from product sales, if ever, we expect to finance our operations through a combination of equity offerings, debt financings, collaborations, strategic alliances and marketing and distribution or licensing arrangements. We may be unable to raise additional funds or enter into such other agreements or arrangements when needed on favorable terms, or at all. If we fail to raise capital or enter into such agreements as, and when, needed, we may have to significantly delay, scale back or discontinue the development and commercialization of one or more of our product candidates. Because of the numerous risks and uncertainties associated with pharmaceutical product development, we are unable to accurately predict the timing or amount of increased expenses or when or if we will be able to achieve or maintain profitability. Even if we are able to generate product sales, we may not become profitable. If we fail to become profitable or are unable to sustain profitability on a continuing basis, then we may be unable to continue our operations at planned levels and be forced to reduce or terminate our operations. As of December 31, 2018, we had cash, cash equivalents and marketable securities of $142.6 million. We believe that our existing cash, cash equivalents and marketable securities will enable us to fund our operating expenses and capital expenditure requirements through 2020. See “-Liquidity and Capital Resources.” Components of Our Results of Operations Revenue To date, we have not generated any revenue from product sales and do not expect to generate any revenue from the sale of products in the foreseeable future. If our development efforts for our product candidates are successful and result in regulatory approval, we may generate revenue in the future from product sales. If we enter into license or collaboration agreements for any of our product candidates or intellectual property, we may generate revenue in the future from payments as a result of such license or collaboration agreements. We cannot predict if, when, or to what extent we will generate revenue from the commercialization and sale of our product candidates. We may never succeed in obtaining regulatory approval for any of our product candidates. Operating Expenses Research and Development Expenses Research and development expenses consist primarily of costs incurred for our research activities, including our drug discovery efforts, and the development of our product candidates, which include: • employee-related expenses, including salaries and related costs, and stock-based compensation expense, for employees engaged in research and development functions; • expenses incurred in connection with the preclinical and clinical development of our product candidates, including under agreements with contract research organizations, or CROs; • the cost of consultants and contract manufacturing organizations, or CMOs, that manufacture drug products for use in our preclinical studies and clinical trials; • facilities, depreciation and other expenses, which include direct and allocated expenses for rent and maintenance of facilities, insurance and supplies; and • payments made under third-party licensing agreements. We expense research and development costs to operations as incurred. Advance payments for goods or services to be received in the future for use in research and development activities are recorded as prepaid expenses. The prepaid amounts are expensed as the related goods are delivered or the services are performed. Our direct research and development expenses are tracked on a program-by-program basis and consist primarily of external costs, such as fees paid to consultants, central laboratories, contractors, CMOs and CROs in connection with our preclinical and clinical development activities. We do not allocate employee costs, costs associated with our platform technology or facility expenses, including depreciation or other indirect costs, to specific product development programs because these costs are deployed across multiple product development programs and, as such, are not separately classified. The table below summarizes our research and development expenses incurred by development programs: The successful development and commercialization of our product candidates is highly uncertain. This is due to the numerous risks and uncertainties, including the following: • successful completion of preclinical studies and clinical trials; • receipt and related terms of marketing approvals from applicable regulatory authorities; • raising additional funds necessary to complete clinical development of and commercialize our product candidates; • obtaining and maintaining patent, trade secret and other intellectual property protection and regulatory exclusivity for our product candidates; • making arrangements with third-party manufacturers, or establishing manufacturing capabilities, for both clinical and commercial supplies of our product candidates; • developing and implementing marketing and reimbursement strategies; • establishing sales, marketing and distribution capabilities and launching commercial sales of our products, if and when approved, whether alone or in collaboration with others; • acceptance of our products, if and when approved, by patients, the medical community and third-party payors; • effectively competing with other therapies; • obtaining and maintaining third-party coverage and adequate reimbursement; • protecting and enforcing our rights in our intellectual property portfolio; and • maintaining a continued acceptable safety profile of the products following approval. A change in the outcome of any of these variables with respect to the development of any of our product candidates would significantly change the costs and timing associated with the development of that product candidate. We may never succeed in obtaining regulatory approval for any 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 expect research and development costs to increase significantly for the foreseeable future as our product candidate development programs progress. However, we do not believe that it is possible at this time to accurately project total program-specific expenses through commercialization. There are numerous factors associated with the successful commercialization of any of our product candidates, including future trial design and various regulatory requirements, many of which cannot be determined with accuracy at this time based on our stage of development. Additionally, future commercial and regulatory factors beyond our control will impact our clinical development programs and plans. General and Administrative Expenses General and administrative expenses consist primarily of salaries and related costs, and stock-based compensation, for personnel in executive, finance and administrative functions. General and administrative expenses also include direct and allocated facility-related costs as well as professional fees for legal, patent, consulting, accounting and audit services. We anticipate that our general and administrative expenses will increase in the future as we increase our headcount to support our continued research activities and development of our product candidates. We also anticipate that we will incur increased accounting, audit, legal, regulatory, compliance, and director and officer insurance costs as well as investor and public relations expenses associated with operating as a public company. Interest and Other Income, Net Interest and other income, net, consists of interest income and insignificant amounts of miscellaneous income and expense unrelated to our core operations. Income Taxes Since our inception, we have not recorded any U.S. federal or state income tax benefits for the net losses we have incurred in each year or for our earned research and orphan drug tax credits, due to our uncertainty of realizing a benefit from those items. As of December 31, 2018, we had net operating loss carryforwards for federal income tax purposes of $40.6 million, of which $17.5 million begin to expire in 2035 and $23.1 million can be carried forward indefinitely. As of December 31, 2018, we had net operating loss carryforwards for state income tax purposes of $40.8 million which begin to expire in 2035. As of December 31, 2018, we also had available research and orphan drug tax credit carryforwards for federal and state income tax purposes of $3.4 million and $0.8 million, respectively, which begin to expire in 2035 and 2030, respectively. Critical Accounting Policies and Significant Judgments and Estimates Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States, or GAAP. The preparation of our consolidated financial statements and related disclosures requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, costs and expenses, and the disclosure of contingent assets and liabilities in our consolidated financial statements. We base our estimates on historical experience, known trends and events and various other factors that we believe are 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. We evaluate our estimates and assumptions on an ongoing basis. Our 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 included 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. Research and Development Expenses As part of the process of preparing our consolidated financial statements, we are required to estimate our accrued research and development expenses. This process involves reviewing open contracts and purchase orders, communicating with our applicable 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 actual costs. The majority of our service providers invoice us in arrears for services performed, on a pre-determined schedule or when contractual milestones are met; however, some require advance payments. We make estimates of our accrued expenses as of each balance sheet date in the consolidated financial statements based on facts and circumstances known to us at that time. We periodically confirm the accuracy of the estimates with the service providers and make adjustments if necessary. Examples of estimated accrued research and development expenses include fees paid to: • vendors in connection with the preclinical development activities; • CROs in connection with preclinical and clinical trials; • CMOs in connection with the production of preclinical and clinical trial materials; and • investigative sites in connection with clinical trials. We base our expenses related to preclinical studies and clinical trials on our estimates of the services received and efforts expended pursuant to quotes and contracts with multiple research institutions and CROs that conduct and manage preclinical studies and clinical trials 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 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 the 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 may result in reporting amounts that are too high or too low in any particular period. To date, there have not been any material adjustments to our prior estimates of accrued research and development expenses. Stock-Based Compensation We measure all 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 compensation expense of those awards over the requisite service period, which is generally the vesting period of the respective award. Generally, we issue stock options and restricted stock awards, or RSAs, with either service-only vesting conditions and record expense using the straight-line method or service and performance vesting conditions and record expense using the graded-vesting method. We have historically granted stock options with exercise prices equivalent to the fair value of our common stock as of the date of the grant. Prior to our IPO, the estimated fair value of our common stock had been determined by our board of directors as of the date of each award 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. Subsequent to our IPO, the fair value of our common stock is based on quoted market prices. We estimate the fair value of each stock option award 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 measure the fair value of stock-based awards granted to non-employees 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, the fair value of these awards is re-measured using the then-current fair value of our common stock and updated assumption inputs in the Black-Scholes option-pricing model for options and the then-current fair value of our common stock for restricted stock. We do not estimate and apply a forfeiture rate as we have elected to account for forfeitures as they occur. 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 Expenses related to our conditioning program increased primarily as a result of costs incurred in connection with our collaboration agreement with Heidelberg Pharma Research GmbH for an upfront technology access fee, research exclusivity fees, target-specific development options and payments for research support related to our drug discovery efforts, primarily lead optimization. Conditioning program costs also increased due to our proof of mechanism and ongoing lead optimization in non-human primate studies. The increase in expense related to our mobilization program was due to an increase in preclinical costs for toxicology studies and manufacturing to support our IND enabling studies. Expenses related to our expansion program decreased primarily as a result of the prior year cost of in-licensing technology of $9.3 million for the rights to MGTA-456 under a license agreement with Novartis. This decrease was partially offset by increased clinical trial and manufacturing costs during the year ended December 31, 2018 incurred for our MGTA-456 Phase 2 study for inherited metabolic diseases, which we initiated in December 2017, and preparation for planned additional clinical trials in indications beyond inherited metabolic diseases. The increase in spending related to our GvHD program was due to costs related to our drug discovery efforts, primarily target validation. The increase in personnel-related costs included in unallocated expenses was due to an increase in headcount and stock-based compensation expense in our research and development function. Personnel-related costs for the year ended December 31, 2018 and 2017 included stock-based compensation expense of $2.7 million and $0.3 million, respectively. The increase in consultant fees was due to an increase in stock-based compensation issued to nonemployees of $2.0 million, from $1.3 million for the year ended December 31, 2017 to $3.3 million for the year ended December 31, 2018. The increase in facility related and other costs was primarily due to higher facility costs related to the sublease agreement for our Cambridge, Massachusetts facility, which we entered into in May 2018. General and Administrative Expenses The increase in personnel-related costs was primarily a result of an increase in stock-based compensation expense and an increase in headcount. Personnel-related costs for the year ended December 31, 2018 and 2017 included stock-based compensation expense of $4.5 million and $0.6 million, respectively. The increase in professional and consultant fees was primarily due to an increase in patent costs and fees associated with operating as a public company. The increase in facility related and other costs was primarily due to higher facility costs related to the sublease agreement for our Cambridge, Massachusetts facility, which we entered into in May 2018, as well as director and officer insurance costs and an increase in information technology-related expenses. Interest and Other Income, Net The increase in interest and other income, net was primarily due to an increase in interest income of $1.9 million resulting from the investment of our net proceeds from our IPO in June 2018 and our sale of series C redeemable convertible preferred stock in April 2018. In addition, the increase was due to $0.4 million of rental income from the sublease of a portion of our Cambridge, Massachusetts facility. 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 Expenses related to our conditioning program increased primarily as a result of our drug discovery efforts for target validation, lead identification and lead optimization. The increase in our mobilization program was due to an increase in preclinical costs for toxicology studies and manufacturing to support our Investigational New Drug, or IND, enabling studies. Expenses related to our expansion program increased primarily due to the cost of in-licensing technology of $9.3 million for the rights to MGTA-456 under a license agreement with Novartis. The cost of in-licensing technology was a result of the issuance of preferred stock to Novartis which was recorded at the fair value of the preferred stock issued. Expansion program costs also increased due to clinical trial costs incurred in preparation for our MGTA-456 Phase 2 study for inherited metabolic diseases, which we initiated in December 2017. The increase in personnel-related costs included in unallocated expenses was due to an increase in headcount in our research and development function. Personnel-related costs for the years ended December 31, 2017 and 2016 included stock-based compensation expense of $0.3 million and $0.1 million, respectively. The increase in consultant fees was primarily due to an increase in stock-based compensation from $0.4 million for the year ended December 31, 2016 to $1.3 million for the year ended December 31, 2017. The increase in facility-related and other costs included in unallocated expenses was primarily due to rent expense under our lease agreement for our Cambridge, Massachusetts facility, which we entered into in February 2017. General and Administrative Expenses The increase in personnel-related costs was primarily a result of an increase in headcount. Personnel-related costs for the years ended December 31, 2017 and 2016 included stock-based compensation expense of $0.6 million and $0.2 million, respectively. The increase in professional and consultant fees was primarily due to an increase in legal, audit and recruiting fees related to ongoing business activities and our preparations to operate as a public company as well as an increase of $0.4 million related to market research activities. The increase in facility-related and other costs was primarily due to rent expense under our lease agreement for our Cambridge, Massachusetts facility, which we entered into in February 2017. Other Income (Expense) There was no interest expense for the year ended December 31, 2017. Interest expense was $0.2 million for the year ended December 31, 2016. The decrease of $0.2 million in interest expense was due to the conversion of outstanding convertible notes into redeemable convertible preferred stock in November 2016. There was $0.2 million other income, net for the year ended December 31, 2017 primarily related to interest income earned on our invested cash balances. There was no other income or expense for the year ended December 31, 2016. Liquidity and Capital Resources Since our inception, we have incurred significant operating losses. We have not yet commercialized any of our product candidates and we do not expect to generate revenue from sales of any product candidates for several years, if at all. To date, we have funded our operations primarily with proceeds from the sales of redeemable convertible preferred stock and issuance of convertible notes. On June 25, 2018, we completed the IPO of our common stock, pursuant to which we issued and sold 6,666,667 shares of common stock at a public offering price of $15.00 per share, resulting in net proceeds of $89.9 million after deducting underwriting discounts and commissions and other offering expenses. As of December 31, 2018, we had cash, cash equivalents and marketable securities of $142.6 million. Cash Flows As of December 31, 2018, our principal sources of liquidity were cash, cash equivalents and marketable securities of $142.6 million. The following table summarizes our sources and uses of cash, cash equivalents and restricted cash for each of the periods presented: Operating Activities During the year ended December 31, 2018, operating activities used $41.9 million of cash, primarily resulting from our net loss of $57.5 million, partially offset by non-cash charges of $11.5 million and cash provided by changes in our operating assets and liabilities of $4.2 million. Net cash provided by changes in our operating assets and liabilities for the year ended December 31, 2018 consisted primarily of a $4.7 million increase in accounts payable and accrued expenses and other current liabilities, and a $1.2 million increase in long-term liabilities, all partially offset by an increase of $1.8 million in prepaid expenses and other current assets. During the year ended December 31, 2017, operating activities used $22.3 million of cash, primarily resulting from our net loss of $35.5 million, partially offset by non-cash charges of $11.9 million and cash provided by changes in our operating assets and liabilities of $1.3 million. Net cash provided by changes in our operating assets and liabilities for the year ended December 31, 2017 consisted primarily of a $2.2 million increase in accounts payable and accrued expenses, partially offset by an increase of $0.9 million in prepaid expenses and other current assets. During the year ended December 31, 2016, operating activities used $6.5 million of cash, primarily resulting from our net loss of $9.4 million, partially offset by non-cash charges of $1.3 million and cash provided by changes in our operating assets and liabilities of $1.6 million. Net cash provided by changes in our operating assets and liabilities for the year ended December 31, 2016 consisted primarily of a $1.6 million increase in accounts payable and accrued expenses. Changes in accounts payable, accrued expenses and other current liabilities and prepaid expenses in both periods were generally due to growth in our business and the timing of vendor invoicing and payments. The increase in long-term liabilities was related to deferred rent related to our sublease agreement for our Cambridge, Massachusetts facility, which we entered into in May 2018. Investing Activities During the year ended December 31, 2018, net cash used in investing activities was primarily attributable to purchases of marketable securities of $84.0 million and purchases of property and equipment of $7.7 million primarily related to leasehold improvements and lab equipment for our Cambridge, Massachusetts facility. During the years ended December 31, 2017 and 2016, we used $2.2 million and $0.1 million, respectively, to purchase property and equipment. Financing Activities During the year ended December 31, 2018, net cash provided by financing activities was $142.1 million, consisting primarily of proceeds from our IPO, net of underwriting discounts and commissions, of $93.0 million and net proceeds of $52.2 million from the sale of series C redeemable convertible preferred stock, both partially offset by $3.1 million of payments of IPO costs. During the year ended December 31, 2017, net cash provided by financing activities was $71.5 million, consisting primarily of $6.3 million of the remaining proceeds received in January 2017 from the sale of Series A preferred stock that we recorded as other receivable as of December 31, 2016, $15.4 million of proceeds from the sale of additional shares of Series A preferred stock and $49.8 million of net proceeds received from the sale of Series B preferred stock. During the year ended December 31, 2016, net cash provided by financing activities was $10.7 million, consisting primarily of proceeds of $6.5 million from the sale of convertible promissory notes and net proceeds of $4.2 million from the sale of Series A preferred stock that we received in 2016. Funding Requirements We expect our expenses to increase substantially in connection with our ongoing activities, particularly as we advance the preclinical activities and clinical trials for our product candidates in development. In addition, we expect to incur additional costs associated with operating as a public company. The timing and amount of our operating expenditures will depend largely on: • the initiation, progress, timing, costs and results of current and future preclinical studies and clinical trials for our product candidates; • the clinical development plans we establish for these product candidates; • the number and characteristics of product candidates that we develop or may in-license; • the terms of any collaboration agreements we may choose to conclude; • the outcome, timing and cost of meeting and maintaining compliance with regulatory requirements established by the U.S. Food and Drug Administration, the European Medical Agency and other comparable foreign regulatory authorities; • the cost of filing, prosecuting, defending and enforcing our patent claims and other intellectual property rights; • the cost of defending intellectual property disputes, including patent infringement actions brought by third parties against us; • the effect of existing or new competing technological and market developments; • the cost and timing of completion of commercial-scale outsourced manufacturing activities; and • the cost of establishing sales, marketing and distribution capabilities for any product candidates for which we may receive regulatory approval in regions where we choose to commercialize our products on our own. As of December 31, 2018, we had cash, cash equivalents and marketable securities of $142.6 million. We believe that our existing cash, cash equivalents and marketable securities will enable us to fund our operating expenses and capital expenditure requirements through 2020. We have based these estimates on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we expect. Because of the numerous risks and uncertainties associated with research, development and commercialization of pharmaceutical product candidates, we are unable to estimate the exact amount of our working capital requirements. Our future funding requirements will depend on and could increase significantly as a result of many factors, including those listed above. Until such time, if ever, as we can generate substantial product revenue, we expect to finance our operations through a combination of equity offerings, debt financings, collaborations, strategic alliances and marketing, distribution or licensing arrangements. We do not currently have any committed external source of funds. To the extent that we raise additional capital through the sale of equity or convertible debt securities, our stockholders’ ownership interest will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect our stockholders’ rights as a common stockholder. Debt financing and preferred 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 acquisitions or capital expenditures or declaring dividends. If we raise additional funds through collaborations, strategic alliances or marketing, distribution 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. If we are unable to raise additional funds through equity or debt financings or other arrangements when needed, we may be required to delay, limit, reduce or terminate our research, 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. Contractual Obligations and Commitments The following summarizes our principal contractual obligations and commitments as of December 31, 2018 and the effects such obligations are expected to have on our liquidity and cash flow in future periods: (1) In May 2018, we entered into a sublease for up to approximately 69,000 square feet of office and laboratory space in Cambridge, Massachusetts. The term of the lease expires in February 2028. (2) In August 2018, in connection with the sublease agreement entered into in May 2018 for office and laboratory space in Cambridge, Massachusetts, we entered into an agreement for the build-out and customization of this space. Under the agreement, we are obligated to make payments of up to $6.8 million of which $6.1 million has been incurred through December 31, 2018. The remaining payments are reflected in the table above. We enter into contracts in the normal course of business with CROs, CMOs and other third parties for clinical trials, preclinical research studies and testing and manufacturing services. These contracts are cancelable by us upon prior written notice. Payments due upon cancellation consist only of payments for services provided or expenses incurred, including noncancelable obligations of our service providers, up to the date of cancellation. These payments are not included in the preceding table as the amount and timing of such payments are not known. We have also entered into license and collaboration agreements with third parties, which are in the normal course of business. We have not included future payments under these agreements in the table of contractual obligations above since obligations under these agreements are contingent upon future events such as our achievement of specified development, regulatory, and commercial milestones, or royalties on net product sales. As of December 31, 2018, we were unable to estimate the timing or likelihood of achieving these milestones or generating future product sales. 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 Securities and Exchange Commission. Recently Issued and Adopted Accounting Pronouncements 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 included in this Annual Report on Form 10-K.
-0.030306
-0.030139
0
<s>[INST] Overview We are a clinicalstage biotechnology company developing novel medicines to extend the curative power of stem cell transplant, gene therapy, genome editing and cell therapy to more patients. Transplant is a wellestablished and often curative medical procedure, and emerging data on stem cell gene therapy, which is stem cell transplant using genemodified stem cells, suggest the potential for meaningful benefit with this newer form of transplant. Stem cell transplant and stem cell gene therapies use the same widelyadopted decadesold transplant process. As it exists today, stem cell transplant is a large market opportunity, and improvements to the current approaches could enable better stem cell transplant and extend stem cell transplant to more patients. The ability to treat patients with a stem cell transplant is limited by the challenges of obtaining sufficient cells to perform the procedure, the inherent morbidity and mortality of current methods used to prepare patients for transplant, and complications following transplant. At Magenta, we believe we are uniquely positioned to overcome these challenges and to lead a new era in transplant medicine. Our portfolio of product candidates includes biologics, small molecules and a cell therapy designed to address deficiencies in existing approaches and extend the curative power of stem cell transplant, gene therapy, genome editing and cell therapy to more patients across many diseases. Currently, only a fraction of eligible patients with these diseases receive a transplant because the risks and challenges outweigh the potential for a cure. These include diseases where stem cell transplant is a standard of care (e.g., blood cancers such as acute myelogenous leukemia, myelodysplastic syndromes, multiple myeloma, and nonHodgkin lymphoma), diseases where transplant is performed but limited in use (e.g., hemoglobinopathies such as sickle cell disease and betathalassemia), and autoimmune diseases. Emerging clinical data suggest that stem cell transplant may represent a breakthrough approach with curative potential for patients with severe autoimmune diseases. For example, recent results from multiple clinical trials show that patients with autoimmune diseases, including multiple sclerosis and scleroderma, can be cured with a transplant. However, based on our epidemiology analyses, currently only approximately 1 to 2% of eligible patients with multiple sclerosis or scleroderma in the United States and Europe receive a stem cell transplant. To address the major unmet medical needs in the existing stem cell transplant process, we are developing a stem cell biology discovery platform and comprehensive portfolio of novel therapeutics. Our programs will improve stem cell dose (expansion), stem cell collection (mobilization), patient preparation for transplant (conditioning) and potential posttransplant complications to address key limitations of the stem cell transplant process to allow more patients to benefit. Within our expansion program, MGTA456 is a cell therapy used with curative intent, and it has the potential to allow more patients to have a better chance for a successful stem cell transplant. We are currently studying it in patients with inherited metabolic disorders and patients with blood cancers. Within our mobilization program, MGTA145 is focused on enabling physicians to more easily harvest a greater number of blood stem cells, known as hematopoietic stem cells or HSCs, from patients and donors to improve patient outcomes and scale the capacity of transplant and apheresis centers. Our targeted transplant conditioning programs, which prepare the patient for transplant, are designed to selectively remove stem and/or immune cells from a patient prior to transplant, and to be far less toxic than the decadesold radiation and chemotherapybased approaches which are still the only available options. Our posttransplant complications program is designed to target the donor immune cells within the patient that cause Graft vs. Host Disease, or GvHD, which can be a fatal complication of transplant. We intend to become a fully integrated discovery, development and commercial company in the field of transplant medicine. We believe that our product portfolio will offer significant commercial synergies. We are developing our products so that they can each be used individually or in combination with each other. As a result, our portfolio could be utilized in a manner tailored to the patient’s disease, such that a patient may receive more than one Magenta therapy as part [/INST] Negative. </s>
2,019
6,415
1,690,585
Magenta Therapeutics, Inc.
2020-03-03
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 our consolidated financial statements and related notes appearing at the end of this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10-K, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties. As a result of many factors, including those factors set forth in the “Risk Factors” section of this Annual Report on Form 10-K, our actual results could 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 clinical-stage biotechnology company developing novel medicines to bring the curative power of immune reset to more patients with autoimmune diseases, blood cancers and genetic diseases. Resetting the immune system through stem cell transplant is a well-established and often curative medical procedure involving a two-step process: (i) removing the disease-causing cells and (ii) replacing them with healthy cells to rebuild the immune system. As it exists today, stem cell transplant is a large market opportunity, but currently only approximately 40 percent of eligible patients receive a curative immune reset because of the risks and toxicities associated with the transplant procedure. New approaches are needed to extend immune reset to more patients, including drugs to: collect sufficient stem cells to rebuild a healthy immune system, remove disease-causing cells and prevent complications in rebuilding the new immune system. At Magenta, we believe we are uniquely positioned to address these opportunities and to lead a new era in immune reset. Our portfolio of product candidates includes biologics, small molecules and a cell therapy designed as new approaches to extend the curative power of immune reset through transplant to more patients across many diseases. Currently, only a fraction of eligible patients with these diseases receive a transplant because the risks and challenges outweigh the potential for a cure. These include diseases where transplant is a standard of care (e.g., blood cancers such as acute myelogenous leukemia, myelodysplastic syndromes, multiple myeloma, and non-Hodgkin lymphoma), diseases where transplant is performed but limited in use (e.g., hemoglobinopathies such as sickle cell disease and beta-thalassemia) and autoimmune diseases (e.g., multiple sclerosis and systemic sclerosis). Emerging clinical data suggest that immune reset through stem cell transplant may represent a breakthrough approach with curative potential for patients with severe autoimmune diseases. For example, recent results from multiple clinical trials show that patients with autoimmune diseases, including multiple sclerosis and systemic sclerosis, can be cured with a transplant. However, based on our epidemiology analyses, currently only approximately 1 to 2% of eligible patients with these autoimmune diseases in the U.S. and Europe receive a stem cell transplant. To harness the curative power of immune reset through stem cell transplant for more patients, we have created a new stem cell biology discovery platform and are developing a comprehensive portfolio of novel therapeutics. Our programs will allow more patients to benefit through a more precise stem cell transplant process. This includes targeted conditioning medicines that remove the disease-causing cells before transplant (conditioning program), a medicine for stem cell collection for donors and patients (mobilization program) and a cell therapy with a high stem cell dose to rebuild a healthy immune system (cell therapy program). Our conditioning programs, including MGTA-117, are designed to selectively remove disease-causing stem and/or immune cells from a patient prior to transplant, and to be far less toxic than the decades-old radiation and chemotherapy-based approaches, which are still the only available options. Within our mobilization program, MGTA-145 is our first-line stem cell mobilization product candidate, and it is designed to enable physicians to more easily collect a greater number of blood stem cells, known as hematopoietic stem cells or HSCs, from patients and donors to improve patient outcomes and scale the capacity of transplant and apheresis centers. MGTA-456 is a cell therapy designed to provide a high dose of stem cells that are well matched to the patient, and it has the potential to allow more patients to have a better chance for a successful stem cell transplant. Our program to prevent post-transplant complications is designed to target the donor immune cells within the patient that cause Graft vs. Host Disease, or GvHD, and allow safe rebuilding of a healthy immune system (post-transplant complications program). We intend to become a fully integrated discovery, development and commercial company that will pioneer the field of immune reset. We believe that our product portfolio will offer significant commercial synergies. We are developing our products so that they can each be used individually or in combination with each other. As a result, our portfolio could be utilized in a manner tailored to the patient’s disease, such that a patient may receive more than one Magenta therapy as part of their individual immune reset journey. Since our inception in 2015, we have focused substantially all of our efforts and financial resources on organizing and staffing our company, business planning, raising capital, acquiring and developing our technology, identifying potential product candidates, and undertaking preclinical studies, and in the case of MGTA-456 and MGTA-145, clinical trials. We do not have any products approved for sale and have not generated any revenue from product sales. In June 2018, we completed an initial public offering, or IPO, of our common stock, pursuant to which we issued and sold 6,666,667 shares of common stock at a public offering price of $15.00 per share, resulting in net proceeds of $89.9 million after deducting underwriting discounts and commissions and other offering expenses. In May 2019, we issued and sold 4,887,500 shares of our common stock, including the underwriters’ exercise in full of their option to purchase additional shares of common stock, in a follow-on public offering at a public offering price of $13.25 per share, resulting in net proceeds of $60.3 million after underwriting discounts and commission and other offering expenses. Prior to our common stock offerings, we funded our operations primarily with proceeds from the sales of redeemable convertible preferred stock and issuance of convertible notes. 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 product candidates. Our net losses were $76.8 million and $57.5 million, respectively, for the years ended December 31, 2019 and 2018. As of December 31, 2019, we had an accumulated deficit of $179.5 million. We expect to continue to incur significant expenses and increasing operating losses for at least the next several years. We expect our expenses and capital requirements will increase substantially in connection with our ongoing activities, particularly as we: • continue enrollment in our Phase 2 clinical trials of MGTA-456 in patients with inherited metabolic disorders and in patients with blood cancer and initiate additional clinical trials for MGTA-145; • prepare for and initiate our preclinical studies and clinical trials of our product candidates, including MGTA-117; • develop any other future product candidates we may choose to pursue; • seek marketing approval for any of our product candidates that successfully complete clinical development, if any; • maintain compliance with applicable regulatory requirements; • develop and scale up our capabilities to support our ongoing preclinical activities and clinical trials for our product candidates and commercialization of any of our product candidates for which we obtain marketing approval, if any; • maintain, expand, protect and enforce our intellectual property portfolio; • develop and expand our sales, marketing and distribution capabilities for our product candidates for which we obtain marketing approval, if any; and • expand our operational, financial and management systems and increase personnel, including to support our clinical development and commercialization efforts and our operations as a public company. We will not generate revenue from product sales unless and until we successfully complete clinical development and obtain regulatory approval for our product candidates. If we obtain regulatory approval for any of our product candidates, we expect to incur significant expenses related to developing our commercialization capability to support product sales, marketing and distribution. Further, we expect to incur additional costs associated with operating as a public company. As a result, we will need substantial additional funding to support our continuing operations and pursue our growth strategy. Until such time as we can generate significant revenue from product sales, if ever, we expect to finance our operations through a combination of equity offerings, debt financings, collaborations, strategic alliances and marketing and distribution or licensing arrangements. We may be unable to raise additional funds or enter into such other agreements or arrangements when needed on favorable terms, or at all. If we fail to raise capital or enter into such agreements as, and when, needed, we may have to significantly delay, scale back or discontinue the development and commercialization of one or more of our product candidates. Because of the numerous risks and uncertainties associated with pharmaceutical product development, we are unable to accurately predict the timing or amount of increased expenses or when or if we will be able to achieve or maintain profitability. Even if we are able to generate product sales, we may not become profitable. If we fail to become profitable or are unable to sustain profitability on a continuing basis, then we may be unable to continue our operations at planned levels and be forced to reduce or terminate our operations. As of December 31, 2019, we had cash, cash equivalents and marketable securities of $145.7 million. We believe that our existing cash, cash equivalents and marketable securities will enable us to fund our operating expenses and capital expenditure requirements into the fourth quarter of 2021. See “-Liquidity and Capital Resources.” Components of Our Results of Operations Revenue To date, we have not generated any revenue from product sales and do not expect to generate any revenue from the sale of products in the foreseeable future. If our development efforts for our product candidates are successful and result in regulatory approval, we may generate revenue in the future from product sales. If we enter into license or collaboration agreements for any of our product candidates or intellectual property, we may generate revenue in the future from payments as a result of such license or collaboration agreements. We cannot predict if, when, or to what extent we will generate revenue from the commercialization and sale of our product candidates. We may never succeed in obtaining regulatory approval for any of our product candidates. Operating Expenses Research and Development Expenses Research and development expenses consist primarily of costs incurred for our research activities, including our drug discovery efforts, and the development of our product candidates, which include: • employee-related expenses, including salaries and related costs, and stock-based compensation expense, for employees engaged in research and development functions; • expenses incurred in connection with the preclinical and clinical development of our product candidates, including under agreements with contract research organizations, or CROs; • the cost of consultants and contract manufacturing organizations, or CMOs, that manufacture drug products for use in our preclinical studies and clinical trials; • facilities, depreciation and other expenses, which include direct and allocated expenses for rent and maintenance of facilities, insurance and supplies; and • payments made under third-party licensing agreements. We expense research and development costs to operations as incurred. Advance payments for goods or services to be received in the future for use in research and development activities are recorded as prepaid expenses. The prepaid amounts are expensed as the related goods are delivered or the services are performed. Our direct research and development expenses are tracked on a program-by-program basis and consist primarily of external costs, such as fees paid to consultants, central laboratories, contractors, CMOs and CROs in connection with our preclinical and clinical development activities. We do not allocate employee costs, costs associated with our platform technology or facility expenses, including depreciation or other indirect costs, to specific product development programs because these costs are deployed across multiple product development programs and, as such, are not separately classified. The successful development and commercialization of our product candidates is highly uncertain. This is due to the numerous risks and uncertainties, including the following: • successful completion of preclinical studies and clinical trials; • receipt and related terms of marketing approvals from applicable regulatory authorities; • raising additional funds necessary to complete clinical development of and commercialize our product candidates; • obtaining and maintaining patent, trade secret and other intellectual property protection and regulatory exclusivity for our product candidates; • making arrangements with third-party manufacturers, or establishing manufacturing capabilities, for both clinical and commercial supplies of our product candidates; • developing and implementing marketing and reimbursement strategies; • establishing sales, marketing and distribution capabilities and launching commercial sales of our products, if and when approved, whether alone or in collaboration with others; • acceptance of our products, if and when approved, by patients, the medical community and third-party payors; • effectively competing with other therapies; • obtaining and maintaining third-party coverage and adequate reimbursement; • protecting and enforcing our rights in our intellectual property portfolio; and • maintaining a continued acceptable safety profile of the products following approval. A change in the outcome of any of these variables with respect to the development of any of our product candidates would significantly change the costs and timing associated with the development of that product candidate. We may never succeed in obtaining regulatory approval for any 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 expect research and development costs to increase significantly for the foreseeable future as our product candidate development programs progress. However, we do not believe that it is possible at this time to accurately project total program- specific expenses through commercialization. There are numerous factors associated with the successful commercialization of any of our product candidates, including future trial design and various regulatory requirements, many of which cannot be determined with accuracy at this time based on our stage of development. Additionally, future commercial and regulatory factors beyond our control will impact our clinical development programs and plans. General and Administrative Expenses General and administrative expenses consist primarily of salaries and related costs, and stock-based compensation, for personnel in executive, finance and administrative functions. General and administrative expenses also include direct and allocated facility-related costs, insurance costs as well as professional fees for legal, patent, consulting, accounting and audit services. We anticipate that our general and administrative expenses will increase in the future as we increase our headcount to support our continued research activities and development of our product candidates. We also anticipate that we will incur increased costs associated with continuing to operate as a growing public company. Interest and Other Income, Net Interest and other income, net, consists of interest income and miscellaneous income and expense unrelated to our core operations. Income Taxes Since our inception, we have not recorded any U.S. federal or state income tax benefits for the net losses we have incurred in each year or for our earned research and orphan drug tax credits, due to our uncertainty of realizing a benefit from those items. As of December 31, 2019, we had net operating loss carryforwards for federal income tax purposes of $75.7 million, of which $17.5 million begin to expire in 2035 and $58.2 million can be carried forward indefinitely. As of December 31, 2019, we had net operating loss carryforwards for state income tax purposes of $78.1 million which begin to expire in 2035. As of December 31, 2019, we also had available research and orphan drug tax credit carryforwards for federal and state income tax purposes of $6.2 million and $1.6 million, respectively, which begin to expire in 2035 and 2030, respectively. Critical Accounting Policies and Significant Judgments and Estimates Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the U.S., or GAAP. The preparation of our consolidated financial statements and related disclosures requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, costs and expenses, and the disclosure of contingent assets and liabilities in our consolidated financial statements. We base our estimates on historical experience, known trends and events and various other factors that we believe are 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. We evaluate our estimates and assumptions on an ongoing basis. Our 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 included 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. Research and Development Expenses As part of the process of preparing our consolidated financial statements, we are required to estimate our accrued research and development expenses. This process involves reviewing open contracts and purchase orders, communicating with our applicable 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 actual costs. The majority of our service providers invoice us in arrears for services performed, on a pre-determined schedule or when contractual milestones are met; however, some require advance payments. We make estimates of our accrued expenses as of each balance sheet date in the consolidated financial statements based on facts and circumstances known to us at that time. We periodically confirm the accuracy of the estimates with the service providers and make adjustments if necessary. Examples of estimated accrued research and development expenses include fees paid to: • vendors in connection with the preclinical development activities; • CROs in connection with preclinical and clinical trials; • CMOs in connection with the production of preclinical and clinical trial materials; and • investigative sites in connection with clinical trials. We base our expenses related to preclinical studies and clinical trials on our estimates of the services received and efforts expended pursuant to quotes and contracts with multiple research institutions and CROs that conduct and manage preclinical studies and clinical trials 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 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 the 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 may result in reporting amounts that are too high or too low in any particular period. To date, there have not been any material adjustments to our prior estimates of accrued research and development expenses. Stock-Based Compensation We measure all stock options and other stock-based awards granted to employees and directors and, commencing January 1, 2019, to non-employees based on the fair value on the date of the grant and recognize compensation expense of those awards over the requisite service period, which is generally the vesting period of the respective award. Generally, we issue stock options and restricted stock awards, or RSAs, with either service-only vesting conditions and record expense using the straight-line method or service and performance vesting conditions and record expense using the graded-vesting method. We have historically granted stock options with exercise prices equivalent to the fair value of our common stock as of the date of the grant. The fair value of our common stock is based on quoted market prices. We estimate the fair value of each stock option award 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. Prior to the adoption of Accounting Standards Update, or ASU, 2018-07 on January 1, 2019, we measured the fair value of stock-based awards granted to non-employees on the date at which the related service was complete. Compensation expense was recognized over the period during which services were rendered by such non-employee consultants until completed. At the end of each financial reporting period prior to completion of the service, the fair value of these awards was re-measured using the then-current fair value of our common stock and updated assumption inputs in the Black-Scholes option-pricing model for options and the then-current fair value of our common stock for restricted stock. We do not estimate and apply a forfeiture rate as we have elected to account for forfeitures as they occur. 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: Research and Development Expenses Expenses related to our conditioning program increased primarily as a result of higher preclinical costs for manufacturing to support our investigational new drug, or IND, enabling studies and future clinical trials. The increase in expenses related to our mobilization program was due to an increase in clinical trial costs related to our MGTA-145 Phase 1 clinical trial, which was initiated in April 2019, partially offset by a decrease in preclinical costs. Expenses related to our cell therapy program increased primarily due to higher manufacturing costs to support the investigator-initiated Phase 2 clinical trial of MGTA-456 in patients with blood cancers that was initiated in December 2018 and our ongoing clinical trials. In addition, expenses related to our cell therapy program increased due to manufacturing process development. The increase in personnel related costs included in unallocated expenses was due to an increase in headcount in our research and development function. The decrease in consultant fees was primarily due to a decrease in stock-based compensation expense. Consultant fees for the years ended December 31, 2019 and 2018 included stock-based compensation expense of $1.6 million and $3.3 million, respectively. The increase in facility related and other costs was primarily due to higher facility costs related to the sublease agreement for our Cambridge, Massachusetts facility, which we entered into in May 2018. General and Administrative Expenses The increase in personnel related costs was primarily a result of an increase in headcount and an increase in stock-based compensation expense. Personnel related costs for the years ended December 31, 2019 and 2018 included stock-based compensation expense of $5.4 million and $4.5 million, respectively. The increase in professional and consultant fees was primarily due to an increase in costs associated with operating as a public company, as well as costs incurred for pre-commercialization activities. The increase in facility related and other costs was primarily due to higher facility costs related to the sublease agreement for our Cambridge, Massachusetts facility, which we entered into in May 2018, as well as director and officer insurance costs. Interest and Other Income, Net The increase in interest and other income, net was primarily due to an increase of $2.4 million of rental income from the sublease of a portion of our Cambridge, Massachusetts facility as well as an increase in interest income of $1.4 million resulting from the investment of the net proceeds from our follow-on public offering in May 2019, our IPO in June 2018, and our series C redeemable convertible preferred stock financing in April 2018. 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 Expenses related to our conditioning program increased primarily as a result of costs incurred in connection with our collaboration agreement with Heidelberg Pharma Research GmbH for an upfront technology access fee, research exclusivity fees, target-specific development options and payments for research support related to our drug discovery efforts, primarily lead optimization. Conditioning program costs also increased due to our proof of mechanism and ongoing lead optimization in non-human primate studies. The increase in expense related to our mobilization program was due to an increase in preclinical costs for toxicology studies and manufacturing to support our IND enabling studies. Expenses related to our cell therapy program decreased primarily as a result of the prior year cost of in-licensing technology of $9.3 million for the rights to MGTA-456 under a license agreement with Novartis International Pharmaceutical Ltd. This decrease was partially offset by increased clinical trial and manufacturing costs during the year ended December 31, 2018 incurred for our MGTA-456 Phase 2 trial for inherited metabolic disorders, which we initiated in December 2017, and preparation for planned additional clinical trials in indications beyond inherited metabolic disorders. The increase in spending related to our post-transplant complications program was due to costs related to our drug discovery efforts, primarily target validation. The increase in personnel related costs included in unallocated expenses was due to an increase in headcount and stock-based compensation expense in our research and development function. Personnel related costs for the year ended December 31, 2018 and 2017 included stock-based compensation expense of $2.7 million and $0.3 million, respectively. The increase in consultant fees was due to an increase in stock-based compensation issued to non-employees of $2.0 million, from $1.3 million for the year ended December 31, 2017 to $3.3 million for the year ended December 31, 2018. The increase in facility related and other costs was primarily due to higher facility costs related to the sublease agreement for our Cambridge, Massachusetts facility, which we entered into in May 2018. General and Administrative Expenses The increase in personnel related costs was primarily a result of an increase in stock-based compensation expense and an increase in headcount. Personnel related costs for the year ended December 31, 2018 and 2017 included stock-based compensation expense of $4.5 million and $0.6 million, respectively. The increase in professional and consultant fees was primarily due to an increase in patent costs and fees associated with operating as a public company. The increase in facility related and other costs was primarily due to higher facility costs related to the sublease agreement for our Cambridge, Massachusetts facility, which we entered into in May 2018, as well as director and officer insurance costs and an increase in information technology-related expenses. Interest and Other Income, Net The increase in interest and other income, net was primarily due to an increase in interest income of $1.9 million resulting from the investment of our net proceeds from our IPO in June 2018 and our sale of series C redeemable convertible preferred stock in April 2018. In addition, the increase was due to $0.4 million of rental income from the sublease of a portion of our Cambridge, Massachusetts facility. Liquidity and Capital Resources Since our inception, we have incurred significant operating losses. We have not yet commercialized any of our product candidates and we do not expect to generate revenue from sales of any product candidates for several years, if at all. In June 2018, we completed the IPO of our common stock, pursuant to which we issued and sold 6,666,667 shares of common stock at a public offering price of $15.00 per share, resulting in net proceeds of $89.9 million after deducting underwriting discounts and commissions and other offering expenses. In May 2019, we issued and sold 4,887,500 shares of our common stock, including the underwriters’ exercise in full of their option to purchase additional shares of common stock, in a follow-on public offering at a public offering price of $13.25 per share, resulting in net proceeds of $60.3 million after underwriting discounts and commissions and other offering expenses. Prior to our IPO and follow-on offering, we had funded our operations primarily with proceeds from the sales of redeemable convertible preferred stock and issuance of convertible notes. On August 8, 2019, we filed a shelf registration statement on Form S-3, or Shelf, with the Securities and Exchange Commission, or SEC, which covers the offering, issuance and sale by us of up to an aggregate of $350.0 million of our common stock, preferred stock, debt securities, warrants and/or units of any combination thereof. We simultaneously entered into a Sales Agreement with Cowen and Company, LLC, as sales agent, to provide for the issuance and sale by the Company of up to $100.0 million of our common stock from time to time in “at-the-market” offerings under the Shelf, which we refer to as the ATM Program. The Shelf was declared effective by the SEC on August 19, 2019. As of December 31, 2019, no sales have been made pursuant to the ATM Program. Cash Flows The following table summarizes our sources and uses of cash for each of the periods presented: Operating Activities During the year ended December 31, 2019, operating activities used $57.1 million of cash, primarily resulting from our net loss of $76.8 million, partially offset by non-cash charges of $10.8 million and cash provided by changes in our operating assets and liabilities of $8.8 million. Net cash provided by changes in our operating assets and liabilities for the year ended December 31, 2019 consisted primarily of a $5.0 million increase in deferred rent and a $5.2 million increase in accounts payable and accrued expenses and other current liabilities, partially offset by an increase of $1.4 million in prepaid expenses and other current assets. During the year ended December 31, 2018, operating activities used $41.9 million of cash, primarily resulting from our net loss of $57.5 million, partially offset by non-cash charges of $11.5 million and cash provided by changes in our operating assets and liabilities of $4.2 million. Net cash provided by changes in our operating assets and liabilities for the year ended December 31, 2018 consisted primarily of a $4.7 million increase in accounts payable and accrued expenses and other current liabilities, and a $1.2 million increase in long-term liabilities, all partially offset by an increase of $1.8 million in prepaid expenses and other current assets. During the year ended December 31, 2017, operating activities used $22.3 million of cash, primarily resulting from our net loss of $35.5 million, partially offset by non-cash charges of $11.9 million and cash provided by changes in our operating assets and liabilities of $1.3 million. Net cash provided by changes in our operating assets and liabilities for the year ended December 31, 2017 consisted primarily of a $2.2 million increase in accounts payable and accrued expenses, partially offset by an increase of $0.9 million in prepaid expenses and other current assets. Changes in accounts payable, accrued expenses and other current liabilities and prepaid expenses in both periods were generally due to growth in our business and the timing of vendor invoicing and payments. The increase in deferred rent was primarily due to a lease incentive received from our landlord related to our sublease agreement for our Cambridge, Massachusetts facility, which we entered into in May 2018. Investing Activities During the year ended December 31, 2019, net cash provided by investing activities was primarily attributable to net maturities of marketable securities of $4.6 million, partially offset by purchases of property and equipment of $3.1 million, consisting primarily of lab equipment and leasehold improvements. During the year ended December 31, 2018, net cash used in investing activities was primarily attributable to purchases of marketable securities of $84.0 million and purchases of property and equipment of $7.7 million primarily related to leasehold improvements and lab equipment for our Cambridge, Massachusetts facility. During the year ended December 31, 2017, we used $2.2 million to purchase property and equipment. Financing Activities During the year ended December 31, 2019, net cash provided by financing activities was $62.3 million, consisting of proceeds from our follow-on public offering, net of underwriting discounts, commissions and offering costs, of $60.3 million and proceeds from the exercise of stock options of $2.0 million. During the year ended December 31, 2018, net cash provided by financing activities was $142.1 million, consisting primarily of proceeds from our IPO, net of underwriting discounts, commissions and offering costs, of $89.9 million and net proceeds of $52.2 million from the sale of series C redeemable convertible preferred stock. During the year ended December 31, 2017, net cash provided by financing activities was $71.5 million, consisting primarily of $6.3 million of the remaining proceeds received in January 2017 from the sale of series A redeemable convertible preferred stock that we recorded as other receivable as of December 31, 2016, $15.4 million of proceeds from the sale of additional shares of series A redeemable convertible preferred stock and $49.8 million of net proceeds received from the sale of series B redeemable convertible preferred stock. Funding Requirements We expect our expenses to increase substantially in connection with our ongoing activities, particularly as we advance the preclinical activities and clinical trials for our product candidates in development. In addition, we expect to incur additional costs associated with operating as a public company. The timing and amount of our operating expenditures will depend largely on: • the initiation, progress, timing, costs and results of current and future preclinical studies and clinical trials for our product candidates; • the clinical development plans we establish for these product candidates; • the number and characteristics of product candidates that we develop or may in-license; • the terms of any collaboration agreements we may choose to conclude; • the outcome, timing and cost of meeting and maintaining compliance with regulatory requirements established by the Food and Drug Administration, the European Medical Agency and other comparable foreign regulatory authorities; • the cost of filing, prosecuting, defending and enforcing our patent claims and other intellectual property rights; • the cost of defending intellectual property disputes, including patent infringement actions brought by third parties against us; • the effect of existing or new competing technological and market developments; • the cost and timing of completion of commercial-scale outsourced manufacturing activities; and • the cost of establishing sales, marketing and distribution capabilities for any product candidates for which we may receive regulatory approval in regions where we choose to commercialize our products on our own. As of December 31, 2019, we had cash, cash equivalents and marketable securities of $145.7 million. We believe that our existing cash, cash equivalents and marketable securities will enable us to fund our operating expenses and capital expenditure requirements into the fourth quarter of 2021. We have based these estimates on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we expect. Because of the numerous risks and uncertainties associated with research, development and commercialization of pharmaceutical product candidates, we are unable to estimate the exact amount of our working capital requirements. Our future funding requirements will depend on and could increase significantly as a result of many factors, including those listed above. Until such time, if ever, as we can generate substantial product revenue, we expect to finance our operations through a combination of equity offerings, including sales under our ATM Program, debt financings, collaborations, strategic alliances and marketing, distribution or licensing arrangements. We do not currently have any committed external source of funds. To the extent that we raise additional capital through the sale of equity or convertible debt securities, our stockholders’ ownership interest will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect our stockholders’ rights as a common stockholder. Debt financing and preferred 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 acquisitions or capital expenditures or declaring dividends. If we raise additional funds through collaborations, strategic alliances or marketing, distribution 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. If we are unable to raise additional funds through equity or debt financings or other arrangements when needed, we may be required to delay, limit, reduce or terminate our research, 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. Contractual Obligations and Commitments The following summarizes our principal contractual obligations and commitments as of December 31, 2019 and the effects such obligations are expected to have on our liquidity and cash flow in future periods: (1) In May 2018, we entered into a sublease, as amended, for up to approximately 69,000 square feet of office and laboratory space in Cambridge, Massachusetts. The term of the lease expires in February 2028. We enter into contracts in the normal course of business with CROs, CMOs and other third parties for clinical trials, preclinical research studies and testing and manufacturing services. These contracts are cancelable by us upon prior written notice. Payments due upon cancellation consist only of payments for services provided or expenses incurred, including noncancelable obligations of our service providers, up to the date of cancellation. These payments are not included in the preceding table as the amount and timing of such payments are not known. We have also entered into license and collaboration agreements with third parties, which are in the normal course of business. We have not included future payments under these agreements in the table of contractual obligations above since obligations under these agreements are contingent upon future events such as our achievement of specified development, regulatory, and commercial milestones, or royalties on net product sales. As of December 31, 2019, we were unable to estimate the timing or likelihood of achieving these milestones or generating future product sales. 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. Recently Issued and Adopted Accounting Pronouncements 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 included in this Annual Report on Form 10-K.
0.034913
0.035008
0
<s>[INST] Overview We are a clinicalstage biotechnology company developing novel medicines to bring the curative power of immune reset to more patients with autoimmune diseases, blood cancers and genetic diseases. Resetting the immune system through stem cell transplant is a wellestablished and often curative medical procedure involving a twostep process: (i) removing the diseasecausing cells and (ii) replacing them with healthy cells to rebuild the immune system. As it exists today, stem cell transplant is a large market opportunity, but currently only approximately 40 percent of eligible patients receive a curative immune reset because of the risks and toxicities associated with the transplant procedure. New approaches are needed to extend immune reset to more patients, including drugs to: collect sufficient stem cells to rebuild a healthy immune system, remove diseasecausing cells and prevent complications in rebuilding the new immune system. At Magenta, we believe we are uniquely positioned to address these opportunities and to lead a new era in immune reset. Our portfolio of product candidates includes biologics, small molecules and a cell therapy designed as new approaches to extend the curative power of immune reset through transplant to more patients across many diseases. Currently, only a fraction of eligible patients with these diseases receive a transplant because the risks and challenges outweigh the potential for a cure. These include diseases where transplant is a standard of care (e.g., blood cancers such as acute myelogenous leukemia, myelodysplastic syndromes, multiple myeloma, and nonHodgkin lymphoma), diseases where transplant is performed but limited in use (e.g., hemoglobinopathies such as sickle cell disease and betathalassemia) and autoimmune diseases (e.g., multiple sclerosis and systemic sclerosis). Emerging clinical data suggest that immune reset through stem cell transplant may represent a breakthrough approach with curative potential for patients with severe autoimmune diseases. For example, recent results from multiple clinical trials show that patients with autoimmune diseases, including multiple sclerosis and systemic sclerosis, can be cured with a transplant. However, based on our epidemiology analyses, currently only approximately 1 to 2% of eligible patients with these autoimmune diseases in the U.S. and Europe receive a stem cell transplant. To harness the curative power of immune reset through stem cell transplant for more patients, we have created a new stem cell biology discovery platform and are developing a comprehensive portfolio of novel therapeutics. Our programs will allow more patients to benefit through a more precise stem cell transplant process. This includes targeted conditioning medicines that remove the diseasecausing cells before transplant (conditioning program), a medicine for stem cell collection for donors and patients (mobilization program) and a cell therapy with a high stem cell dose to rebuild a healthy immune system (cell therapy program). Our conditioning programs, including MGTA117, are designed to selectively remove diseasecausing stem and/or immune cells from a patient prior to transplant, and to be far less toxic than the decadesold radiation and chemotherapybased approaches, which are still the only available options. Within our mobilization program, MGTA145 is our firstline stem cell mobilization product candidate, and it is designed to enable physicians to more easily collect a greater number of blood stem cells, known as hematopoietic stem cells or HSCs, from patients and donors to improve patient outcomes and scale the capacity of transplant and apheresis centers. MGTA456 is a cell therapy designed to provide a high dose of stem cells that are well matched to the patient, and it has the potential to allow more patients to have a better chance for a successful stem cell transplant. Our program to prevent posttransplant complications is designed to target the donor immune cells within the patient that cause Graft vs. Host Disease, or GvHD, and allow safe rebuilding of a healthy immune system (posttransplant complications program). We intend to become a fully integrated discovery, development and commercial company that will pioneer the field of immune reset. We believe that our product portfolio will offer significant commercial synergies. We are developing our products so that they can each be used individually or in combination with each other. [/INST] Positive. </s>
2,020
6,541
1,467,623
DROPBOX, INC.
2019-02-25
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 section titled “Selected Consolidated Financial and Other Data” and 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. Overview Our modern economy runs on knowledge. Today, knowledge lives in the cloud as digital content, and Dropbox is a global collaboration platform where more and more of this content is created, accessed, and shared with the world. We serve more than 500 million registered users across 180 countries. Since our founding in 2007, our market opportunity has grown as we’ve expanded from keeping files in sync to keeping teams in sync. We believe the need for our platform will continue to grow as teams become more fluid and global, and content is increasingly fragmented across incompatible tools and devices. Dropbox breaks down silos by centralizing the flow of information between the products and services our users prefer, even if they’re not our own. By solving these universal problems, we’ve become invaluable to our users. The popularity of our platform drives viral growth, which has allowed us to scale rapidly and efficiently. We’ve built a thriving global business with 12.7 million paying users. Our Subscription Plans We generate revenue from individuals, teams, and organizations by selling subscriptions to our platform, which serve the varying needs of our diverse customer base. Subscribers can purchase individual licenses through our Plus and Professional plans, or purchase multiple licenses through a Standard, Advanced, or Enterprise team plan. Each team represents a separately billed deployment that is managed through a single administrative dashboard. Teams must have a minimum of three users, but can also have more than tens of thousands of users. Customers can choose between an annual or monthly plan, with a small number of large organizations on multi-year plans. A majority of our customers opt for our annual plans. We typically bill our customers at the beginning of their respective terms and recognize revenue ratably over the term of the subscription period. International customers can pay in U.S. dollars or a select number of foreign currencies. Our premium subscription plans, such as Professional and Advanced, provide more functionality than other subscription plans and have higher per user prices. Our Standard and Advanced subscription plans offer robust capabilities for businesses, and the vast majority of Dropbox Business teams purchase our Standard or Advanced subscription plans. While our Enterprise subscription plan offers more opportunities for customization, companies can subscribe to any of these team plans for their business needs. Our Customers Our customer base is highly diversified, and in the period presented, no customer accounted for more than 1% of our revenue. Our customers include individuals, teams, and organizations of all sizes, from freelancers and small businesses to Fortune 100 companies. They work across a wide range of industries, including professional services, technology, media, education, industrials, consumer and retail, and financial services. Within companies, our platform is used by all types of teams and functions, including sales, marketing, product, design, engineering, finance, legal, and human resources. Our Business Model Drive new signups We acquire users efficiently and at relatively low costs through word-of-mouth referrals, direct in-product referrals, and sharing of content. Anyone can create a Dropbox account for free through our website or app and be up and running in minutes. These users often share and collaborate with other non-registered users, attracting new signups into our network. Increase conversion of registered users to our paid subscription plans We generate over 90% of our revenue from self-serve channels-users who purchase a subscription through our app or website. We actively encourage our registered users to become paying users through in-product prompts and notifications, time-limited free trials of paid subscription plans, email campaigns, and lifecycle marketing. Upgrade and expand existing customers We offer a range of paid subscription plans, from Plus and Professional for individuals to Standard, Advanced, and Enterprise for teams. We analyze usage patterns within our network and run hundreds of targeted marketing campaigns to encourage paying users to upgrade their plans. We prompt individual subscribers who collaborate with others on Dropbox to purchase our Standard or Advanced plans for a better team experience, and we also encourage existing Dropbox Business teams to purchase additional licenses or to upgrade to premium subscription plans. Key Business Metrics We review a number of operating and financial metrics, including the following key metrics to evaluate our business, measure our performance, identify trends affecting our business, formulate business plans, and make strategic decisions. Paying users We define paying users as the number of users who have active paid licenses for access to our platform as of the end of the period. One person would count as multiple paying users if the person had more than one active license. For example, a 50-person Dropbox Business team would count as 50 paying users, and an individual Dropbox Plus user would count as one paying user. If that individual Dropbox Plus user was also part of the 50-person Dropbox Business team, we would count the individual as two paying users. As of December 31, 2018, across all of our paying users, more than 30% subscribe to a Dropbox team plan while the remainder are on a Dropbox individual plan. We have experienced growth in the number of paying users across our products, with the majority of paying users for the periods presented coming from our self-serve channels. The below table sets forth the number of paying users as of December 31, 2018, 2017, and 2016: Average revenue per paying user We define average revenue per paying user, or ARPU, as our revenue for the period presented divided by the average paying users during the same period. For interim periods, we use annualized revenue, which is calculated by dividing the revenue for the particular period by the number of days in that period and multiplying this value by 365 days. Average paying users are calculated based on adding the number of paying users as of the beginning of the period to the number of paying users as of the end of the period, and then dividing by two. In 2017, we launched our Dropbox Business Advanced plan. At the time of launch, we grandfathered existing Dropbox Business teams into the Dropbox Business Advanced plan at their legacy price. During the second quarter of 2018, a significant portion of those grandfathered teams renewed at a higher price. As a result of these renewals, and combined with an increased mix of sales towards our higher-priced subscription plans, we experienced an increase in our average revenue per paying user for the year ended December 31, 2018, compared to the year ended December 31, 2017. Our ARPU increased for the year ended December 31, 2017, compared to the year ended December 31, 2016, primarily due to an increased mix of sales towards our higher priced subscription plans, including our Dropbox Business Advanced plan launched in early 2017. The below table sets forth our ARPU for the years ended December 31, 2018, 2017, and 2016. Non-GAAP Financial Measure In addition to our results determined in accordance with U.S. generally accepted accounting principles, or GAAP, we believe that free cash flow, or FCF, a non-GAAP financial measure, is useful in evaluating our liquidity. Free cash flow We define FCF as GAAP net cash provided by operating activities less capital expenditures. We believe that FCF is a liquidity measure and that it provides useful information regarding cash provided by operating activities and cash used for investments in property and equipment required to maintain and grow our business. FCF is presented for supplemental informational purposes only and should not be considered a substitute for financial information presented in accordance with GAAP. FCF has limitations as an analytical tool, and it should not be considered in isolation or as a substitute for analysis of other GAAP financial measures, such as net cash provided by operating activities. Some of the limitations of FCF are that FCF does not reflect our future contractual commitments, excludes investments made to acquire assets under capital leases, and may be calculated differently by other companies in our industry, limiting its usefulness as a comparative measure. Our FCF increased for the year ended December 31, 2018, compared to the year ended December 31, 2017, primarily due to higher cash provided by operating activities, which was driven by increased subscription sales, as a majority of our paying users are invoiced in advance. These cash inflows were partially offset by an increase in capital expenditures primarily related to the build-out of our new corporate headquarters. Our FCF increased for the year ended December 31, 2017, compared to the year ended December 31, 2016, primarily due to higher cash provided by operating activities, which was driven by increased subscription sales, as a majority of our paying users are invoiced in advance. In addition, FCF increased due to a decrease in capital expenditures related to our office and datacenter build-outs. We expect our FCF to fluctuate in future periods as we purchase infrastructure equipment to support our user base and invest in our new and existing office spaces, including our new corporate headquarters, to support our plans for growth. These activities, along with certain increased operating expenses as described below, may result in a decrease in FCF as a percentage of revenue in future periods. The following is a reconciliation of FCF to the most comparable GAAP measure, net cash provided by operating activities: Components of Our Results of Operations Revenue We generate revenue from sales of subscriptions to our platform. Revenue is recognized ratably over the related contractual term generally beginning on the date that our platform is made available to a customer. Our subscription agreements typically have monthly or annual contractual terms, although a small percentage have multi-year contractual terms. Our agreements are generally non-cancelable. We typically bill in advance for monthly contracts and annually in advance for contracts with terms of one year or longer. Amounts that have been billed are initially recorded as deferred revenue until the revenue is recognized. Our revenue is driven primarily by the number of paying users and the price we charge for access to our platform, which varies based on the type of plan to which a customer subscribes. We generate over 90% of our revenue from self-serve channels. No customer represented more than 1% of our revenue in the periods presented. Cost of revenue and gross margin Cost of revenue. Our cost of revenue consists primarily of expenses associated with the storage, delivery, and distribution of our platform for both paying users and free users, also known as Basic users. These costs, which we refer to as infrastructure costs, include depreciation of our servers located in co-location facilities that we lease and operate, rent and facilities expense for those datacenters, network and bandwidth costs, support and maintenance costs for our infrastructure equipment, and payments to third-party datacenter service providers. Cost of revenue also includes costs, such as salaries, bonuses, employer payroll taxes and benefits, travel-related expenses, and stock-based compensation, which we refer to as employee-related costs, for employees whose primary responsibilities relate to supporting our infrastructure and delivering user support. Other non-employee costs included in cost of revenue include credit card fees related to processing customer transactions, and allocated overhead, such as facilities, including rent, utilities, depreciation on leasehold improvements and other equipment shared by all departments, and shared information technology costs. In addition, cost of revenue includes amortization of developed technologies, professional fees related to user support initiatives, and property taxes related to the datacenters. In recent years, we have taken several steps to improve the efficiency of the infrastructure that supports our platform. These efforts include an initiative that focused on migrating the vast majority of user data stored on the infrastructure of third-party service providers to our own lower cost, custom-built infrastructure in co-location facilities that we directly lease and operate. In order to host user data on our own infrastructure, we leased or purchased infrastructure that is depreciated within our cost of revenue. During the migration to our internal infrastructure, we duplicated our users’ data between our internal infrastructure and that of our third-party service providers, resulting in higher storage costs. We reduced this practice over time until we completed the migration in the fourth quarter of 2016. Related to this initiative, we no longer duplicate data between our internal infrastructure and that of any third-party service providers. We expect to continue to realize benefits from expanding our internal infrastructure due to our operating scale and lower unit costs. Starting in 2016, we also took measures to manage the storage footprint of certain long-inactive Basic users, freeing up additional storage capacity. Specifically, we closed the accounts of certain Basic users who had not engaged in any activity on the Dropbox platform in the last year and did not respond to multiple e-mail inquiries from us regarding their inactivity. We continue to regularly take similar measures to manage long-inactive and non-responsive Basic user accounts, and our total registered user numbers do not include accounts that have been closed. This effort, along with additional usage optimizations in 2017, enabled us to continue operating our business within our existing infrastructure base without a need for extensive incremental capital expenditures and leasing activity. These efforts are collectively referred to as our Infrastructure Optimization, and some are ongoing. Our Infrastructure Optimization reduced unit costs and helped limit capital expenditures and associated depreciation. Combined with the concurrent increase in our base of paying users, we experienced a reduction in our cost of revenue, an increase in our gross margins, and an improvement in our free cash flow in the periods presented. During the first quarter of 2018, based on considerations including our asset replacement cycle and our ongoing Infrastructure Optimization efforts, we revisited the useful life estimates of certain infrastructure equipment. These optimization efforts include efficiencies that allow us to utilize certain infrastructure equipment for longer periods of time. As a result, we determined that the useful lives of the impacted infrastructure equipment, which are depreciated through cost of revenue, should be increased from three to four years. We accounted for this as a change in estimate that was applied prospectively, effective as of January 1, 2018. This change in useful life resulted in a reduction in depreciation expense within cost of revenue of $16.1 million during the year ended December 31, 2018. We plan to continue increasing the capacity and enhancing the capability and reliability of our infrastructure to support user growth and increased use of our platform. We expect that cost of revenue, excluding the impact of certain stock-based compensation charges described in “-Significant Impacts of Stock-Based Compensation”, will increase in absolute dollars in future periods. In addition, as a result of certain stock-based compensation charges described in “-Significant Impacts of Stock-Based Compensation”, our cost of revenue increased significantly in absolute dollars during the year ended December 31, 2018 due to the completion of our initial public offering. Gross margin. Gross margin is gross profit expressed as a percentage of revenue. Our gross margin may fluctuate from period to period based on the timing of additional capital expenditures and the related depreciation expense, or other increases in our infrastructure costs, as well as revenue fluctuations. As we continue to increase the utilization of our internal infrastructure, we generally expect our gross margin, excluding the impact of certain stock-based compensation charges described in “-Significant Impacts of Stock-Based Compensation”, to remain relatively constant in the near term and to increase modestly in the long term. Operating expenses Research and development. Our research and development expenses consist primarily of employee-related costs for our engineering, product, and design teams, and allocated overhead. Additionally, research and development expenses include internal development-related third-party hosting fees. We have expensed almost all of our research and development costs as they were incurred. We plan to continue to hire employees for our engineering, product, and design teams to support our research and development efforts. We expect that research and development costs will increase in absolute dollars in future periods and, excluding the impact of certain stock-based compensation charges described in “-Significant Impacts of Stock-Based Compensation”, vary from period to period as a percentage of revenue. Sales and marketing. Our sales and marketing expenses relate to both self-serve and outbound sales activities, and consist primarily of employee-related costs, brand marketing costs, lead generation costs, sponsorships and allocated overhead. Sales commissions earned by our outbound sales team and the related payroll taxes, as well as commissions earned by third-party resellers that we consider to be incremental and recoverable costs of obtaining a contract with a user, are deferred and amortized over an estimated period of benefit of five years. Additionally, sales and marketing expenses include non-employee costs related to app store fees and fees payable to third-party sales representatives. We plan to continue to invest in sales and marketing to grow our user base and increase our brand awareness, including marketing efforts to continue to drive our self-serve business model. We expect that sales and marketing expenses will increase in absolute dollars in future periods and, excluding the impact of certain stock-based compensation charges described in “-Significant Impacts of Stock-Based Compensation”, vary from period to period as a percentage of revenue. The trend and timing of sales and marketing expenses will depend in part on the timing of marketing campaigns. General and administrative. Our general and administrative expenses consist primarily of employee-related costs for our legal, finance, human resources, and other administrative teams, as well as certain executives. In addition, general and administrative expenses include allocated overhead, outside legal, accounting and other professional fees, non-income based taxes, and contributions to the Dropbox Charitable Foundation. We expect to incur additional general and administrative expenses to support the growth of the Company as well as our transition to being a publicly traded company, which includes the recognition of stock-based compensation expense related to grants of restricted stock made to our co-founders. We expect that general and administrative expenses will increase in absolute dollars in future periods and, excluding the impact of certain stock-based compensation charges described in “-Significant Impacts of Stock-Based Compensation”, vary from period to period as a percentage of revenue. As a result of certain stock-based compensation charges described in “-Significant Impacts of Stock-Based Compensation”, our research and development, sales and marketing, and general and administrative expenses increased significantly in absolute dollars and as a percentage of revenue during the year ended December 31, 2018 due to the completion of our initial public offering. Interest income (expense), net Interest income (expense), net consists primarily of interest income earned from our money market funds classified as cash and cash equivalents and short-term investments, partially offset by interest expense related to our capital lease obligations for infrastructure and our imputed financing obligation for our liability to the legal owner of our previous corporate headquarters. Beginning in the fourth quarter of 2018, we no longer incur interest expense for our imputed financing obligation due to the termination of our master lease for our previous corporate headquarters in the third quarter of 2018. Other income, net Other income, net consists of other non-operating gains or losses, including those related to lease arrangements, which include ongoing subleases. Sublease income in excess of our original lease obligation is split with the original lessor per the terms of the sublease agreement, with our portion recorded to other income, net. Other income, net also includes foreign currency transaction gains and losses, and realized gains and losses related to our short-term investments. Provision for income taxes Provision for income taxes consists primarily of U.S. federal and state income taxes and income taxes in certain foreign jurisdictions in which we conduct business. For the periods presented, the difference between the U.S. statutory rate and our effective tax rate is primarily due to the valuation allowance on deferred tax assets. Our effective tax rate is also impacted by earnings realized in foreign jurisdictions with statutory tax rates lower than the federal statutory tax rate. We maintain a full valuation allowance on our net deferred tax assets for federal, state, and certain foreign jurisdictions as we have concluded that it is not more likely than not that the deferred assets will be realized. As of December 31, 2018, we had $923.6 million of federal and $403.5 million of state net operating loss carryforwards available to reduce future taxable income. Of our federal net operating loss carryforwards, $307.4 million will begin to expire in 2031 and $616.2 million will carryforward indefinitely, while state net operating losses begin to expire in 2029. As of December 31, 2018, we also had $265.1 million of foreign net operating loss carryforwards available to reduce future taxable income, which will carryforward indefinitely. In addition, we had $22.9 million of foreign acquired net operating losses, which will carryforward indefinitely. It is possible that we will not generate taxable income in time to use these net operating loss carryforwards before their expiration. In addition, under Section 382 and 383 of the Internal Revenue Code of 1986, as amended, or the Code, if a corporation undergoes an “ownership change,” the corporation’s ability to use its pre-change net operating loss carryforwards and other pre-change attributes, such as research tax credits, to offset its post-change income may be limited. In general, an “ownership change” will occur if there is a cumulative change in our ownership by “5-percent shareholders” that exceeds 50 percentage points over a rolling three-year period. Similar rules may apply under state tax laws. We performed a study for the period through December 31, 2018, and determined that no ownership changes exceeding 50 percentage points have occurred. Our ability to use net operating loss and tax credit carryforwards to reduce future taxable income and liabilities may be subject to annual limitations as a result of ownership changes from January 1, 2019, and subsequent years. The Tax Cuts and Jobs Act, or the Tax Reform Act, was enacted on December 22, 2017 and provides for significant changes to U.S. tax law. Among other provisions, the Tax Reform Act reduces the U.S. corporate income tax rate to 21% effective in 2018. The Tax Reform Act also contains a number of provisions that may impact us in future years. At December 31, 2017, we had not completed our accounting for all of the enactment-date income tax effects of the Tax Reform Act for remeasurement of deferred tax assets and liabilities, one-time transition tax, and tax on global intangible low-taxed income. During the twelve months ended December 31, 2018 we completed our accounting for all of the enactment-date income tax effects of the Tax Reform Act. Upon completing our analysis, we have recognized no material adjustments to our provisional amounts recorded for the year ended December 31, 2017. We continue to monitor ongoing guidance in this area, as the U.S. Treasury Department, the IRS, and other standard-setting bodies could interpret or issue guidance on how provisions of the Tax Reform Act will be applied or otherwise administered that is different from our interpretation. As a result of the reduction in the corporate rate, we remeasured our U.S. deferred tax assets and liabilities as of December 31, 2017 to reflect the lower rate expected to apply when these temporary differences reverse. As of December 31, 2017, we determined the remeasurement resulted in a reduction in deferred tax assets of $63.1 million, which was fully offset by a corresponding change to our valuation allowance. There were no material changes from provisional amounts recorded for the year ended December 31, 2017. The Tax Reform Act repeals the corporate alternative minimum tax, or AMT, effective beginning in 2018 and permits AMT credit carryforwards to be refunded to the extent unused through 2021. Since we do not anticipate the use of these credits to reduce future federal taxes, we recognized an income tax benefit and established an income tax receivable to reflect anticipated refunds of $1.4 million for our 2016 AMT credit carryforward during the year ended December 31, 2018. There were no material changes from provisional amounts recorded for the year ended December 31, 2017. The Tax Reform Act also provides for a transition to a new territorial system of taxation and generally requires companies to include certain untaxed foreign earnings of non-U.S. subsidiaries into taxable income in 2017, or the Transition Tax. As a result of the cumulative deficits in our foreign subsidiaries, we have no Transition Tax inclusion. The Tax Reform Act subjects a U.S. shareholder to current tax on global intangible low-taxed income (GILTI) earned by certain foreign subsidiaries. The FASB Staff Q&A, Topic 740 No. 5, Accounting for Global Intangible Low-Taxed Income, states that an entity can make an accounting policy election to either recognize deferred taxes for temporary differences expected to reverse as GILTI in future years or provide for the tax expense related to GILTI in the year the tax is incurred. We have elected to recognize the tax on GILTI as a period expense in the period the tax is incurred. As a result of the tested losses in our foreign subsidiaries under GILTI regulations, we have no GILTI inclusion for the year ended December 31, 2018. Results of Operations The following tables set forth our results of operations for the periods presented and as a percentage of our total revenue for those periods: (1) Includes stock-based compensation as follows: (2) During the year ended December 31, 2018, we recognized the cumulative unrecognized stock-based compensation of $418.7 million related to our two-tier restricted stock units upon the effectiveness of our registration statement for our IPO. Refer to "Significant Impacts of Stock-Based Compensation" included elsewhere in this Annual Report on Form 10-K for further information. Comparison of the year ended December 31, 2018 and 2017 Revenue Revenue increased $284.9 million or 26% during the year ended December 31, 2018, as compared to the year ended December 31, 2017. This increase was primarily due to a 16% increase in the number of paying users between periods. The average revenue per paying user also increased between periods primarily due to an increased mix of sales towards our higher priced subscription plans, including our Dropbox Business Advanced plan launched in early 2017. Cost of revenue, gross profit, and gross margin Cost of revenue increased $25.8 million or 7% during the year ended December 31, 2018, as compared to the year ended December 31, 2017, primarily due to an increase of $34.8 million in stock-based compensation, which included expense recognized due to the achievement of the performance vesting condition of our two-tier RSUs upon the effectiveness of the registration statement related to our IPO. Cost of revenue also increased due to $10.1 million in credit card transaction fees due to higher sales and professional fees for user support, and $4.3 million in overhead-related costs. These increases were partially offset by a decrease of $23.3 million in our infrastructure costs primarily due to continued infrastructure usage optimization efforts, which included a reduction in depreciation expense due to the change in depreciable useful life of certain of our infrastructure equipment, which was effective on January 1, 2018. Our gross margin increased from 67% during the year ended December 31, 2017 to 72% during the year ended December 31, 2018, primarily due to a 26% increase in our revenue during the period and a decrease in our infrastructure costs as described above. The increase in gross margin was partially offset by the increase in stock-based compensation from the achievement of the performance vesting condition related to our two-tier RSUs upon the effectiveness of the registration statement related to our IPO. Research and development Research and development expenses increased $387.9 million or 102% during the year ended December 31, 2018, as compared to the year ended December 31, 2017, primarily due to an increase of $275.1 million in stock-based compensation, which included expense recognized due to the achievement of the performance vesting condition of our two-tier RSUs upon the effectiveness of the registration statement related to our IPO. Further, the increase in research and development expense was due to an increase of $61.8 million in employee-related expenses, excluding stock-based compensation, which was due to headcount growth and employer payroll taxes related to the release of our two-tier RSUs, and an increase of $39.9 million in overhead-related costs. Sales and marketing Sales and marketing expenses increased $125.6 million or 40% during the year ended December 31 2018, as compared to the year ended December 31, 2017, primarily due to an increase of $60.6 million in stock-based compensation, which included expense recognized due to the achievement of the performance vesting condition of our two-tier RSUs upon the effectiveness of the registration statement related to our IPO. Sales and marketing expenses also increased $22.3 million due to brand marketing costs, lead generation costs, third-party sales representative fees, and sponsorships. In addition, the increase in sales and marketing expense was due to an increase of $17.5 million in employee-related expenses, excluding stock-based compensation, which was due to headcount growth and employer payroll taxes related to the release of our two-tier RSUs, and an increase of app store fees as a result of increased sales. General and administrative General and administrative expenses increased $125.9 million or 80% during the year ended December 31, 2018, as compared to the year ended December 31, 2017, primarily due to an increase of $115.0 million in stock-based compensation, which included expense recognized due to the achievement of the performance vesting condition of our two-tier RSUs, and the performance-based vesting condition for the Co-Founder Grants in connection with our IPO. In addition, general and administrative expenses increased $12.0 million due to employee-related expenses, excluding stock-based compensation, due to headcount growth and employer payroll taxes related to the release of our two-tier RSUs. These increases were offset by a decrease of $11.3 million in contributions to the Dropbox Charitable Foundation, of which $9.4 million was a non-cash contribution of Class A common stock for its initial funding, and $1.9 million was related to cash contributions made during the year ended December 31, 2017. Interest income (expense), net Interest income (expense), net increased $18.1 million during the year ended December 31, 2018, as compared to the year ended December 31, 2017, primarily due to an increase in interest income from our money market funds and short-term investments of $13.8 million, and a decrease of interest expense of $4.2 million due to fewer assets acquired under capital leases. Other income, net Other income, net decreased $6.4 million during the year ended December 31, 2018, as compared to the year ended December 31, 2017, primarily due to foreign currency losses of $1.9 million during the year ended December 31, 2018, compared to foreign currency gains of $5.0 million during the year ended December 31, 2017, primarily related to monetary assets and liabilities denominated in euros and pounds. Provision for income taxes Provision for income taxes increased by $4.6 million during the year ended December 31, 2018 as compared to the year ended December 31, 2017, primarily as a result of an increase in foreign taxes and the one-time benefit recorded during the year ended December 31, 2017 from the repeal of the AMT pursuant to the Tax Reform Act. Comparison of the year ended December 31, 2017 and 2016 Revenue Revenue increased $262.0 million or 31% during the year ended December 31, 2017 as compared to the year ended December 31, 2016. This increase was primarily due to a 25% increase in the number of paying users between periods. The average revenue per paying user also increased slightly between periods primarily due to an increased mix of sales towards our higher priced subscription plans, including our Dropbox Business Advanced plan launched in early 2017. Cost of revenue, gross profit, and gross margin Cost of revenue decreased $21.7 million or 6% during the year ended December 31, 2017, as compared to the year ended December 31, 2016, primarily due to a $35.1 million decrease in our infrastructure costs due to our Infrastructure Optimization. Further, the decrease in cost of revenue was due to a $5.9 million decrease in amortization of developed technologies, as certain intangible assets became fully amortized during 2016. These decreases were partially offset by an increase of $11.0 million in employee-related expenses, which was due to headcount growth, and an increase of $8.3 million in credit card transaction fees and professional fees for user support. Our gross margin increased from 54% during the year ended December 31, 2016 to 67% during the year ended December 31, 2017 primarily due to a 31% increase in our revenue during the period and our Infrastructure Optimization. Research and development Research and development expenses increased $90.6 million or 31% during the year ended December 31, 2017, as compared to the year ended December 31, 2016, primarily due to an increase of $64.7 million in employee-related expenses, which was due to headcount growth. Further, the increase in research and development expense was due to an increase of $14.1 million in overhead-related costs and an increase of $4.5 million in internal development-related third-party hosting fees. Sales and marketing Sales and marketing expenses increased $63.4 million or 25% during the year ended December 31, 2017, as compared to the year ended December 31, 2016, primarily due to an increase of $40.9 million in spend related to brand campaign fees, lead generation fees, and third-party sales representative fees. In addition, sales and marketing expenses increased due to $17.8 million in employee-related expenses excluding stock-based compensation, which was due to headcount growth. Stock-based compensation decreased $10.9 million due to the modification of an executive stock grant during 2016, that resulted in a charge of $18.8 million in that prior period. Sales and marketing expenses also increased $7.6 million due to an increase in overhead-related costs and an increase in app store fees as a result of increased sales. General and administrative General and administrative expenses increased $49.9 million or 46% during the year ended December 31, 2017, as compared to the year ended December 31, 2016, primarily due to an increase of $17.3 million in non-income based taxes as a result of the growth in our business. General and administrative expenses during 2016 included a $12.4 million benefit relating to a non-income based tax ruling. In addition, employee-related expenses increased $13.3 million during 2017, as compared to 2016, due to headcount growth, and other general and administrative expenses increased $11.3 million related to the funding of the Dropbox Charitable Foundation. Included in this amount was an equity-based charitable contribution of $9.4 million and cash contributions of $1.9 million. Further, general and administrative expenses increased $4.3 million due to legal-related expenses and accounting services. Interest income (expense), net Interest income (expense), net decreased $5.4 million during the year ended December 31, 2017, as compared to the year ended December 31, 2016, primarily due to a decrease in interest expense of $3.3 million due to fewer assets acquired under capital leases. In addition, interest income from our money market funds increased by $2.1 million. Other income, net Other income, net increased $8.3 million during the year ended December 31, 2017, as compared to the year ended December 31, 2016, primarily due to an increase of $8.6 million in foreign currency gains related to monetary assets and liabilities denominated in euros and British pound sterling. Provision for income taxes Provision for income taxes decreased by $5.0 million during the year ended December 31, 2017 as compared to the year ended December 31, 2016, primarily as a result of a change in our U.S. alternative minimum tax ("AMT") position. We were subject to U.S. AMT during 2016, and were not subject to U.S. AMT during 2017. In addition, as a result of the repeal of AMT as part of the Tax Reform Act, we recognized a benefit and established a receivable in 2017 to reflect anticipated refunds of our 2016 AMT credit carryforward. Quarterly Results of Operations The following table sets forth our unaudited quarterly statements of operations data for each of the last eight quarters ended December 31, 2018. The information for each of these quarters has been prepared on the same basis as the audited annual financial statements included elsewhere in this Annual Report on Form 10-K and, in the opinion of management, includes all adjustments, which includes only normal recurring adjustments, necessary for the fair statement of the results of operations for these periods. This data should be read in conjunction with our audited consolidated financial statements and related notes thereto included elsewhere in this Annual Report on Form 10-K. These quarterly results of operations are not necessarily indicative of our future results of operations that may be expected for any future period. (1) Includes stock-based compensation as follows: (2) During the three months ended March 31, 2018 we recognized the cumulative unrecognized stock-based compensation of $418.7 million related to our two-tier RSUs upon the effectiveness of our registration statement for our IPO. During the quarter, we also released 26.8 million shares of common stock underlying the vested two-tier RSUs, and as a result recorded $13.9 million in employer related payroll tax expenses associated with these same awards. Refer to "Significant Impacts of Stock-Based Compensation" included elsewhere in this Annual Report on Form 10-K for further information. (3) During the year ended December 31, 2017, our Board of Directors voted to approve a modification of vesting schedules for certain unvested one-tier and two-tier RSUs to align the vesting schedules for all RSUs to vest once per quarter. As a result, we recognized an incremental $10.0 million in stock-based compensation during the three months ended March 31, 2018. Refer to "Significant Impacts of Stock-Based Compensation" included elsewhere in this Annual Report on Form 10-K for further information. Quarterly revenue trends Our revenue increased sequentially in each of the quarters presented primarily due to increases in the number of paying users and increases in ARPU. Seasonality in our revenue is not material. Quarterly cost of revenue and gross margin trends Except for the three months ended March 31, 2018, our cost of revenue fluctuated in each of the quarters presented primarily due to the timing of our Infrastructure Optimization efforts, which combined with increases in our revenue caused our gross margins to increase or remain constant. In addition, our cost of revenue increased significantly, in absolute dollars and as a percentage of revenue, during the three months ended March 31, 2018, due to the completion of our initial public offering, as further described in "-Significant Impacts of Stock-Based Compensation". Quarterly operating expense trends Except for the three months ended March 31, 2018, our total quarterly operating expenses increased sequentially in the quarters presented primarily due to headcount growth in connection with the expansion of our business and other events that are discussed herein. In addition, our quarterly operating expenses increased significantly, in absolute dollars and as a percentage of revenue, during the three months ended March 31, 2018, due to the completion of our initial public offering, as further described in "-Significant Impacts of Stock-Based Compensation". Research and development Our research and development expenses increased at a faster rate during the three months ended March 31, 2018, comparatively to other quarters, primarily due to the completion of our initial public offering, as further described in "-Significant Impacts of Stock-Based Compensation". Sales and marketing Our sales and marketing expenses fluctuated in the quarters presented primarily due to employee-related expenses and brand advertising campaigns. The timing of brand advertising campaigns can impact the trends in sales and marketing expenses. Our sales and marketing expenses increased at a faster rate during the three months ended March 31, 2018, primarily due to the completion of our initial public offering, as further described in "-Significant Impacts of Stock-Based Compensation". General and administrative Our general and administrative expenses fluctuated in the quarters presented, primarily due to increases in employee-related expenses and legal, accounting, and other professional fees. Our general and administrative expenses for the three months ended June 30, 2017 included expense of $9.4 million for a non-cash charitable donation of shares of our common stock as initial funding for the Dropbox Charitable Foundation. Additionally, as a result of our initial public offering, and in the same quarter, we began recognizing stock-based compensation expense related to market-based awards granted to our co-founders in 2017 ("Co-Founder Grants"), as further described in "-Significant Impacts of Stock-Based Compensation". Liquidity and Capital Resources As of December 31, 2018, we had cash and cash equivalents of $519.3 million and short-term investments of $570.0 million, which were held for working capital purposes. Our cash, cash equivalents, and short-term investments consist primarily of cash, money market funds, corporate notes and obligations, U.S. treasury securities, U.S. agency obligations, commercial paper, and certificates of deposits. As of December 31, 2018, we had $133.8 million of our cash and cash equivalents held by our foreign subsidiaries. We do not expect to incur material taxes in the event we repatriate any of these amounts. On March 27, 2018, upon the completion of our IPO and concurrent private placement, we received aggregate proceeds of $638.2 million, net of underwriters' discounts and commissions. On March 28, 2018, the underwriters exercised their option to purchase an additional 5,400,000 shares of our Class A common stock. This transaction closed on April 3, 2018, resulting in additional proceeds of $108.4 million, net of underwriters' discounts and commissions. Our net proceeds from the IPO, the concurrent private placement, and underwriters' option totaled $746.6 million, before deducting offering costs of $6.9 million, net of reimbursements. Since our inception, we have financed our operations primarily through equity issuances, cash generated from our operations, and capital leases to finance infrastructure-related assets in co-location facilities that we directly lease and operate. We enter into capital leases in part to better match the timing of payments for infrastructure-related assets with that of cash received from our paying users. In our business model, some of our registered users convert to paying users over time, and consequently there is a lag between initial investment in infrastructure assets and cash received from some of our users. Our principal uses of cash in recent periods have been funding our operations, purchases of short-term investments, the satisfaction of tax withholdings in connection with the settlement of restricted stock units, making principal payments on our capital lease obligations, and capital expenditures. In April 2017, we entered into a $600.0 million credit facility with a syndicate of financial institutions. Pursuant to the terms of the revolving credit facility, we may issue letters of credit under the revolving credit facility, which reduce the total amount available for borrowing under such facility. The revolving credit facility terminates on April 4, 2022. In February 2018, we amended our revolving credit facility to, among other things, permit us to make certain investments, enter into an unsecured standby letter of credit facility, and increase our standby letter of credit sublimit to $187.5 million. We also increased our borrowing capacity under the revolving credit facility from $600.0 million to $725.0 million. We may from time to time request increases in the borrowing capacity under our revolving credit facility of up to $275.0 million, provided no event of default has occurred or is continuing or would result from such increase. Interest on borrowings under the revolving credit facility accrues at a variable rate tied to the prime rate or the LIBOR rate, at our election. Interest is payable quarterly in arrears. Pursuant to the terms of the revolving credit facility, we are required to pay an annual commitment fee that accrues at a rate of 0.20% per annum on the unused portion of the borrowing commitments under the revolving credit facility. In addition, we are required to pay a fee in connection with letters of credit issued under the revolving credit facility that accrues at a rate of 1.5% per annum on the amount of such letters of credit outstanding. There is an additional fronting fee of 0.125% per annum multiplied by the average aggregate daily maximum amount available under all letters of credit. The revolving credit facility contains customary conditions to borrowing, events of default, and covenants, including covenants that restrict our ability to incur indebtedness, grant liens, make distributions to our holders or our subsidiaries’ equity interests, make investments, or engage in transactions with our affiliates. In addition, the revolving credit facility contains financial covenants, including a consolidated leverage ratio covenant and a minimum liquidity balance. We were in compliance with all covenants under the revolving credit facility as of December 31, 2018. As of December 31, 2018, we had no amounts outstanding under the revolving credit facility and an aggregate of $68.5 million in letters of credit outstanding under the revolving credit facility. Our total available borrowing capacity under the revolving credit facility was $656.5 million as of December 31, 2018. We believe our existing cash and cash equivalents, together with our short-term investments, cash provided by operations and amounts available under the revolving credit facility, will be sufficient to meet our needs for the foreseeable future. Our future capital requirements will depend on many factors including our revenue growth rate, subscription renewal activity, billing frequency, the timing and extent of spending to support further infrastructure development and research and development efforts, the timing and extent of additional capital expenditures to invest in existing and new office spaces, such as our new corporate headquarters, the satisfaction of tax withholding obligations for the release of restricted stock units, the expansion of sales and marketing and international operation activities, the introduction of new product capabilities and enhancement of our platform, and the continuing market acceptance of our platform. We have and may in the future enter into arrangements to acquire or invest in complementary businesses, services, and technologies, including intellectual property rights. We may be required to seek additional equity or debt financing. In the event that additional financing is required from outside sources, we may not be able to raise it on terms acceptable to us or at all. If we are unable to raise additional capital when desired, our business, results of operations, and financial condition would be materially and adversely affected. Our cash flow activities were as follows for the periods presented: Operating activities Our largest source of operating cash is cash collections from our paying users for subscriptions to our platform. Our primary uses of cash from operating activities are for employee-related expenditures, infrastructure-related costs, and marketing expenses. Net cash provided by operating activities is impacted by our net loss adjusted for certain non-cash items, including depreciation and amortization expenses and stock-based compensation, as well as the effect of changes in operating assets and liabilities. For the year ended December 31, 2018, net cash provided by operating activities was $425.4 million, which mostly consisted of our net loss of $484.9 million, adjusted for stock-based compensation expense of $650.1 million and depreciation and amortization expenses of $166.8 million, and net cash inflow of $83.2 million from operating assets and liabilities. The inflow from operating assets and liabilities was primarily due to an increase of $66.4 million in deferred revenue from increased subscription sales, as a majority of our paying users are invoiced in advance. Additionally, cash provided by operating activities increased due to an increase in other operating assets and liabilities of $16.8 million. Our net cash provided by operating activities for the year ended December 31, 2018 also included a payment of $13.8 million of employer payroll taxes related to the release of our two-tier RSUs in connection with our IPO, which was paid in the first quarter of 2018. For the year ended December 31, 2017, net cash provided by operating activities was $330.3 million, which mostly consisted of our net loss of $111.7 million, adjusted for depreciation and amortization expenses of $181.8 million and stock-based compensation expense of $164.6 million, and net cash inflow of $81.3 million from operating assets and liabilities. The inflow from operating assets and liabilities was primarily due to an increase of $64.3 million in deferred revenue from increased subscription sales, as a majority of our paying users are invoiced in advance. The increase in net cash provided by operating activities during the year ended December 31, 2017, compared to the year ended December 31, 2016, was primarily due to a reduction of our net loss, as adjusted for stock-based compensation and depreciation and amortization expenses, as well as cash inflow from changes in operating assets and liabilities. For the year ended December 31, 2016, net cash provided by operating activities was $252.6 million, which primarily consisted of our net loss of $210.2 million, adjusted for depreciation and amortization expenses of $191.6 million and stock-based compensation expense of $147.6 million, as well as a net cash inflow of $118.8 million from operating assets and liabilities. The inflow from operating assets and liabilities was primarily due to an increase of $87.6 million in deferred revenue from increased subscription sales, as a majority of our paying users are invoiced in advance, and an increase of $35.6 million in accrued compensation and benefits due to the introduction of our annual bonus plan. Investing activities Net cash used in investing activities is primarily impacted by purchases of short-term investments, purchases of property and equipment to make improvements to existing and new office spaces, and for purchasing infrastructure equipment in co-location facilities that we directly lease and operate. For the year ended December 31, 2018, net cash used in investing activities was $633.8 million, which primarily related to purchases of short-term investments of $850.4 million and capital expenditures of $63.0 million related to our office and datacenter build-outs. These outflows were partially offset by inflows of $283.6 million related to proceeds from maturities and sales of short-term investments. For the year ended December 31, 2017, net cash used in investing activities was $23.9 million, which mostly consisted of capital expenditures related to our infrastructure equipment and office build-outs. The decrease in cash used in investing activities during the year ended December 31, 2017, compared to the year ended December 31, 2016, was primarily due to decreases in capital expenditures for infrastructure equipment and leasehold improvements related to our current corporate headquarters. For the year ended December 31, 2016, net cash used in investing activities was $118.0 million, which mostly consisted of capital expenditures related to our infrastructure and office build-outs. Financing activities Net cash provided by (used in) financing activities is primarily impacted by the completion of our IPO, repurchases of common stock to satisfy the tax withholding obligation for the release of RSUs and capital lease obligations for our infrastructure equipment. In 2017, we began releasing shares of common stock underlying vested one-tier RSUs, which generally have a service-based vesting condition over a four-year period and resulted in cash outflows to satisfy the employee tax withholding obligation for those employees who elected to net share settle their awards. See “-Significant Impacts of Stock-Based Compensation” for additional information. For the year ended December 31, 2018, net cash provided by financing activities was $300.8 million, which primarily consisted of $746.6 million in net proceeds from the completion of our IPO and concurrent private placement. The proceeds were offset by $351.9 million for the satisfaction of tax withholding obligations for the release of restricted stock units and $109.1 million in principal payments against capital lease obligations. For the year ended December 31, 2017, net cash used in financing activities was $231.7 million, which primarily consisted of $133.0 million in principal payments against capital lease obligations and $87.9 million for the satisfaction of tax withholding obligations for the release of restricted stock units. The increase in cash used by financing activities during the year ended December 31, 2017, compared to the year ended December 31, 2016, was primarily due to the increase of $87.9 million related to the satisfaction of tax withholding obligations for the release of restricted stock units. For the year ended December 31, 2016, net cash used in financing activities was $134.5 million, which primarily consisted of $137.9 million in principal payments against capital lease obligations and $3.8 million in principal payments against a note payable issued in 2015, offset by $8.8 million in proceeds received for a sale-leaseback agreement. Contractual Obligations Our principal commitments consist of obligations under operating leases for office space and datacenter operations, and capital leases for datacenter equipment. The following table summarizes our commitments to settle contractual obligations in cash as of December 31, 2018, for the periods presented below: (1) Consists of future non-cancelable minimum rental payments under operating leases for our offices and datacenters, excluding rent payments from our sub-tenants and variable operating expenses. As of December 31, 2018, we are entitled to non-cancelable rent payments from our sub-tenants of $43.5 million, which will be collected over the next 5 years. (2) Consists of future non-cancelable minimum rental payments under capital leases primarily for our infrastructure. (3) Consists of commitments to third-party vendors for services related to our infrastructure, infrastructure warranty contracts, asset retirement obligations for office modifications, and a note payable related to financing of our infrastructure. In addition to the contractual obligations set forth above, as of December 31, 2018, we had an aggregate of $68.5 million in letters of credit outstanding under our revolving credit facility. In May 2018, we amended our lease for our current corporate headquarters, modifying the original lease termination date from 2027 to 2019. As a result of the amendment, we expect to vacate our current corporate headquarters in August 2019, but are obligated to pay rent through February 2020. Accordingly, our future operating lease commitments were reduced by $192.4 million. The lease amendment did not have a material impact to our consolidated statement of operations in the year ended December 31, 2018, nor do we expect it to be material through our lease termination date in 2019. See Note 10, "Commitments and Contingencies" to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for further information. In 2017, we entered into a new lease agreement for office space in San Francisco, California, to serve as our new corporate headquarters. We took initial possession of our new corporate headquarters in June 2018 and began to recognize rent expense in the same period. Off-Balance Sheet Arrangements As of December 31, 2018, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or variable interest entities, which would have been established for the purpose of facilitating off balance sheet arrangements or other contractually narrow or limited purposes. Significant Impacts of Stock-Based Compensation Restricted Stock Units We have granted restricted stock units, or RSUs, to our employees and members of our Board of Directors under our 2008 Equity Incentive Plan, or 2008 Plan, our 2017 Equity Incentive Plan, or 2017 Plan and our 2018 Equity Incentive Plan, or 2018 Plan. We have two types of RSUs outstanding as of December 31, 2018: • One-tier RSUs, which have a service-based vesting condition over a four-year period. These awards typically have a cliff vesting period of one year and continue to vest quarterly thereafter. We recognize compensation expense associated with one-tier RSUs ratably on a straight-line basis over the requisite service period. • Two-tier RSUs, which have both a service-based vesting condition and a liquidity event-related performance vesting condition. These awards typically have a service-based vesting period of four years with a cliff vesting period of one year and continue to vest monthly thereafter. Upon satisfaction of the Performance Vesting Condition, these awards vest quarterly. The Performance Vesting Condition was satisfied upon the effectiveness of the registration statement related to our IPO. Our last grant date for two-tier RSUs was May 2015. We recognize compensation expense associated with two-tier RSUs using the accelerated attribution method over the requisite service period. Upon the effectiveness of the registration statement related to our IPO, we recognized stock-based compensation related to our two-tier RSUs using the accelerated attribution method, with a cumulative catch-up in the amount of $418.7 million attributable to service provided prior to such effective date. As of December 31, 2018, the unamortized stock-based compensation related to our two-tier RSUs was $0.1 million, which will be recognized if the requisite service is provided over a remaining weighted average period of 0.2 years. Co-Founder Grants In December 2017, the Board of Directors approved a grant to our co-founders of restricted stock awards, or RSAs, with respect to 14.7 million shares of Class A Common Stock in the aggregate, or collectively, the Co-Founder Grants, of which 10.3 million RSAs were granted to Mr. Houston, the Company’s co-founder and Chief Executive Officer, and 4.4 million RSAs were granted to Mr. Ferdowsi, the Company’s co-founder and Director. These Co-Founder Grants have service-based, market-based, and performance-based vesting conditions. While the Co-Founder Grants have certain stockholder rights prior to their vesting, such as the right to vote the shares with the other holders of our Class A common stock, the Co-Founder Grants will be excluded from Class A common stock issued and outstanding until the satisfaction of these vesting conditions. The Co-Founder Grants are eligible to vest over the ten-year period following the date the Company’s shares of Class A common stock began trading on the Nasdaq Global Select Market in connection with our IPO, which occurred on March 23, 2018. The Co-Founder Grants comprise nine tranches that are eligible to vest based on the achievement of stock price goals (each, a "Stock Price Target"), measured over a consecutive thirty-day trading period during the Performance Period, which will begin on January 1, 2019, as follows: During the first four years of the Performance Period, no more than 20% of the shares subject to each Co-Founder Grant would be eligible to vest in any calendar year. After the first four years, all shares are eligible to vest based on the achievement of the Company Stock Price Targets. The Co-Founder Grants contain an implied performance-based vesting condition that was satisfied on the date of our IPO. We estimated the grant date fair value of the Co-Founder Grants using a model based on multiple stock price paths developed through the use of a Monte Carlo simulation that incorporates into the valuation the possibility that the Stock Price Targets may not be satisfied. The average grant date fair value of each Co-Founder Grant was estimated to be $10.60 per share, and we will recognize total stock-based compensation expense of $156.2 million over the requisite service period of each tranche, which ranged from 2.9 to 6.9 years, using the accelerated attribution method. If the Stock Price Targets are met sooner than the derived service period, we will adjust our stock-based compensation to reflect the cumulative expense associated with the vested awards. We will recognize stock-based compensation expense if the requisite service period is provided, regardless of whether the market conditions are achieved. The performance vesting condition for the Co-Founder Grants was satisfied on the date that our shares of Class A common stock began trading on the Nasdaq Global Select Market in connection with our IPO. We recognized the cumulative unrecognized expense of our Co-Founder Grants of $10.6 million in the first quarter of 2018, using the accelerated attribution method, which increased our general and administrative expenses. Award Modifications During the year ended the year ended December 31, 2017, our Board of Directors voted to approve a modification of vesting schedules for certain unvested one-tier and two-tier RSUs to align the vesting schedules for all RSUs to vest once per quarter. The modification was effective February 15, 2018, which resulted in accelerated vesting of impacted RSUs that had met their service requirement as of that date. As a result, we recognized an incremental $10.0 million in stock-based compensation during the first quarter of 2018, which is included in the results for the year ended December 31, 2018, related to these modified RSUs. We do not expect to record incremental stock-based compensation related to this modification in future periods. See Note 1, “Description of the Business and Summary of Significant Accounting Policies” and Note 11, “Stockholders’ Equity” to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for more information regarding our equity awards. Critical Accounting Policies and Judgments Our consolidated financial statements and the related notes thereto included elsewhere in this Annual Report on Form 10-K are prepared in accordance with generally accepted accounting principles, or GAAP, in the United States. The preparation of consolidated financial statements also requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, costs and expenses, and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results could differ significantly from the estimates made by management. To the extent that there are differences between our estimates and actual results, our future financial statement presentation, financial condition, results of operations, and cash flows will be affected. We believe that the accounting policies described below 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 operations. Revenue recognition We generate revenue from sales of subscriptions to our platform. Subscription fees exclude sales and other indirect taxes. We determine revenue recognition through the following steps: • Identification of the contract, or contracts, with a customer • Identification of the performance obligations in the contract • Determination of the transaction price • Allocation of the transaction price to the performance obligations in the contract • Recognition of revenue when, or as, we satisfy a performance obligation Our subscription agreements typically have monthly or annual contractual terms, and a small percentage have multi-year contractual terms. Revenue is recognized ratably over the related contractual term generally beginning on the date that our platform is made available to a customer. Our agreements are generally non-cancelable. We typically bill in advance for monthly contracts and annually in advance for contracts with terms of one year or longer. Deferred commissions Certain sales commissions and the related payroll taxes earned by our outbound sales team, as well as commissions earned by third-party resellers, are considered to be incremental and recoverable costs of obtaining a contract with a customer. These costs are deferred and then amortized over a period of benefit that we have determined to be five years. We determined the period of benefit by taking into consideration our historical customer attrition rates, the useful life of our technology, and the impact of competition in our industry. Common stock valuations Since August 2015, we have granted RSUs as the only stock-based payment awards to our employees, excluding the Co-Founder Grants. While we stopped granting stock options in August 2015, we currently have stock options outstanding that will continue to vest through 2019 if the requisite service is provided. The fair values of the common stock underlying the RSUs prior to the date of our IPO were determined by our Board of Directors, with input from management and contemporaneous third-party valuations, which were performed at least quarterly. If RSUs were granted a short period of time prior to the date of a valuation report, we retrospectively assessed the fair value used for financial reporting purposes after considering the fair value reflected in the subsequent valuation report and other facts and circumstances on the date of grant as discussed below. Given the absence of a public trading market for our common stock prior to our IPO, and in accordance with the American Institute of Certified Public Accountants Practice Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, or AICPA Guide, our Board of Directors exercised reasonable judgment and considered numerous objective and subjective factors to determine the best estimate of the fair value of our common stock including: • The results of contemporaneous valuations of our common stock by unrelated third parties; • The rights, preferences, and privileges of our convertible preferred stock relative to those of our common stock; • Market multiples of comparable public companies in our industry as indicated by their market capitalization and guideline merger and acquisition transactions; • Our performance and market position relative to our competitors, who may change from time to time; • Our historical financial results and estimated trends and prospects for our future performance; • Valuations published by institutional investors that hold investments in our capital stock; • The economic and competitive environment; • The likelihood and timeline of achieving a liquidity event, such as an initial public offering or sale, given prevailing market conditions; • Any adjustments necessary to recognize a lack of marketability for our common stock; and • Precedent sales of or offers to purchase our capital stock. In valuing our common stock, our Board of Directors determined the fair value of our common stock using both the income and market approach valuation methods. The income approach estimates value based on the expectation of future cash flows that a company will generate. These future cash flows are discounted to their present values using a discount rate based on our weighted average cost of capital, and is adjusted to reflect the risks inherent in our cash flows. The market approach estimates value based on a comparison of the subject company to comparable public companies in a similar line of business. From the comparable companies, a representative market value multiple is determined and then applied to the subject company’s financial forecasts to estimate the value of the subject company. For valuations prior to August 31, 2017, the equity valuation was based on both the income and the market approach valuation methods, in addition to giving consideration to recent secondary sales of our common stock. The Option Pricing Method was selected as the principal equity allocation method. These methods were consistent with prior valuations. For valuations as of and subsequent to August 31, 2017, we have used a hybrid method to determine the fair value of our common stock, in addition to giving consideration to recent secondary sales of our common stock. Under the hybrid method, multiple valuation approaches were used and then combined into a single probability weighted valuation. Our approach included the use of initial public offering scenarios, a scenario assuming continued operation as a private entity, and a scenario assuming an acquisition of the company. Application of these approaches involves the use of estimates, judgment, and assumptions that are highly complex and subjective, such as those regarding our expected future revenue, expenses, and cash flows, discount rates, market multiples, the selection of comparable companies, and the probability of future events. Changes in any or all of these estimates and assumptions, or the relationships between those assumptions, impact our valuations as of each valuation date and may have a material impact on the valuation of common stock. For valuations after our initial public offering, our Board of Directors determines the fair value of each share of underlying common stock based on the closing price of our Class A common stock as reported on the date of the grant. Fair value of market condition awards The Co-Founder Grants contain market-based vesting conditions. The market-based vesting condition is considered when calculating the grant date fair value of these awards, which requires the use of various estimates and assumptions. The grant date fair value of the Co-Founder Grants was estimated using a model based on multiple stock price paths developed through the use of a Monte Carlo simulation that incorporates into the valuation the possibility that the market condition may not be satisfied. A Monte Carlo simulation requires the use of various assumptions, including our underlying stock price, volatility, and the risk-free interest rate as of the valuation date, corresponding to the length of time remaining in the performance period, and expected dividend yield. A Monte Carlo simulation also calculates a derived service period for each of the nine vesting tranches, which is the measure of the expected time to achieve the market conditions. Expense associated with market-based awards is recognized over the requisite service period of each tranche using the accelerated attribution method, regardless of whether the market conditions are achieved. Recent Accounting Pronouncements See Note 1, “Description of the Business and Summary of Significant Accounting Policies” to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for recently adopted accounting pronouncements and recently issued accounting pronouncements not yet adopted as of the date of this Annual Report on Form 10-K.
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<s>[INST] Overview Our modern economy runs on knowledge. Today, knowledge lives in the cloud as digital content, and Dropbox is a global collaboration platform where more and more of this content is created, accessed, and shared with the world. We serve more than 500 million registered users across 180 countries. Since our founding in 2007, our market opportunity has grown as we’ve expanded from keeping files in sync to keeping teams in sync. We believe the need for our platform will continue to grow as teams become more fluid and global, and content is increasingly fragmented across incompatible tools and devices. Dropbox breaks down silos by centralizing the flow of information between the products and services our users prefer, even if they’re not our own. By solving these universal problems, we’ve become invaluable to our users. The popularity of our platform drives viral growth, which has allowed us to scale rapidly and efficiently. We’ve built a thriving global business with 12.7 million paying users. Our Subscription Plans We generate revenue from individuals, teams, and organizations by selling subscriptions to our platform, which serve the varying needs of our diverse customer base. Subscribers can purchase individual licenses through our Plus and Professional plans, or purchase multiple licenses through a Standard, Advanced, or Enterprise team plan. Each team represents a separately billed deployment that is managed through a single administrative dashboard. Teams must have a minimum of three users, but can also have more than tens of thousands of users. Customers can choose between an annual or monthly plan, with a small number of large organizations on multiyear plans. A majority of our customers opt for our annual plans. We typically bill our customers at the beginning of their respective terms and recognize revenue ratably over the term of the subscription period. International customers can pay in U.S. dollars or a select number of foreign currencies. Our premium subscription plans, such as Professional and Advanced, provide more functionality than other subscription plans and have higher per user prices. Our Standard and Advanced subscription plans offer robust capabilities for businesses, and the vast majority of Dropbox Business teams purchase our Standard or Advanced subscription plans. While our Enterprise subscription plan offers more opportunities for customization, companies can subscribe to any of these team plans for their business needs. Our Customers Our customer base is highly diversified, and in the period presented, no customer accounted for more than 1% of our revenue. Our customers include individuals, teams, and organizations of all sizes, from freelancers and small businesses to Fortune 100 companies. They work across a wide range of industries, including professional services, technology, media, education, industrials, consumer and retail, and financial services. Within companies, our platform is used by all types of teams and functions, including sales, marketing, product, design, engineering, finance, legal, and human resources. Our Business Model Drive new signups We acquire users efficiently and at relatively low costs through wordofmouth referrals, direct inproduct referrals, and sharing of content. Anyone can create a Dropbox account for free through our website or app and be up and running in minutes. These users often share and collaborate with other nonregistered users, attracting new signups into our network. Increase conversion of registered users to our paid subscription plans We generate over 90% of our revenue from selfserve channelsusers who purchase a subscription through our app or website. We actively encourage our registered users to become paying users through inproduct prompts and notifications, timelimited free trials of paid subscription plans, email campaigns, and lifecycle marketing. Upgrade and expand existing customers We offer a range of paid subscription plans, from Plus and Professional for individuals to Standard, Advanced, and Enterprise for teams. We analyze usage patterns within our network and run hundreds of targeted marketing campaigns to encourage paying users to upgrade their plans. We prompt individual subscribers who collaborate with others on Dropbox to purchase our Standard or Advanced plans for a better team experience, and we also encourage existing Dropbox Business teams to purchase additional licenses or to upgrade to premium subscription plans. Key Business Metrics We review a number of operating and financial metrics, including the following key metrics to evaluate our business, measure our performance, identify trends affecting our business, formulate business plans, and make strategic decisions. Paying users We define paying users as the number of users who have active paid licenses for access to our platform as of the end of the period. One person would count as multiple paying [/INST] Positive. </s>
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